The Asset Allocation Debate: A Review and Reconciliation

October 2006
Journal of Financial Planning;Oct2006, Vol. 19 Issue 10, p52
Academic Journal
This paper reviews several aspects of the asset allocation debate and offers observations to reshape or provide a fresh perspective. The first area of exploration is the debate over the well-known 1986 study by Brinson, Hood, and Beebower, in which they contend that the changes in portfolio return variations over time can be explained by static index implementation of asset allocation versus active management. This is measured by the time-series R-squared. Critics have focused on the degree to which actual returns can be explained by asset allocation versus active management. This is measured by the cross-sectional R-squared. The paper contends that actual and policy returns may have a very high time-series R-squared and, at the same time, a very low cross-sectional R-squared, resulting in very different overall returns. The paper also confirms that the nature of the samples has influenced past results. The magnitudes of time-series and cross-sectional R-squared is lower for portfolios that engage in a greater degree of active management and which are less diversified. The debate should be refocused from R-squared to what really matters to investors: whether active management can increase risk-adjusted return. The paper finds that, on average, active management reduces return and increases volatility. Several proponents have suggested replacing static asset allocations with dynamic allocations, which change with expected returns and capital market opportunities. Although this premise is sound, dynamic asset allocation can enhance portfolio performance only if investors have the ability to consistently predict expected returns in financial markets.


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