1985-1994

Determinants of Portfolio Performance

Gary P: Brinson, L. Randolph Hood, and Gilbert L. Beebower

A recent study indicates that more than 80 per Table I illustrates the framework for analyzing
,cent of all corporate pension plans with as.sets portfolio returns. Quadrant I represents policy.
greater than $2 billion have more than 10 manag- Here we would place the fund's benchmark return
ers, and of all plans with assets greater than $50 for the period, as determined by its long-term
million, less than one-third have only one invest- investment policy.
ment manager. ~ Many funds that employ multiple A plan's benchmark return is a consequence
managers focus their attention solely on the prob- of the investment policy adopted by the plan spon-
lem of manager selection. Only now are some sor. Investment policy identifies the long-term
funds beginning to realize that they must develop asset allocation plan (included asset classes and
a method for delineating responsibility and mea- normal weights) selected to control the overall risk
suring the performance contribution of those ac- and meet fund objectives. In short, policy identi-
tivities that compose the investment management fies the entire plan's normal portfolio. 4 To calculate
process---investment policy, market timing and the policy benchmark return, we need (1) the
security selection. 2 weights of all asset classes, specified in advance,
The relative importance of policy, timing and and (2) the passive (or benchmark) return assigned
selection can be determined only if we have a clear to each asset class. 5
and relevant method of attributing returns to these Quadrant II represents the return effects of
factors. This article examines empirically the ef- policy and timing. Timing is the strategic under or
fects of investment policy, market timing and overweighting of an asset class relative to its nor-
security (or manager) selection on total portfolio mal weight, for purposes of return enhancement
return. Our goal is to determine, from historical
and/or risk reduction. Timing is undertaken to
investment data on U.S. corporate pension plans,
achieve incremental returns relative to the policy
which investment decisions had the greatest im-
return.
pacts on the magnitude of total return and on the
Quadrant III represents returns due to policy
variability of that return.
and security selection. Security selection is the
A FRAMEWORK FOR ANALYSIS active selection of investments within an asset
We develop below a framework that can be used to class. We define it as the portfolio's actual asset
decompose total portfolio returns. Conceptually class returns (e.g., actual returns to the segments
valid, yet computationally simple, this framework of common stocks and bonds) in excess of those
has been used successfully by a variety of institu- classes' passive benchmark returns and weighted
tional pension sponsors, consultants and invest- by the normal total fund asset allocations.
ment managers; it is currently being used to at- Quadrant IV represents the actual return to
tribute performance contributions in actual the total fund for the period. This is the result of
portfolios. the actual portfolio segment weights and actual
Performance attribution, while not new, is still segment returns.
an evolving discipline. Early papers on the subject, Table 2 presents the methods for calculating
focusing on risk-adjusted returns, suggested the the values for these quadrants. Table 3 gives the
initial framework, but paid little attention to mul- computational method for determining the active
tiple asset performance measurement. 3 Our task is returns (those returns due to investment strategy).
to rank in order of importance the decisions made Our framework clearly differentiates between
by investment clients and managers, and then to the effects of investment policy and investment
measure the overall importance of these decisions strategy. Investment strategy is shown to be com-
to actual plan performance. posed of timing, security (or manager) selection,
and the effects of a cross-product term. We can
Reprintedfrom FinancialAnalystsJournal (July~August1986):39- calculate the exact effects of policy and strategy
44. using the algebraic measures given.

Financial Analysts Journal/January-February 1995 133

© 1995, AIMR®
1985-1994

Table 1. A Simplified Framework for Retum In o r d e r to be selected, a p l a n h a d to satisfy

