Attribution Decomposed:

Attribution is one of many hot topics going around the wealth management industry today. Known as a set of techniques
to explain why a portfolio’s performance differed from a benchmark, Performance Attribution helps in explaining how the investment manager achieved active performance vs. the model/benchmark. In essence, it serves as a decision scorecard to see how decisions impacted the active portfolio out- or underperformance.

There are three specific attributes that help explain active out/underperformance in an attribution report: Selection, Allocation, and Interaction. The sum of these three attributes is the active return the portfolio generated.

1. Selection – Selection measures the impact of the Investment Manager’s asset/manager selection decisions vs. the model benchmark within each asset class/sector (industry, etc.). It answers: How well did the portfolio manager select assets vs. the benchmark in this particular asset class/sector?

 

 

R_P= Portfolio return in asset class/sector

R_^B= Benchmark/model account return for asset class/sector

W_B= Weight of benchmark/model account for the asset class/sector

A manager achieves a positive selection effect by outperforming the benchmark in a certain asset class/sector. The size of the effect depends not only on the outperformance within the asset class/sector but also the weight of the model account/benchmark. Thus, large outperformance could have a small selection effect if the benchmark weighting is small, or small outperformance could have a large selection effect if the model account/benchmark weighting is large.

 

2. Allocation – Allocation measures the impact of the Investment Managers’ allocation decisions vs. the model account/benchmark in the respective asset classes/sectors. It answers: How did the portfolio managers’ decisions to over/underweight an asset class/sector vs. the model account/benchmark impact the active return of the portfolio?

W_S= Weight of asset class or sector

R_TB= Return of total benchmark/model account

The allocation attribute only focuses on the weighting of the portfolio within each asset class/sector. All other parts of the equation are related to the benchmark. For example, if there is a larger portfolio allocation vs. the benchmark/model account and the benchmark’s asset class is outperforming the overall benchmark return, the result is a positive allocation effect. Therefore, the decision to over-allocate an outperforming asset class/sector leads to a positive allocation effect. Conversely, an underweight decision in an underperforming asset class/sector also generates a positive allocation effect.

3. Interaction – Interaction is the impact of the allocation and selection effect working together within an asset class/sector. Interaction answers: How did the portfolio managers’ allocation and selection decisions impact the active portfolio return?

Overweighting an outperforming asset class/sector vs. the benchmark or underweighting an underperforming asset class/sector vs. the benchmark/model account generates a positive interaction effect.

Overweighting and underperforming or underweighting and outperforming asset class/sector vs. the model account will generate a negative interaction effect.

Wrap-up

The attribution report is a great tool in decomposing the active portfolio return. As mentioned above, it can act as a decision making scorecard for the portfolio manager as it pertains to the allocation decisions regarding the money invested in each asset class/sector and the selection process within each asset class/sector vs. the benchmark/model account.

First Rate has an inventory of other reports that are good compliments to the attribution report, including trade analysis, allocation comparison and return comparison. Contact us for more information about this report or other comparable options.

Other reports that are good compliments to the attribution report are: contribution reports, the trade analysis report, and the allocation comparison and return comparison reports, which are available within First Rate.