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Determinants of Portfolio

In order to delineate investment responsibility and measure performance contribution, pension plan sponsors
and investment managers need a clear and relevant method of attributing returns to those activities that
compose the investment management process investment policy, market timing and security selection. The
authors provide a simple framework based on a passive, benchmark portfolio representing the plan´s long-term
asset classes, weighted by their long-term allocations. Returns on this ´”investment policy” portfolio are
compared with the actual returns resulting from the combination of investment policy plus market timing (over
or under weighting asset classes relative to the plan benchmark) and security selection (active selection within
an asset class).
Data from 91 large U.S. pension plans over the 1974-83 period indicate that investment policy dominates
investment strategy (market timing and security selection), explaining on average 93.6 percent of the variation in
total plan return. The actual mean average total return on the portfolio over the period was 9.01 percent, versus
10.11 percent for the benchmark portfolio. Active management cost the average plan 1.10 percent per year,
although its effects on individual plans varied greatly, adding as much as 3.69 percent per year. Although
investment strategy can result in significant returns, these are dwarfed by the return contribution from
investment policy – the selection of asset classes and their normal weights.

is to rank in order of importance the decisions made

A recent study indicates that more than 80 by investment clients and managers, and then to
percent of all corporate pension plans with assets measure the overall importance of these decisions
greater than $2 billion have more than 10 managers, to actual plan performance.
and of all plans with assets greater than $50 million, Table I illustrates the framework for analyzing
less than one-third have only one investment portfolio returns. Quadrant I represents Policy. Here
manager.1 Many funds that employ multiple we would place the fund´s benchmark return for the
managers focus their attention solely on the period, as determined by its long-term investment
problem of manager selection. Only now are some policy.
funds beginning to realize that they must develop a A plan´s benchmark return is a consequence of the
method for delineating responsibility and investment policy adopted by the plan sponsor.
measuring the performance contribution of those Investment policy identifies the long-term asset
activities that compose the investment management allocation plan (included asset classes and normal
process – investment policy, market timing and weights) selected to control the overall risk and
security selection. 2 meet fund objectives. In short, policy identifies the
The relative importance of policy, timing and entire plan´s normal portfolio.4 To calculate the
selection can be determined only if we have a clear policy benchmark return, we need (1) the weights
and relevant method of attribution return to these of all asset classes, specified in advance, and (2) the
factors. This article examines empirically the passive (or benchmark) return assigned to each
effects of investment policy, market timing and asset class. 5
security (or manager) selection on total portfolio Quadrant II represents the return effects of Policy
return. Our goal is to determine, from pension and Timing. Timing is the strategic under or over
plans, which investment decisions had the greatest weighting of an asset class relative to its normal
impacts on the magnitude of total return and on the weight, for purposes of return enhancement and/or
variability of that return. risk reduction. Timing is undertaken to achieve
incremental returns relative to the policy return.
A Framework for Analysis Quadrant III represents returns due to Policy and
We develop below a framework that can be used to Security Selection. Security selection is the active
decompose total portfolio returns. Conceptually selection of investments within an asset class. We
valid, yet computationally simple, this framework define it as the portfolio ´s actual asset class returns
has been used successfully by a variety of (e.g., actual returns to the segments of common
institutional pension sponsors, consultants and stocks and bonds) in excess of those classes´
investment managers; it is currently being used to passive benchmark return and weighted by the
attribute performance contributions in actual normal total fund asset allocations.
portfolios. Quadrant IV represents the actual return to the total
Performance attribution, while not new, is still an fund for the period. This is the result of the actual
evolving discipline. Early papers on the subject, portfolio segment weights and actual segment
focusing on risk-adjusted returns, suggested the returns.
initial framework, but paid little attention to Table II presents the methods for calculating the
multiple asset performance measurement.3 Our task values for these quadrants. Table III gives the
computational method for determining the active “other” weight proportionally across the remaining
returns (those returns due to investment strategy). asset classes. The bottom panel of Table IV gives
Our framework clearly differentiates between the the weighting information.
effects of investment policy and investment Table IV also gives the market indexes used as
strategy. Investment strategy is shown to be passive benchmark returns.7 For common stocks,
composed of timing, security (or manager) we used the S&P 500 composite index total return.
