(October 29, 2012) — How important is strategic asset allocation for the overall performance of an investment portfolio?
The answer: Really important.
According to one academic paper, the impact of strategic asset allocation on total returns of investment portfolios is striking, confirming the results of previous studies that found strategic asset allocation dominating the other investment decisions such as market timing and security selection. Using data from Australian managed funds, strategic asset allocation is found to account for most of the total returns in terms of magnitude and around 88% of the variability in total portfolio returns, the paper’s author Lujer Santacruz, a professor at Australia-based University of Southern Queensland.
However, the author also concluded that strategic asset allocation plays a greater role as the proportion of risky assets in the portfolio increases. Titled “Strategic Asset Allocation and Portfolio Performance,” Santacruz theorized that it may be more important to adopt a strategic asset allocation with risky portfolios so that mean reversion in the returns of the risky asset classes is better realized in the long term.
Shedding light on potential critics of his research, the author explained that literature suggests active investment management in terms of market timing and security selection does not conclusively add returns to passive investment management. A study among Australian pension funds found that fund managers do not exhibit significantly positive market timing or security selection skill. Another study among Australian managed funds showed that active managers have been unable to deliver superior returns through tactical asset allocation, which is somewhat equivalent to market timing.
The paper concluded by outlining the limitations of the study, namely that it only accounted for Australian managed funds. The total size of these funds, A$2.9 billion, although significant is still just a drop in the bucket, the author said. “The size of the Australian managed fund industry is currently estimated at A$1.9 trillion…Although it has generated some useful general conclusions, this paper mainly serves as a starting point for conducting a more thorough study of the Australian investment environment as far as the importance of strategic asset allocation is concerned. Further research will be carried out using similar data that can be obtained from other fund managers.”