AccoumaUHty several criteria. Each p l a n h a d to h a v e b e e n a
Selection corporate p e n s i o n trust w i t h i n v e s t m e n t discretion
Actual Passive solely in the h a n d s of the c o r p o r a t i o n itself (i.e., no
(IV) (II) e m p l o y e e - d e s i g n a t e d funds). Large p l a n s w e r e
Actual Policy and u s e d b e c a u s e only those plans h a d sufficient re-
bt) < Portfolio Timing t u r n a n d i n v e s t m e n t w e i g h t i n f o r m a t i o n to satisfy
Return Return o u r c o m p u t a t i o n a l needs. Public a n d m u l t i - e m -
(III) (i) p l o y e r plans w e r e excluded, b e c a u s e legislative,
Policy and Policy Return legal or o t h e r constraints could h a v e dramatically
Security (Passive
altered their asset mixes f r o m w h a t m i g h t h a v e
Selection Portfolio
Return Benchmark) obtained.
The s a m p l e r e p r e s e n t s a m a j o r p o r t i o n of the
Active Returns Due to: large c o r p o r a t e p e n s i o n plans of SEI's clients o v e r
Timing II - I
Selection III- I the 10-year period. The m a r k e t capitalization of
Other IV - I I I - II + I individual p l a n s in the u n i v e r s e r a n g e s f r o m ap-
Total IV - I p r o x i m a t e l y $100 million at the b e g i n n i n g of the
s t u d y p e r i o d to well o v e r $3 billion b y its e n d .
Table 4 s u m m a r i z e s the data collected f r o m
Table 2. Cornputalional Requirements for Retum each plan. N o r m a l w e i g h t s for each asset class for
AccoumU,ty
each p l a n w e r e not available. W e t h u s a s s u m e d
Selection that the 10-year m e a n a v e r a g e h o l d i n g of each
Actual Passive
asset class w a s sufficient to a p p r o x i m a t e the a p p r o -
3 (IV) (ii) priate n o r m a l holding. 6 Portfolio s e g m e n t s con-
00
~i(Wai • Rai) Ei(Wai • Rpi) sisted of c o m m o n stocks, m a r k e t a b l e b o n d s (fixed
i n c o m e d e b t w i t h a m a t u r i t y of at least one y e a r ,
(III) (I) a n d excluding private p l a c e m e n t s a n d m o r t g a g e -
0~ Ei(Wpi • Rai) Ei(Wpi • Rpi) b a c k e d securities), cash equivalents (fixed i n c o m e
obligations w i t h maturities less t h a n o n e year) a n d
Wpi = policy (passive) weight for asset class i a m i s c e l l a n e o u s category, " o t h e r , " including con-
Wai = actual weight for asset class i vertible securities, international h o l d i n g s , real es-
Rpi = passive return for asset class i tate, v e n t u r e capital, insurance contracts, m o r t -
Rai = active return for asset class i g a g e - b a c k e d b o n d s a n d private p l a c e m e n t s .
Because a c o m p l e t e history of the contents of
the " o t h e r " c o m p o n e n t is not available for m a n y
To test the f r a m e w o r k , w e u s e d data f r o m 91 plans, w e elected to exclude this s e g m e n t f r o m
p e n s i o n plans in the SEI Large Plan Universe. SEI m o s t of the analysis. W e instead calculated a
h a s d e v e l o p e d quarterly data for a c o m p l e t e 10- c o m m o n stock/bonds/cash equivalent subporffolio
y e a r (40-quarter) p e r i o d b e g i n n i n g in 1974; this for u s e in all q u a d r a n t s except the total f u n d actual
w a s c h o s e n as the b e g i n n i n g of the period for return; h e r e w e u s e d the actual r e t u r n as r e p o r t e d
study. (including " o t h e r " ) . W e c o n s t r u c t e d the s u b p o r t -

Table 3. CalculaUon of Active Contributions to Total P~fomnance

Return Due to: Calculated by: Expected Value
Timing Z[(Wai • Rpi) - (Wpi. Rpi)] >0
(Quadrant II - Quadrant I)
Security selection E[(Wpi • Rai) - (Wpi. Rpi)] >0
(Quadrant I I I - Quadrant I)
Other E[(Wai - Wpi) (Rai. Rpi)] N/A
[Quadrant IV - (Quadrant II + Quadrant III+ Quadrant I)]
Total E[(Wai • Rai) - (Wpi. Rpi)] >0
(Quadrant IV Quadrant I)
-