selection, and the effects of a cross-product term. The S&P comes under frequent attack for not being
We can calculate the exact effects of policy and representative of the U.S. equity market. We
strategy using the algebraic measures given. nevertheless selected it, for several reasons. First,
the S&P is still quoted and used as a benchmark by
Data many plan sponsors. This indicates its continued
To test the framework, we used data from 91 acceptance. Second, it is one of the few indexes
pension plans in the SEI Large Plan Universe. SEI known over the entire study period, and actually
has developed quarterly data for a complete 10-year available for investment by plan sponsors via, for
(40-quarter) period as the beginning of the period example, index funds. Third, the S&P 500 does not
for study. suffer from the lack of liquidity that affects some
In order to be selected, a plan had to satisfy several segments of the broader market indexes. For
criteria. Each plan had to have been a corporate completeness, however, we recomputed all the
pension trust with investment discretion solely in calculations performed below using the Wilshire
the hands of the corporation itself (i.e., no 5000 Capitalization Weighted Total Return Index in
employee-designated funds). Large plans were used place of the S&P, the results were virtually
because only those plans had sufficient return and identical.
investment weight information to satisfy our We chose the Shearson Lehman Government/
computational needs. Public and multi-employer Corporate Bond Index (SLGC) for the bond
plans were excluded, because legislative, legal or component passive index, this is representative of
other constraints could have dramatically altered all publicly traded, investment-grade bonds
their asset mixes from what might have obtained. (excluding mortgage-backed securities) with a
The sample represents a major portion of the large maturity of at least one year and a minimum par
corporate pension plans of SEI´s clients over the amount outstanding of $1 million. We used the total
10-year period. The market capitalization of return on a 30-day Treasury bill for cash
individual plans in the universe ranges from equivalents.
approximately $100 million at the beginning of the
study period to well over $3 billion by its end. Results
Table IV summarizes the data collected from each To analyze the relative importance of investment
plan. Normal weights for each asset class for each policy versus investment strategy, we began vu
plan were not available. We thus assumed that the calculating the total returns for each of our 91
10-year mean average holding of each asset class annualized compound total 10-years rates of return
was sufficient to approximate the appropriate for each quadrant.
normal holding.6 Portfolio segments consisted of The mean average annualized total return over the
common stocks, marketable bonds (fixed income 10-year period (Quadrant IV) was 9.01 percent.
debt with a maturity of at least one year, and This is the return to the entire plan portfolio, not
excluding private placements and mortgage-backed just the common stock/ bonds/ cash equivalents
securities), cash equivalents (fixed income portion of the plan.8 The average plan lost 66 basis
obligations with maturities less than one year) and a points per year in market timing and lost another 36
miscellaneous category, “other,” including basis points per year from security selection. The
convertible securities, international holdings, real mean average annualized total return for the normal
estate, venture capital, insurance contracts, plan policy (passive index returns and average
mortgage-backed bonds and private placements. weighting) for the sample was 10.11 percent
Because a complete history of the contents of the (Quadrant I).
“other” component is not available for many plans, Active management (and therefore its control) is
we elected to exclude this segment from most of the clearly important. But how important is it relative
analysis. We instead calculated a common stock/ to investment policy itself? The relative magnitudes
bonds/ cash equivalent sub-portfolio for use in all indicate that investment policy provides the larger
quadrants except the total fund actual return; here portion of return. This is not surprising in itself, and
we used the actual return as reported (including most would not disagree that the “value added”
“other”). We constructed the sub-portfolio by from active management is small (though
eliminating the “other” investment weight from important) relative to asset class returns as a whole.
each plan in each quarter and calculating new However, what does it imply? It implies that is the
weights and portfolio returns for the components normal asset class weights and the passive asset
that remained, this had the effect of spreading the
classes themselves that provide the bulk of return to The first two decisions are properly part of
a portfolio. investment policy; the last two reside in the
Note that the range of outcomes and standard sphere of investment strategy. Because of its
deviations of policy returns is small, reflecting the relative importance, the investment policy
historical tendency of similar (large, corporate) should be addressed carefully and
plans to gravitate toward the same policy allocation systematically by investors.
