Notes for “Asset Allocation: Management Style and Performance Measurement” by William F. Sharpe (JPM, Winter 1992) Basic idea: Asset allocation accounts for the majority of variability in portfolio returns. This paper builds an asset class factor model that captures portfolio style and thus provides a style-specific benchmark for measuring an active manager’s performance. Model uses 12 asset classes: Bills Int Govt Bonds LT Govt Bonds Corp Bonds Mortgage-Related Securities Large Cap Value Stocks Large Cap Growth Stocks Medium Cap Stocks Small Cap Stocks Non-US Bonds European Stocks Japanese Stocks Passive returns on all asset classes are measured via well known indicies. Modeling Fund Exposure: Explain fund returns (over 60 months) using returns on the 12 indicies as explanatory variables! Table 2 shows results from unconstrained, constrained, and quadratic approaches. The QP approach constrains the sensitivity factors to be positive and less than 100%. The resulting coefficients reasonably capture the style of the fund under analysis. Define R-squared as the proportion of variance attributable to the specific style (AA) of the fund and the residual to security selection. Note: the style analysis illustrates how a portfolio behaves, not necessarily what it holds. (e.g., utility fund example) Performance Measurement: Interpret SS return as the difference between total performance of fund and the synthetic passive portfolio that mimics its style. 1. Estimate coefficients over 60 months (ending with t-1) 2. Compute return on the style benchmark for month t. 3. Define the residual (Actual-Forecast) as security selection.