Attribution Analysis

What is “Attribution Analysis”?

Attribution analysis is a tool used by investors to evaluate the performance of a portfolio. It can help distinguish how an investment portfolio manager’s decisions have impacted the overall performance of the portfolio. The analysis can help determine the investment performance drivers, and analyze the return components – this is pivotal for better understanding the impact of investment choices. Attribution analysis also helps us in providing a context to how portfolio managers are actively allocating capital.

Attribution Analysis – Objective and Types

The primary objective of attribution analysis is to evaluate a portfolio manager and their performance, and also to potentially improve the portfolio management process.

There are several different methods available to conduct attribution analysis. All compare the performance of a portfolio to a benchmark, not only to identify the sources of different returns from the benchmark, but also to quantify the sources of differential returns.

When looking at portfolio performance, investors want to understand what to attribute a manager’s performance too. It could be due to many factors such as the underlying stock selection, sector selection, market timing, sector (or industry) weighting, or selecting the right investment style. Attribution analysis seeks to look into this in more detail.

Risk-adjusted attribution analysis: the aim here is to determine the amount of risk taken by the portfolio manager and assess if it is equitable to the returns obtained by the portfolio. This gives an indication of how well the portfolio manager is managing the overall risk of the portfolio while providing adequate returns for its investors.

Generally, risk-adjusted analysis is based on various ratios, out of which the Sharpe ratio and the Treynor ratio are the most popular ones. But for deeper insights, such analysis can go on to add Alpha, information ratio, omega, R^2 coefficient, M^2 ratio, and the Sortino ratio.

Style analysis: this helps assess how well the portfolio or the portfolio managers perform within their broad investment universe. The universe here is determined by the style of the manager.

Looking at the US stock markets, these markets are differentiated along two simple dimensions, size – whether they are large-cap or small-cap stocks or mid-cap – and valuation i.e. are they value stocks or are there more growth stocks. We can combine these two dimensions to discern a style of portfolio – whether it is looking at large-cap value, large-cap growth, small-cap value, or small-cap growth.

In attribution style analysis we look at the returns over the style benchmark. This can be absolute or excess return over the style benchmark. We can then decipher how much of the return can be attributed to the style or the investment universe the manager works in, and how much of the return can be attributed to the specific investment decisions of that portfolio manager.

Peer Group Analysis: the aim here is to determine how well the investment fund performed comparatively. Here, instead of comparing the portfolio to a benchmark such as an index, we are comparing the portfolio manager’s performance to a more defined peer group. Usually, this is comparing multiple managers’ performance within the same strategy, and the strategy must be very similar to maximize the usefulness of this analysis. It might be noted that peer group analysis becomes more effective, as the size of the peer group increases.

Attribution Analysis – Sharpe Ratio

The Sharpe ratio evaluates the performance of a portfolio manager – on the basis of the rate of return and diversification.

This formula is shown below:

Sharpe Ratio = R(P) – R(F) / S(P)
R(P) = Expected return on portfolio
R(F) = Risk-free rate of return
S(P) = Standard deviation of portfolio return

Sharpe Ratio – Evaluating Portfolio Managers Performance

Here is an example of using the Sharpe ratio to evaluate three portfolio managers’ performance (Manager A, Manager B, and Manager C). The uses 10-year performance results vis-a-vis the average annual return and portfolio standard deviation.  The example assumes that the S&P 500’s (market portfolio) 10-year annual return is 11% and the risk-free rate of return is 5%.

Manager A has the highest Sharpe ratio i.e. this manager has yielded the best results relative to the level of risk undertaken. In other words, the fund headed by Manager A has a superior portfolio performance (i.e. superior risk-adjusted return), compared to Manager B and Manager C.