134 Financial Analysts Joumal/ January-February 1995

 1985-1994

Table 4. Summaryof Holdings of 91 Large Pension Plans, 1974-1983

Standard
Holdings Average Minimum Maximum Deviation PolicyBenchmark
All holdings
Common stock 57.5% 32.3% 86.5% 10.9% S&P 500 Total Return
Index (S&P500)
Bonds 21.4 0.0 43.0 9.0 Shearson Lehman
Government/Corporate
Bond Index (SLGC)
Cash equivalents 12.4 1.8 33.1 5.0 30-Day TreasuryBills
Other 8.6 0.0 53.5 8.3 None
Total 100~0%
Stocks, bonds and cash only
Common stock 62.9% 37.9% 89.3% 10.6%
Bonds 23.4 0.0 51.3 9.4
Cash equivalents 13.6 2.0 35.0 5.2
Total !00.0%

folio by eliminating the "other" investment weight RESULTS

from each plan in each quarter and calculating new To analyze the relative importance of investment
weights and portfolio returns for the components policy versus investment strategy, we began by
that remained; this had the effect of spreading the calculating the total returns for each of our 91
"other" weight proportionally across the remain- portfolios. Table 5 repeats the framework outlined
ing asset classes. The bottom panel of Table 4 give s in Table 1 and provides a mean of 91 annualized
the weighting information. compound total lO-year rates of return for each
Table 4 also gives the market indexes used as quadrant.
passive benchmark returns. 7 For common stocks,
we used the S&P 500 composite index total return.
Table 5. Mean Annualized Returns by AcUvity, 91
The S&P comes under frequent attack for not being Large Plans, 1974-1983
representative of the U.S. equity market; we nev-
ertheless selected it, for several reasons. First, the Selection
Actual Passive
S&P is still quoted and used as a benchmark by
many plan sponsors; this indicates its continued (IV) (II)
acceptance. Second, it is one of the few indexes
known over the entire study period, and actually
i < 9.01% 9.44%

available for investment by plan sponsors via, for O9

(III) (i)
example, index funds. Third, the S&P 500 does not 0~ 9.75% lO.11%
suffer from the lack of liquidity that affects some
segments of the broader market indexes. For com- Active Retums Due to:
pleteness, however, we recomputed all the calcu- Timing -0.66%
lations performed below using the Wilshire 5000 Security Selection -0.36
Capitalization Weighted Total Return Index in Other -0.07
Total active return -1.10%
place of the S&P; the results were virtually identi-
cal.
We chose the Shearson Lehman Government/
Corporate Bond Index (SLGC) for the bond com-
ponent passive index; this is representative of all The mean average annualized total return
publicly traded, investment-grade bonds (exclud- over the 10-year period (Quadrant IV) was 9.01 per
ing mortgage-backed securities) with a maturity of cent. This is the return to the entire plan portfolio,
at least one year and a minimum par amount not just the common stock/bonds/cash equivalents
outstanding of $1 million. We used the total return portion of the plan. 8 The average plan lost 66 basis
on a 30-day Treasury bill for cash equivalents. points per year in market timing and lost another

Financial Analysts Journal/January-February 1995 135

1985-1994

36 basis points per year from security selection. decision, we would see less of a tendency to
The mean average annualized total return for the cluster asset mix policy according to "peer imita-
normal plan policy (passive index returns and tion" or "conventional" investment postures.
average weighting) for the sample was 10.11 per
cent (Quadrant I). Retum VadalJon
Table 6 provides more detail on the various The ability of investment policy to dictate
effects of active management and investment pol- actual plan return requires further analysis. Table 7
icy at work. The effect of market timing on the examines the relative amount of variance contrib-
compound annual return of individual plans uted by each quadrant to the return to the total
ranged from +0.25 to --2.68 per cent per year over portfolio. It thus addresses directly the relative
the period. The effect of security selection ranged importance of the decisions affecting total return.
from +3.60 to -2.90 per cent per year. On aver- The figures here represent the average
age, total active management cost the average plan amounts of variance of total portfolio return ex-
1.10 per cent per year. Its effects on individual plained by each of the quadrants. They were
plans varied, however, from a low of --24.17 per calculated by regressing each plan's actual total
cent per year to a high of +3.69 per cent per return (Quadrant IV) against, in turn, its calculated
year--a range of 7.86 per cent. common stocks/bonds/cash equivalents invest-

