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Asset allocation versus security selection: Evidence from global markets

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Abstract:

One of the most debated issues of investment management is the relative importance of asset allocation and security selection, and the overwhelming consensus is that asset allocation is more important. This paper argues that many investors have a false impression of the relative importance of these activities, because they fail to distinguish between the consequences of investor behaviour and the opportunity set offered by the capital markets. A methodology is applied that controls for investor behaviour and isolates the respective opportunity sets associated with asset allocation and security selection. Contrary to the widely held view, it turns out that choosing stocks within the equity component of a portfolio is substantially more important than choosing a portfolio's exposure among stocks, bonds and cash. Further evidence is provided of the dominant importance of security selection by applying option pricing theory to value asset allocation skill and security selection skill. The results, taken together with earlier studies of the historical impact of security selection on fund performance, provide compelling evidence that investment managers compress the natural distribution of opportunities available from security selection.Journal of Asset Management (2002) 3, 202–212; doi:10.1057/palgrave.jam.2240075

Document Type: Research Article

DOI: http://dx.doi.org/10.1057/palgrave.jam.2240075

Affiliations: 1: 1Windham Capital Management Boston, 5 Revere Street, Cambridge, MA, 02138, USA, Tel: +1 617 576 7360, Fax: +1 617 576 7359, Email: mkritzman@wcmbllc.com 2: 2Senior associate at State Street Associates

Publication date: December 1, 2002

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