There is a lot of research, both academic and professional, looking at the ability of an investor to "beat the index" adding value through either asset allocation or stock selection, or both. Let’s examine the evidence.
Asset allocation is the practice of mixing assets together to find an optimal balance of risk and return based on an investor’s investment profile. Asset allocation seeks to minimize risk while maximizing returns for each portfolio.
Stock selection is the process of identifying individual securities within a certain asset class that will make up the portfolio.
Asset allocation recognises the uncertainty in asset prices – that assets will vary in value depending on the market and economic conditions at any given time. For example, in market conditions when stocks perform well, bonds tend to perform less well, or when large-cap stocks outperform the market, small-cap stocks may underperform. In investment terms, these assets are not correlated.
Stock selection requires fundamental analysis and on-going due diligence. This approach assumes that the investor’s research provides useful information about the likely future direction of prices. Stock-pickers can choose to focus on one or a combination of different strategies – value, growth, momentum, market capitalisation, regional, thematic – in order to try and outperform their chosen market.
What does the academic research tell us about the likely success?
Academic studies tend to conclude that asset allocation is a much larger determinant of investment performance than individual stock selection. While it may be true that a portfolio of well-chosen stocks has the opportunity to outperform the market index, this assumes that the manager has consistently made the correct decisions across a number of areas: chosen the right weighting between holdings, timed the entry and exit point well, efficiently weighed up the risk and return and, ultimately, selected the right companies to outperform.
To illustrate this in our UK home market, the total return of the FTSE 100 and its constituents in the year to 31 March 2019 was +7.6%, with the top ten stocks on average up +65.3% and the bottom ten stocks on average down -27.1%.
Overall, the number of stocks in the index outperforming was 49 (out of 100) and the average weight of these 49 stocks was 61.5%. In this environment, an active manager would have roughly a 50% chance of outperforming the market if holding half of the index, with that likelihood falling the fewer stocks held.
Market selection matters
At a geographic level the UK market has been one of the most unloved areas for investment by institutional money managers (BAML surveys suggest managers have never been more underweight), and this has had an impact on its relative performance compared to other regions.
On a global basis, the difference in performance between regions over the past ten years has been marked. The graph below shows the US leading the charge (blue line) compared to one of the weaker regions, emerging markets (green). The pink line shows the MSCI AC World Index excluding the US.
Source: Schroders, FactSet in USD as at 31 March 2019. MSCI indices are net dividend re-invested. The sectors, securities, regions and countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell. Relative to the MSCI AC World (NDR).
Drilling down into the figures at a fund level, the poorest-performing US active equity manager returned +218.9% over ten years to 31 March 2019, while the best performing emerging market manager returned +219.3% over the same period1.
In this example, market selection would have had a far greater impact on returns than stock selection.
The danger, of course, is that investors either miss returns by not having a diversified allocation or perhaps end up chasing historic market outperformance to the detriment of better opportunities elsewhere – this is where we believe active management will help add value and why asset allocation is held to be so beneficial to overall returns.
While the past ten years have seen positive performance from developed equity markets, driven by strong US equity performance, there have been periods where having allocations to other asset classes will have been beneficial.
In the ten-year period to 31 December 2018, and using one-year rolling performance data (monthly total returns in GBP), there have been 26 instances where cash (3-month LIBOR) has outperformed global equities (MSCI AC World) and 28 instances where cash has outperformed UK government bonds (FTA British Govt. All Stocks). This suggests that, using this dataset, roughly 20% of the time having an exposure to an asset other than equities would have been a positive to portfolio performance.
Breaking the above time period down further, the worst month’s performance for equities was -28% in February 2009, while bonds were +8% and cash +5%.
While we have yet to see protracted falls of a similar magnitude since that date, there have been periods subsequently where equity returns have been negative while bonds and cash produced positive returns.
Going back further, a wide-ranging academic research paper analysing market returns between 1991 and 2011 suggested that during periods of extended market stress the monthly difference between portfolios that allocated assets well versus those that did it poorly was meaningful. The analysis covered markets including Australia, Germany, Japan, UK and US and concluded that over the entire period the difference between the top and bottom 5% of portfolios asset allocating well was 2.0% per month whereas the difference between the top and bottom 5% of portfolios where stock selection was the key driver was 1.6% per month. While there is clearly a danger of backward-looking analysis the trends seen are fairly consistent throughout a number of market environments.
The evidence does suggest that both asset allocation and stock selection can add value, although empiric analysis suggests that investors stand to benefit more from asset allocation than stock selection.
The challenge for investors is to identify successful asset allocators and stock selectors ahead of time. We believe in the importance of a rigorous and repeatable investment process, analysing economics, valuations, sentiment and risks throughout the business cycle.
Our fund selection process seeks to identify managers who we think are likely to add active value. We diversify across both asset classes and managers to help offset volatility and offer a level of diversification to returns that we believe will benefit our investors over the long-term.
Ben joined Schroders in 2009 and currently works as a Portfolio Manager within the Charities team. Alongside managing client portfolios, he sits on the Charity Investment Committee and the UK Equity, Global Equity and Property Asset Class Committees. Ben is a Chartered Wealth Manager and holds the IMC and PCIAM qualifications. He studied Classics at Royal Holloway, University of London.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.