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What Is the Dominant Driver of Returns?

Written by: Dan Suzuki | Richard Bernstein Advisors

The financial industry is obsessed with “alpha”

The main goal of portfolio management is to maximize returns relative to a targeted risk tolerance. Typically, portfolio returns can be broken down into alpha and beta. Beta generally measures the portion of returns that is attributable to the directional moves of the overall market, while alpha is everything else —generally a function of company- or industry-specific dynamics and/or market timing. The financial industry is obsessed with seeking alpha because it generally reflects portfolio managers’ ability to pick specific stocks.

But investing for alpha has been synonymous with fees and underperformance

But consider our oft-cited adage: “Returns are greatest when capital is scarce” and renowned stock-picker Charlie Munger’s comment: “For years and years and years, what we did was shoot fish in a barrel…It was so easy. It's gotten harder and harder and harder.” The vast majority of the assets and resources dedicated to active management (consider most active mutual funds, hedge funds and research firms for starters) are primarily focused on picking stocks. There are currently 54 Wall Street analysts listed as actively covering Apple’s stock, and one could reasonably conclude it will be difficult to achieve alpha when the stock gets so much attention. Munger is correct. Bank of America recently highlighted only 11% of actively managed large cap mutual funds outperformed their benchmark during the bull market from 2009 – 20191 (Chart 1). In addition, managers tend to hold too many stocks and “diversify away” potential alpha.

Asset allocation (beta management) is the dominant driver of returns

A well-known study of pension returns from 1977-1987 suggests that asset allocation was the “dominant contributor to total return,” with asset allocation driving over 91% of the quarterly return variability2 . Stocks, with their higher returns and greater volatility, have tended to be the primary driver of returns (Chart 2), but an allocation to stocks is NOT stock picking. Equity beta, not alpha, has been the biggest driver of portfolio returns, yet far fewer resources seem to be dedicated to the active management of beta.

Why actively manage beta?

There are clear historical relationships between equity market risk/return and fundamental factors such as profits, liquidity and sentiment. It seems obvious the risk of auto accidents is lower on less crowded straightaways on sunny days. Similarly, the risk of significant market declines is lower when profits are accelerating, liquidity is improving, and nobody wants to own stocks. Those are periods where it makes sense to step on the gas pedal a bit harder.

1 La Roche, J. (2017, February 15). Charlie Munger explains why he and Buffett have changed their minds about tech and airlines. Yahoo Finance. Retrieved from http://www.finance.yahoo.com

2 Gary P. Brinson, Brian D. Singer & Gilbert L. Beebower (1991) Determinants of Portfolio Performance II: An Update, Financial Analysts Journal, 47:3, 40-48, DOI: 10.2469/faj.v47.n3.40

Related: How to Invest in Equities When Guidance Disappears