What is Attribution Analysis?
Attribution analysis is a sophisticated method for evaluating the performance of a portfolio or fund manager. It quantitatively analyzes aspects of an active fund manager’s investment selections and decisions, aiming to identify sources of excess returns, especially compared to an index or other benchmark.
For portfolio managers and investment firms, attribution analysis is an effective tool to assess their strategies. For investors, it provides a means to gauge the performance of fund or money managers.
- Attribution analysis explains and analyzes a portfolio’s (or manager’s) performance against a specific benchmark.
- It focuses on three core factors: investment picks and asset allocation, investment style, and the market timing of decisions and trades.
- Asset class and asset weighting within a portfolio play a crucial role in analyzing investment choices.
- Investment style reveals the nature of the holdings: low-risk, growth-oriented, etc.
- Market timing’s impact is hard to quantify and often considered less significant than asset selection and investment style.
How Attribution Analysis Works
Attribution analysis emphasizes three factors: the manager’s investment picks and asset allocation, their investment style, and the market timing of their decisions and trades.
The method begins by identifying the asset class in which a fund manager chooses to invest. An asset class broadly describes the type of investments chosen by a manager; within that, it can also be more specific, describing a geographical marketplace or an industry sector. For instance, European fixed income debt or U.S. technology equities.
Next, it considers the allocation of different assets—what percentage of the portfolio is weighted to specific segments, sectors, or industries.
Specifying the type of assets assists in identifying a general benchmark for performance comparison. This benchmark often takes the form of a market index, a basket of comparable assets. Market indexes can be broad, such as the S&P 500 or the Nasdaq Composite Index, which cover a wide range of stocks, or they can be quite specific, focusing on, for instance, real estate investment trusts or corporate high-yield bonds.
Analyzing Investment Style
The next step in attribution analysis is determining the manager’s investment style. Similar to asset class identification, a style provides a benchmark to gauge the manager’s performance.
The first method of style analysis focuses on the nature of the manager’s holdings. For example, if they are equities, are they from large-cap or small-cap companies? Are they value- or growth-oriented?
American economist Bill Sharpe introduced the second type of style analysis in 1988. Returns-based style analysis (RBSA) charts a fund’s returns and seeks an index with comparable performance history. Sharpe refined this method with his technique of quadratic optimization, allowing him to assign a blend of indices closely correlated to a manager’s returns.
Explaining Alpha
Once an attribution analyst identifies a blend of indices, they can create a customized benchmark of returns to evaluate the manager’s performance. This analysis aims to highlight the excess returns, or alpha, generated over those benchmarks.
The next step involves explaining this alpha. Is it due to the manager’s stock picks, the sectors selected, or their market timing? To determine the alpha generated by stock picks, an analyst must identify and subtract the portion attributable to sector and timing. By developing custom benchmarks based on the manager’s blend of sectors and the timing of their trades, the analyst can assign specific portions of alpha to sector selection and trade timing. The remaining portion is the stock selection alpha.
Market Timing and Attribution Analysis
Although some managers use a buy-and-hold strategy, most actively trade, making buy and sell decisions throughout a given period. Segmenting returns by activity helps to determine whether a manager’s decisions to add or reduce positions benefited or hurt the final return compared to a more passive approach.
Market timing is the third crucial factor in attribution analysis, though its significance is highly debated.
This aspect is the most challenging part of attribution analysis to quantify accurately. To measure market timing, it’s essential to compare a manager’s returns against benchmarks during market upturns and downturns. Ideally, funds should perform well in bullish periods and decline less than the market in bearish times.
Despite its importance, many analysts argue that a significant portion of a manager’s performance in market timing is due to chance or luck. Therefore, generally, more weight is given to asset selection and investment style than to market timing.
Related Terms: return attribution, performance attribution, benchmarking, investment analysis, market index.
References
- Equitas Capital Advisors. “Attribution Analysis”.
