Background to the study

The study "Determinants of Portfolio Performance" by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, published in the "Financial Analysts Journal" in 1986, sought to isolate and measure the contribution of the various components of investment portfolio management - namely investment policy, market timing and security selection - to the overall performance of U.S. pension fund portfolios. The researchers used historical data from 1974 to 1983, covering 91 large pension funds in the USA.

The methodology adopted involved comparing actual portfolio returns with those of a passive benchmark portfolio, representing long-term asset classes and weighted according to their long-term allocations. This approach made it possible to attribute returns to the various investment management activities. The data were analyzed using regressions to determine the proportion of the total variation in returns explained by each component.

Results of the study

The diagram below shows the attribution of pension fund returns according to stock selection and timing parameters.

  • Quadrant I represents the returns attributable to capital allocation between different asset classes with complete passivity on timing and stock selection.
  • Quadrant II illustrates the effects of timing and capital allocation on returns. Timing refers to the strategic overweighting or underweighting of an asset class relative to its normal weighting, with the aim of enhancing returns or reducing risk.
  • Quadrant III represents returns attributable to security selection and capital allocation. Security selection is the active choice of investments within an asset class. It is defined as the actual returns of the portfolio's asset class (for example, the actual returns of the common stock and bond segments) exceeding the returns of the passive benchmarks of these classes, weighted according to the total fund's normal asset allocations.
  • Quadrant IV illustrates the total fund's actual return for the given period.

Source: Determinants of Portfolio Performance

The results of the study revealed that investment policy (capital allocation) was the dominant factor, explaining on average 93.6% of total fund performance. The funds' annualized real return (Quadrant IV) averaged 9.01%, compared with 10.11% if they had opted for a passive strategy in terms of timing and stock selection (Quadrant I). Active management therefore "cost" the funds an average of 1.10% per annum, although the effect varied considerably from case to case, ranging from -4.17% to +3.69% per annum. Market-timing and stock selection had less impact than capital allocation.

Source: Determinants of Portfolio Performance

Contributions of the study to the field of stock market investing

This study has made a significant contribution to the understanding of investment portfolio performance. It has highlighted the crucial importance of investment policy on overall performance, compared to other aspects of active management. For investors, this means that the construction of an investment portfolio should focus primarily on the selection and weighting of long-term asset classes.

In practice, investors should pay particular attention to capital allocation when designing their portfolios, carefully selecting the asset classes to be included in their portfolios and determining their weights. Market timing and stock selection decisions, while relevant, should be considered secondary to investment policy.

This also implies that investors should evaluate the performance of their asset managers not only on the basis of absolute returns, but also by taking into account how these returns compare to a passive benchmark portfolio. For example, an investment fund specializing in US technology stocks with an annualized return of 14% over the past 10 years has nothing to boast about when compared with an annualized return of 18% for the Nasdaq-100 and 20.7% for the MSCI USA Information Technology. On the other hand, an investment fund specializing in European small caps, which has generated an annualized return of 14% over the past decade, has much to boast about when compared with the MSCI Europe Small Cap, which has returned around 5% per annum.

The Brinson, Hood and Beebower study, although dating back to 1986, reinforced the idea that the key to stock portfolio performance lies more in capital allocation than in stock selection and market-timing. This study was updated in 1991 with an analysis of the performance of 82 pension funds between 1977 and 1987, and confirms the same conclusions.

In short, if you want to achieve decent returns on the stock market, start by investing (rather than holding lots of cash and trying to "time" the market), and focus on diversifying your portfolio: diversification by asset class, but also by geography, sector, company size, risk/volatility, and so on.