What is “Performance Attribution”?
Performance Attribution is a quantitative method that investors use to evaluate the performance of a fund manager or a portfolio against a particular benchmark. It analyses whether the decisions made by the manager added value to the overall portfolio performance through the effect of stock selection and asset allocation.
Although sophisticated, this approach could also identify if returns achieved over the long-term were a result of a favorable market environment, market timing (luck), or genuine investment capabilities.
Key Learning Points
- Total Attribution is the difference between the return of a portfolio and the return of its target benchmark.
- Performance attribution analyzes the source of excess returns achieved by a portfolio or fund manager.
- The two main components of performance attribution are the stock selection effect and the asset allocation effect.
- It is used by investors to assess whether a manager’s decisions were the driver for a portfolio’s returns.
- Performance attribution could increase transparency and reassure investors that the strategy is properly implemented.
The selection effect measures the manager’s ability to pick specific stocks (or other securities) relative to a benchmark – it could be either positive, negative, or in rare cases neutral if equals zero. Whether a fund manager has a positive or negative view on a specific security, he or she will normally go overweight or respectively underweight in that security compared to the benchmark index.
Positive stock selection occurs when the manager has made good investment decisions and picked securities that outperformed the same (or similar) securities in the benchmark. On the other hand, if the securities held in the portfolio underperformed the same (or similar) securities in the benchmark, the selection effect will be negative and will signal poor investment decisions.
Calculation Formula and example:
((Benchmark sector beginning weight))*((Portfolio sector return) – (Benchmark sector return))
((Portfolio sector beginning weight plus purchases) – (Benchmark sector beginning weight))*((Portfolio sector return) – (Benchmark sector return))
Selection Effect: 0.002=((0.05*(0.05-0.03))+((0.1-0.05)*(0.05-0.03))
The allocation effect measures the manager’s ability to generate an above-market return by allocating funds to specific sectors, regions, or asset classes. It determines whether taking active positions in a particular segment against the benchmark, either overweight or underweight, was a contributor (positive) or a detractor (negative) to the overall portfolio performance.
The allocation effect is calculated as the arithmetic difference between the portfolio’s sector (or region) weights and returns against those in the target index. The positive allocation effect occurs when the overweight positions in a segment outperform the same segment within the benchmark, where the negative allocation effect occurs when overweight segment positions in the portfolio underperform the same segment in the benchmark.
Calculation Formula and example:
((Portfolio sector beginning weight plus purchases) – (Benchmark sector beginning weight))
(Benchmark sector return)
Allocation effect: 0.0015=(0.1-0.05)*0.03
The interaction effect is the combined effect of stock selection and asset allocation, but it is difficult to ascertain because the combination of the two will not always equal the total attribution. Therefore, the difference is explained as “other” and it is a mathematical consequence rather than attributable to investment decisions as managers do not aim to add value through the interaction effect.
Active Management Effect
The active management effect is the combination of the selection, allocation, and interaction effects. It measures the excess return (or loss) achieved by the portfolio relative to the benchmark and is attributed to the manager’s investment decisions.