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The investment industry has investors convinced that the only path to better performance is through stock selection. As a result, most investors approach the challenges of portfolio construction exactly backward and miss out on the most important opportunities to produce differentiated performance. The purpose of this series is to challenge the conventions that lead to misguided asset allocation priorities and offer compelling reasons for practitioners to reverse their thinking, with the goal of delivering better outcomes for investors.
And so, before we jump into today’s topic, here’s an important guide to the longest-running, and perhaps most important debate in investment management: What is the relative importance of asset allocation versus security selection?
Reminder: We Updated Grinold’s Fundamental Law Using Principal Component Analysis
To review, Part I of this series introduced Grinold’s Fundamental Law of Active Management. Grinold proved that an investor’s opportunity to generate performance depends largely on the number of diverse investments that are available to construct portfolios. All else equal, an investor with more diverse investment choices should outperform an investor with fewer choices.
In Part II, we explained how to determine the number of truly independent sources of return in a portfolio. We used a technique called principal component analysis, and demonstrated how to isolate equity ‘beta’ from the returns of the 30 Dow stocks. We also illustrated why, according to a simple interpretation, the Dow 30 stocks are explained by just 3 independent sources of return, and why, using a higher bar, that could be reduced to a single source.
Here, in Part III, we use the framework described in Part II, along with some assumptions about the relationships between global asset classes, to illustrate the relative importance of asset allocation relative to security selection for an unconstrained strategy, such as Global Tactical Asset Allocation. We approach the problem from a theoretical perspective in order to capture the full opportunity set that is available to investors who focus in each domain. In addition, we quantify the proportion of global portfolio breadth that is available to active asset allocators versus stock-pickers given a range of correlation assumptions.
We find…continue reading here…