Determinants of Portfolio Performance

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 underweighting 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 per cent of the variation in total plan return. The actual mean average total return on the portfolio over the period was 9.01 per cent, versus 10.11 per cent for the benchmark portfolio. Active management cost the average plan 1.10 per cent per year, although its effects on individual plans varied greatly, adding as much as 3.69 per cent 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.