Two drivers of returns

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The typical investment or superannuation portfolio is of a diversified nature. That is, the portfolio contains a mix of exposure across different asset classes such as shares, bonds, property and cash – including both Australian and global shares and bonds.

To ensure a portfolio is suitable for an investor’s risk profile and individual goals and objectives, it’s important to align an appropriate mix of those assets. This effectively determines descriptions of investor types, such as conservative, balanced, growth and high growth.

Asset allocation is king – isn’t it?

Many studies have been conducted to determine what portion of a portfolio’s return is driven by asset allocation, and it’s generally agreed that the figure is around 90%.

Vanguard’s Principles for Investing Success (1986) says: “This has been well documented in theory and in practice. For example, in a paper confirming the seminal 1986 study by Brinson, Hood, and Beebower, Scott et al. (2016) showed that the asset allocation decision was responsible for 89% of a diversified portfolio’s return patterns over time”.

Let’s clarify something before we take this information at face value.

‘Investor types’ – such as balanced and growth – reflect an investor’s ‘risk profile’ in the primary instance, but to also to a strong extent their likely return outcome.

This is because risk and return aren’t independent of each other, but in fact closely linked. It’s a generally accepted rule that the higher the risk, the higher the expected return (over an appropriate investment time frame for each given asset class).

Risk and return assumptions are essential in selecting an appropriate asset allocation for any investors. I believe that many within the industry have become over-engaged with the notion of asset allocation explaining circa 90% of returns, at the expense of little reference to the associated explanation of risk or volatility.

Don’t miss the point in the above study of asset allocation being responsible for 89% of the return patterns over time. That is, it explains how the returns are achieved – not just the level of return. In fact, it’s the pattern of returns that effectively represents the risk or volatility of how the given returns are achieved.

Drilling into the detail

In my experience, in the investment industry there is a far greater percentage of time, effort and research spent on investment funds than on the overarching asset classes.

To me, this underlying level of diversification in a portfolio – that is, having a range of investment funds within an asset class – is equally as important as the asset class exposure itself.

As the number – and, more importantly, range and varying type – of funds has steadily grown over time, so too I believe has the importance of fund selection in constructing a portfolio.

The data below explores this in further detail – firstly by assessing the differences in return outcomes between asset classes, and then between different funds within each asset class.

Table 1: Asset class returns to 30 November 2018

Performance to 30 November 2018 (% p.a.)
Asset class (index) 1 year 3 years 5 years 10 years
Australian Equities
(S&P/ASX 300 Accumulation Index)
-1.0 7.7 5.8 8.9
Australian Equities – Small Companies
(S&P/ASX Small Ordinaries Accum Index)
-1.6 10.4 7.1 7.8
Global Equities
(MSCI World Index ex- Australia AUD unhedged)
4.2 8.2 11.7 9.6
Australian Listed Property
(S&P/ASX 300 A-REIT Accumulation Index)
1.6 8.4 11.9 9.3
Australian Fixed Income
(Bloomberg AusBond Composite Index)
2.5 3.3 4.5 5.2
Global Fixed Income
(Barclays Global Aggregate $A Hedged)
0.4 3.0 4.5 6.5

(Bloomberg AusBond Bank Bill Index)

1.9 1.9 2.2 3.1
Difference between ‘highest and lowest’ 5.8 8.5 9.7 6.5

Source: Zenith Investment Partners – Fund Survey Reports. Returns to 30 November 2018

The variance in returns between the best and worst performing asset class across each of the different timeframes (see the bottom row of the table) is quite significant, illustrating how the asset class decision is a significant factor in driving the return outcome.

It is somewhat surprising, however, that the smallest difference in asset class returns is across the shortest time frame of one year. Typically the greatest variances occur over the shorter periods.

This can be explained, however, by the somewhat muted nature of returns across all asset classes for the 2018 calendar, levels that are clearly lower than longer-term averages. To highlight the swings in growth asset class returns that can and do occur over shorter-term timeframes, the below shows the related equity market (and cash) index returns over one year at the end of September 2018.

Table 2: Asset class returns over 1 year to 30 September 2018

Asset class (index) 1 year (%)
Australian Equities
(S&P/ASX 300 Accumulation Index)
Australian Equities – Small Companies
(S&P/ASX Small Ordinaries Accum Index)
Global Equities
(MSCI World Index ex- Australia AUD unhedged)

(Bloomberg AusBond Bank Bill Index)


Source: Zenith Investment Partners – Fund Survey Reports. Returns to 30 September 2018

In this instance the difference between the best and worst performing asset class is a significantly higher 18.9%. This further highlights the volatility of short-term returns, and why longer-term return expectations should be used when assessing and determining an appropriate asset allocation mix within a portfolio.

Looking back to Table 1, the largest spread between the best and worst performing asset classes was recorded over the five-year period – the longest timeframe. This difference of 9.7% would make an impactful difference to the overall return of any investment portfolio.

It’s also worth assessing the difference in returns between asset classes within the overarching categories of ‘growth’ and ‘income/defensive’.

Across all timeframes, the best performance came from those asset classes classified as ‘growth’ – shares and property. The lowest return in each time period was recorded by a sector classified as ‘income’ or ‘defensive’ – fixed income or cash.

So another key asset allocation decision is the allocation between growth and income/defensive assets.

Looking at the returns between the ‘growth’ and ‘income/defensive’ asset classes over the 5-year timeframe, a more narrow spread is evident.

Within the ‘growth’ category, the difference between the highest and lowest performing asset classes is 6.1% (note it’s significantly less over 10 years at 1.8%). Within the ‘income/defensive’ category, the difference is 2.3%.