Table 6. Annualized 10-Year Retums of 91 Large Plans, 1974-1983

Total Returns Average R e t u r n MinimumR e t u r n MaximumReturn Standard Deviation
Portfolio returns
Policy 10.11% 9.47% 10.57% 0.22%
Policy and timing 9.44 7.25 10.34 0.52
Policy and selection 9.75 7.17 13.31 1.33
Actual portfolio 9.01 5.85 13.40 1.43
Active returns
Timing only -0.66% -2.68% 0.25% 0.49%
Security selection only -0.36 -2.90 3.60 1.36
Other -0.07 - 1.17 2.57 0.45
Total active return -1.10% -4.17%* 3.69%* 1.45%*
* Not additive.

Active management (and therefore its control) ment policy return (Quadrant I), policy and timing
is clearly important. But h o w important is it rela- return (Quadrant II) and policy and selection re-
tive to investment policy itself? The relative mag- turn (Quadrant III). The value in each quadrant
nitudes indicate that investment policy provides thus has 91 regression equations behind it, and the
the larger portion of return. This is not surprising number shown is the average of 91 unadjusted
in itself, and most would not disagree that the R-squares of the regressions. ~
The results are striking. Naturally, the total
"value added" from active management is small
plan performance explains 100 per cent of itself
(though important) relative to asset class returns as
(Quadrant IV). But the investment policy return in
a whole. However, what does this imply? It im- Quadrant I (normal weights and market index
plies that it is the normal asset class weights and returns) explained on average fully 93.6 per cent of
the passive asset classes themselves that provide the total variation in actual plan return; in partic-
the bulk of return to a portfolio. ular plans it explained no less than 75.5 per cent
Note that the range of outcomes and standard and up to 98.6 per cent of total return variation.
deviations of policy returns is small, reflecting the Returns due to policy and timing added modestly
historical tendency of similar (large, corporate) to the explained variance (95.3 per cent), as did
plans to gravitate toward the same policy mix. We policy and security selection (97.8 per cent). Tables
would expect that, over time, as plan sponsors 6 and 7 clearly show that total return to a plan is
dedicate more resources to the policy allocation dominated by investment policy decisions. Active

136 Financial Analysts Journal / January-February 1995

 1985-1994

Table 7. Percentage of Total Return VadaUon • d e c i d i n g u p o n t h e n o r m a l , or l o n g -

Explained by Investment Activity, Average t e r m , w e i g h t s for e a c h of the asset
of 91 Plan.%1973-1985 classes a l l o w e d in the portfolio;
Selection • strategically a l t e r i n g t h e i n v e s t m e n t
Actual Passive mix w e i g h t s a w a y f r o m n o r m a l in a n
a t t e m p t to c a p t u r e excess r e t u r n s f r o m
(IV) (II) s h o r t - t e r m f l u c t u a t i o n s in asset class
< 100.0% 95.3%
prices ( m a r k e t timing); a n d
• selecting i n d i v i d u a l securitie s w i t h i n a n
(III) (I) asset class to a c h i e v e s u p e r i o r r e t u r n s
97.8% 93.6% relative to t h a t asset Class (security se-
lection).
Variance Explained T h e first t w o decisions are p r o p e r l y p a r t of invest-
Standard m e n t policy; the last t w o reside in t h e s p h e r e of
Average Minimum Maximum Deviation i n v e s t m e n t strategy. Because of its relative i m p o r -
t a n c e , i n v e s t m e n t policy s h o u l d be a d d r e s s e d care-
Policy 93.6% 75.5% 98.6% 4.4%
fully a n d s y s t e m a t i c a l l y b y i n v e s t o r s .
Policy and 95.3 78.7 98.7 2.9
timing F u t u r e a t t e m p t s to q u a n t i f y the i m p o r t a n c e of
Policy and 97.8 80.6 99.8 3.1 i n v e s t m e n t m a n a g e m e n t decisions to portfolio
Selection p e r f o r m a n c e w o u l d b e n e f i t f r o m a n e x a m i n a t i o n of
the i n t e g r a t i o n of i n v e s t m e n t p o l i c y a n d invest-
m e n t strategy. A n explicit d e l i n e a t i o n a n d recog-
nition of the links b e t w e e n i n v e s t m e n t policy a n d
m a n a g e m e n t , while i m p o r t a n t ; describes far less i n v e s t m e n t s t r a t e g y w o u l d h e l p to clarify f u r t h e r
of a p l a n ' s r e t u r n s t h a n i n v e s t m e n t policy. the role of b o t h activities in the i n v e s t m e n t p r o -
cess. A s i m p l e a n d accurate, y e t c o m p l e t e a n d
m e a s u r a b l e , r e p r e s e n t a t i o n of the i n v e s t m e n t de-
IMPUCATIONS cision-making process would further our under-
Design Of a portfolio involves at least four steps: s t a n d i n g of t h e i m p o r t a n c e of the v a r i o u s c o m p o -
• d e c i d i n g w h i c h asset classes to i n c l u d e n e n t s of i n v e s t m e n t activity a n d , w e h o p e , lead to
a n d w h i c h to e x c l u d e f r o m the p o r t f o - a concise a n d i n t e g r a t e d f r a m e w o r k of i n v e s t m e n t
lio; responsibility.

