The decisions you make about portfolio structure will have a greater impact on your portfolio’s returns and risks than stock selection, trading or just about anything else. Several academic studies have empirically demonstrated this fact, including two that show that all of the average portfolio’s return, and as much as 90 percent of its variability over time (i.e. risk), are explained by portfolio structure. This may surprise some readers, especially those who have been in the habit of taking hot tips from stock brokers. But if you want to be a better investor, you need to break the hot tip habit and focus on portfolio structure.
What is portfolio structure?
Portfolio structure refers to the strategic composition of your portfolio and answers questions such as:
- What return does my portfolio need to earn in order to accomplish my goals?
- What portfolio structure can deliver that return with the least amount of risk?
- How much of my portfolio should I invest in stocks?
- How much should be in bonds or money market funds?
- Should I invest in the United States or overseas?
- Should the bond maturities be longer or shorter?
- How much of my portfolio can I invest in illiquid assets?
Answering these questions thoroughly will require effort on your part to understand your goals and time horizons. In our experience, investors who take the time to answer the questions of portfolio structure are better able to withstand challenging market environments. In other words, they become much better investors.
The academic evidence
The first academic study to address the importance of portfolio structure was published in 1986 by Gary Brinson, Randolph Hood, and Gilbert Beebower in the Financial Analysts Journal. Their article, “Determinants of Portfolio Performance,” looked at quarterly returns of 91 large U.S. pension funds from 1974 to 1983. They found that, on average, 93.6 percent of the variation in portfolio returns was explained by portfolio structure.
In 1991, Brinson and his colleagues updated the study with quarterly returns of 82 large U.S. pension funds from 1978 to 1987. This updated study estimated that 91.5 percent of the variability in returns across time was explained by portfolio structure. These two studies ignited a firestorm within finance and investment circles. The findings directly challenged the underpinnings of an entire industry. If the authors were correct, why bother with stock picking or market timing?
In a 1999 article for the Journal of Portfolio Management, Ronald Surz, Dale Stevens and Mark Wimer took a closer look at the Brinson study. They noted that the critics of the Brinson study based their criticism on a mischaracterization of Brinson’s conclusions. Brinson and his colleagues never made any statement about drivers of performance. Their work focused on variations in returns. To Surz, Stevens and Wimer, the Brinson study stopped short of answering the real question: How much of a portfolio's return did asset allocation explain?
To answer this question, Surz et al. recognized that the total return of a portfolio could be broken down into two parts, the return from asset allocation and the return from active management decisions (i.e., market timing, stock selection, trading, etc.). If they could calculate the return from the portfolio’s asset allocation, any excess return beyond the asset allocation return could be ascribed to active management.
The authors looked at 10 years of monthly returns for 94 U.S. balanced mutual funds in the Morningstar database and 5 years of quarterly returns for 53 U.S. pension funds. The endpoint for both studies was 31 March 1998. They calculated the portfolio return for each portfolio by measuring the performance of a portfolio of index funds held in proportion to the portfolio’s asset allocation. They then compared the portfolio returns with the asset allocation returns and found that, on average, asset allocation returns were higher than the portfolio returns. In other words, active management decisions such as stock selection and market timing, together with trading costs and management fees, subtracted from portfolio performance for all but a few of the very top performing funds. Even among the best funds, active management explained only 15 percent of the returns. Active portfolio management decisions added little or no value.
The academic evidence could not be clearer. The decisions you make regarding the structure of your portfolio will have far greater impact on your performance and risk than anything else you will do. It pays to make these decisions carefully.