decision, we would see less of a tendency to cluster Future attempts to quantify the importance of
asset mix policy according to “peer imitation” or investment management decisions to portfolio
“conventional” investment postures. performance would benefit from an
examination of the integration of investment
Return Variation policy and investment strategy. An explicit
The ability of investment policy to dictate actual delineation and recognition of the links
plan return requires further analysis. Table VII between investment policy and investment
examines the relative amount of variance strategy would help to clarify further the role
contributed by each quadrant to the return to the of both activities in the investment process. A
total portfolio. It thus addresses directly the relative simple and accurate, yet complete and
importance of the decisions affecting total return. measurable, representation of the investment
The figures here represent the average amounts of decision-making process would further our
variance of total portfolio return explained by each understanding of the importance of the various
of the quadrants. They were calculated by components of investment activity and, we
regressing each plan´s actual total return (Quadrant hope, lead to a concise and integrated
IV) against, in turn, its calculated common stocks/ framework of investment responsibility.
bonds/ cash equivalents investment policy return
(Quadrant I), policy and timing return (Quadrant II)
and policy and selection return (Quadrant III). The
value in each quadrant thus has 91 regression 1
equations behind it, and the number shown is the SEI Corporation, “Number of Managers by Plan
average or 91 unadjusted R-squares of the Size” (Wayne, Pennsylvania, 1985), p. 1.
regressions.9 The results are striking. Naturally, the See, for example, W.R. Good, “Accountability
total plan performance explains 100 percent of for Pension Performance,” Financial Analysts
itself (Quadrant IV). But the investment policy Journal, January/ February 1984, pp. 39-42.
return in Quadrant I (normal weights and market Early works include E.F. Fama, “Components of
index returns) explained on average fully 93.6 Investment Performance,” Journal of Finance, June
percent of the total variation in actual plan return, in 1972, pp. 551-567, and M.C. Jensen, “The
particular plans it explained no less than 75.5 Performance of Mutual Funds in the Period 1945-
percent and up to 98.6 percent of total return 1964,” Journal of Finance, May 1968, pp. 389-416.
variation. Returns due to policy and timing added Some more recent works have clearly forged ahead.
modesty to the explained variance (95.3 percent), as As an excellent example, see J.L. Farrell, Jr. Guide
did policy and security selection (97.8 percent). to Portfolio Management (New York: McGraw-
Tables VI and VII clearly show that total return to a Hill, 1983), pp. 321-339.
plan is dominated by investment policy decisions. For a clear treatment of policy versus strategy, see
Active management, while important, describes far D.A. Love, “Editorial Viewpoint,” Financial
less of a plan´s returns than investment policy. Analysts Journal, March/ April 1977, p. 22. For a
discussion of normal portfolios, see A. Rudd and
Implications H.K. Clasing, Jr., Modern Portfolio Theory
Design of a portfolio involves at least four steps: (Homewood, III: Dow Jones-Irwin, 1982), pp. 71-
o deciding which asset classes to include 72.
and which to exclude from the portfolio; We say “specified” even though the actual
o deciding upon the normal, or long-term, weights may not be known in advance; this
weights for each of the asset classes accounts for those who wish to use portfolio
allowed in the portfolio; insurance techniques. In our view, these techniques
o strategically altering the investment mix are more ones of active asset allocation (market
weights away from normal in an attempt timing) than investment policy. We view
to capture excess returns from short-term investment policy as having an indefinite time
fluctuations in asset class prices (market horizon, as opposed to a specific, though
timing); and extendable, one.
o selecting individual securities within an Throughout this article we will use the terms
asses class to achieve superior returns “normal,” “benchmark” and “passive”
relative to that asset class (security interchangeably. For a detailed description on how
selection). an investment policy can be derived, see G.P.
Brinson. J.J. Diermeier and G.G. Schlarbaum, “A
Composite Portfolio Benchmark for Pension
Plans,” Financial Analysts Journal, March/ April
While this is clearly a simplification, we are
unable to address more accurately the problem of
normal weights. Since 10 years covers several
business cycles, and since the average standard
deviation of asset class holdings for common stocks
and bonds is not high relative to the average
amounts held, this is probably not a serious
problem in the analysis.
Data for benchmark returns were provided by
R.G. Ibbotson & Associates (Chicago, III.) and
Shearson/ Lehman American Express (New York).
We also calculated the stock/ bonds/ cash
equivalents return series and, in all of the analysis
that follows, also used that actual fund return;
results were similar in all cases.
By “unadjusted,” we mean that the R-squared
measures are not adjusted for degrees of freedom;
thus, for our three simple regression models, the R-
squared represents a square of the correlation
coefficient, and represents the amount of variance
of total return explained in excess of the average.
While the average of the quarterly total returns may
not be predictable, it is nonetheless of interest ex
post and, in essence, can be specified by the passive
portfolio that, when established, becomes the
relevant benchmark for any further comparison.