FOOTNOTES
1. SEI Corporation, Number of Managers by Plan Size (Wayne, timing) than investment policy. We view investment Policy
Pennsylvania, 1985):1. as having an indefinite time horizon, as opposed to a
2. See W.R. Good, "'Accountability for Pension Performance," specific, though extendable, one.
Financial Analysts Journal (January/February 1984):39-42. Throughout this article we will use the words "normal,"
3. Early works include E.F. Fama, "Components of Investment "benchmark" and "passive" interchangeably. For a detailed
Performance," The Journal of Finance (June 1972):551-67, and description on how an investment policy can be derived, see
M.C. Jensen, "The Performance of Mutual Funds in the G.P. Brinson, J.J. Diermeier , and G.G. Schlarbaum, "A
Period 1945-1964," The Journal of Finance (May 1968):389- Composite Portfolio Benchmark for Pension Plans," Finan-
416. Some more recent works have clearly forged ahead. As
cial Analysts Journal (March/April 1986):15-24.
an excellent example, see J.L. Farrell, Jr., Guide to Portfolio
6. While this is clearly a simplification, we are unable to
Management (New York: McGraw-Hill, 1983):321-39.
4. For a clear treatment of policy versus strategy, see D.A. address more accurately the problem of normal weights.
Love, "Editorial Viewpoint," Financial Analysts Journal Since 10 years covers several business cycles, and since the
(March/April 1977):22. For a discUssion of normal portfolios, average standard deviation of asset class holdings for com-
see A. Rudd and H.K. Clasing, Jr., Modern Portfolio Theory mon stocks and bonds is not high relative to the average
(Homewood, IlL: Dow Jones-Irwin, 1982):71-72. amounts held, this is probably not a serious problem in the
5. We say "specified" ewm though the actual weights may not analysis.
be known in advance; this accounts for those who wish to 7. Data for benchmark returns were provided by R.G. Ibbotson
use portfolio insurance techniques. In our view, these tech- & Associates (Chicago, Ill.) and Shearson/Lehman American
niques are more ones of active asset allocation (market Express (New York).

Financial Analysts Journal/January-February 1995 137

1985-1994

8. We also calculated the stock/bonds/cash equivalents return of the correlation Coefficient, and represents the amount of
series and, in all of the analysis that follows, also used that variance of total return explained in excess of the average.
calculated return wherever we used the actual fund return; While the average of the quarterly total returns may not be
results were similar in all cases. predictable, it is nonetheless of interest ex post and, in
9. By "unadjusted," we mean that the R-squared measures are essence, can be specified by the passive portfolio that, w h e n
not adjusted for degrees of freedom; thus, for our three established, becomes the relevant benchmark for any further
simple regression models, the R-squared represents a square comparison.

138 Financial Analysts Joumal/ January-February 1995