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Performance Attribution Approaches, Pitfalls & Best Practices
Gone are the days where back-of-the-head understanding of returns and risks was good enough to manage and maneuver the portfolio. With availability of sophisticated solutions, fund managers are increasingly adopting advanced techniques to measure the portfolio performance in an objective and comprehensive manner. This paper discusses the performance analysis, their approaches and some best practices.
Table 1 1 demonstrates a sample Fund benchmarked against an Index. The holdings comprise of four stocks with suggested weights and returns. Portfolio outperforms the index by 0.7% (Alpha=0.7%), the outperformance being contributed by various securities. Let's consider the Contribution column which suggests that Stock A overweight was the best decision yielding 0.5% outperformance. This can be interpreted as more weight in Stock A would have increased alpha.
Table 1. Table 1. Base Case Scenario
| Stocks | Funds Wt. | Index Wt. | Returns | Fund Returns | Index Returns | Contribution | Attribution |
|---|---|---|---|---|---|---|---|
| A | 33% | 25% | 6% | 2.0% | 1.5% | 0.5% | 0.3% |
| B | 19% | 25% | 3% | 0.6% | 0.8% | -0.2% | 0.0% |
| C | 29% | 25% | 5% | 1.5% | 1.3% | 0.2% | 0.1% |
| D | 19% | 25% | -4% | -0.8% | -1.0% | 0.2% | 0.4% |
| Total | 100% | 100% | - | 3.2% | 2.5% | 0.7% | 0.7% |
Table 2 demonstrates the effect of putting additional 3% in Stock A in the fund, thus overweighting it even more. The 3 % is balanced by reducing 1 % from other stocks. Rightly, by putting more money in the best performing stock, the portfolio alpha increases to 0.9%.
Table 2. Aligning Weights as per Contribution
| Stocks | Funds Wt. | Index Wt. | Returns | Fund Returns | Index Returns | Contribution | Attribution |
|---|---|---|---|---|---|---|---|
| A | 36% | 25% | 6% | 2.2% | 1.5% | 0.7% | 0.4% |
| B | 18% | 25% | 3% | 0.4% | 0.8% | -0.2% | 0.0% |
| C | 28% | 25% | 5% | 1.4% | 1.3% | 0.2% | 0.1% |
| D | 18% | 25% | -4% | -0.7% | -1.0% | 0.3% | 0.5% |
| Total | 100% | 100% | - | 3.4% | 2.5% | 0.9% | 0.9% |
Now let's consider the Attribution column in Table 1. Attribution column depicts that the majority of outperformance was contributed by the underweight decision in Stock D. This can be interpreted as even more underweight in Stock D would have increased alpha. Table 3 demonstrates the eect of removing additional 3% from Stock D in the fund, thus underweighting it even more. The 3 % is balanced by adding 1 % to other stocks. As expected due to more underweight in the worse performing sector the alpha contributed by Stock D increases. It's worth noting that the alpha of the portfolio has increased to 1%, which is higher than the alpha is Table 2.
Table 3. Aligning Weights as per Contribution
| Stocks | Funds Wt. | Index Wt. | Returns | Fund Returns | Index Returns | Contribution | Attribution |
|---|---|---|---|---|---|---|---|
| A | 34% | 25% | 6% | 2.0% | 1.5% | 0.5% | 0.3% |
| B | 20% | 25% | 3% | 0.6% | 0.8% | -0.2% | 0.0% |
| C | 30% | 25% | 5% | 1.5% | 1.3% | 0.3% | 0.1% |
| D | 16% | 25% | -4% | -0.6% | -1.0% | 0.4% | 0.6% |
| Total | 100% | 100% | - | 3.5% | 2.5% | 1.0% | 1.0% |
This implies that underweighting Stock D was a better decision as compared to overweighting Stock A, with the given weights, which is brought forward clearly by Attribution analysis.
The example establishes the fact that analysis based on contribution, though informative, can be quite misleading in nature.
Segregating returns contributed by various constituent securities can also be termed as attribution
Attribution Approach
Fund managers should use the attribution
approach as per the fund management style
and mandate. This section provides a brief
on the various approaches to attribution.
A deep dive and explanation of each
methodology is beyond the scope of this
paper.
Holdings vs. Transaction Based
The holdings based approach primarily works on the holdings data and doesn't take into account the transactions. This might be good enough for a passive portfolio, however for active portfolio managers who regularly maneuver their portfolios, transactions based approach is advisable. It becomes a must when one is analyzing performance over a long period where the number of transactions might start impacting the returns.
Based on Fund Management Decisions (type of fund
equity/debt, Fund Style etc.)
Since the objective of performance attribution it to attribute performance to fund management decisions, the approach followed for a fund should map the fund management philosophy. Many fund managers get plagued by using the attribution system without regard to the fund style.
While the equity fund managers decide on the sector allocation and stock selection, the xed income fund managers' decisions are relevant to the movement of base yields, spreads across the maturity buckets. Using an equity attribution approach by a debt fund manager might not be wise. Attribution factors like Carry, Curve and Spread would make more sense to a debt fund manager. Similarly, an equity fund manager who is mandated to be a stock picker without any constraints around sectors, shouldn't be using a typical equity allocation-selection approach
Based on fund management decisions (type of fund equity/debt, Fund Style etc)
Within equity attribution, there are various approaches including the Arithmetic and Geometric approach. Where Arithmetic
approach calculates the out performance based on the difference of returns, geometric approach calculates the same as a ratio of portfolio and benchmark returns. The approaches can use
various methodologies including Brinson, Brinson-Fachler and Brinson-Hood-Beebower models to segregate the out performance into the relevant factors
