By: William Sharpe
Published: Journal of Portfolio Management, Winter 1992
The Hedge Fund of Funds Industry, with its focus on unique strategies, manager style and style-drift owes much to this seminal paper by The Man, William Sharpe.
“It is widely agreed that asset allocation accounts for a large part of the variability in the return on a typical investor’s portfolio. This is especially true if the overall portfolio is invested in multiple funds, each including a number of securities.
“Asset allocation is generally defined as the allocation of an investor’s portfolio among a number of “major” asset classes. Clearly such a generalization cannot be made operational without defining such classes.
“Once a set of asset classes has been defined, it is important to determine the exposures of each component of an investor’s overall portfolio to movements in their returns. Such information can be aggregated to determine the investor’s overall effective asset mix. If it does not conform to the desired mix, appropriate alterations can then be made.
“Once a procedure for measuring exposures to variations in returns of major asset classes is in place, it is possible to determine how effectively individual fund managers have performed their functions and the extent (if any) to which value has been added through active management. Finally, the effectiveness of the investor’s overall asset allocation can be compared with that of one or more benchmark asset mixes.
“An effective way to accomplish all these tasks is to use an asset class factor model. After describing the characteristics of such a model, we illustrate applications of a model with twelve asset classes to analyze the performance of a set of open-end mutual funds between 1985 and 1989.”