Understanding Attribution Analysis

Attribution analysis is a sophisticated method used to evaluate the performance of a portfolio or fund manager. Termed as “return attribution” or “performance attribution,” this technique aims to quantitatively analyze the investment decisions of an active fund manager to identify sources of excess returns, especially in comparison to an index or benchmark.

Portfolio managers and investment firms leverage attribution analysis as a powerful tool to assess strategies. For investors, it serves as a means to evaluate the performance of fund or money managers effectively.

• Attribution analysis is an evaluation tool that explains and analyzes a portfolio’s or portfolio manager’s performance, particularly against a specific benchmark.
• It delves into three key factors: the manager’s investment selections and asset allocation, their investment style, and the market timing of their decisions and trades.
• Asset class and asset weighting within a portfolio play a crucial role in analyzing investment choices.
• Investment style reflects the nature of the holdings, whether characterized by low-risk or growth-oriented assets.
• The impact of market timing, though challenging to quantify, is generally considered less important in attribution analysis compared to asset selection and investment style.

How Attribution Analysis Operates

Attribution analysis concentrates on the manager’s investment picks, asset allocation, investment style, and market timing.

The analysis begins by identifying the asset class in which a fund manager invests, describing the type of investments chosen, such as geographical or industry sectors.

It further assesses the allocation of assets within the portfolio, determining the percentage assigned to specific segments, sectors, or industries.

Asset specification aids in establishing a benchmark for performance comparison, typically based on a market index or a basket of similar assets.

Market indexes can vary from broad ones like the S&P 500 Index to specific ones focusing on sectors like real estate investment trusts or corporate high yield bonds.

Analyzing Investment Style

The next step involves defining the manager’s investment style, providing a benchmark for evaluating their performance based on the nature of their holdings or the returns-based style analysis.

Furthermore, the method introduced by economist Bill Sharpe in 1988, known as returns-based style analysis (RBSA), helps in aligning a fund’s returns with corresponding indices, refining performance evaluation techniques.

Explaining Alpha

Following benchmark identification, analysts can derive a customized benchmark to assess the manager’s performance and identify any excess returns, or alpha, gained over benchmarks.

The subsequent step aims to explain this alpha, attributing it to the manager’s stock picks, sector selections, and market timing through the development of custom benchmarks.

Market Timing and Attribution Analysis

While some managers adopt a buy-and-hold strategy, most engage in constant trading activities, emphasizing the importance of analyzing market timing within attribution analysis.

Market timing constitutes a significant factor in attribution analysis, despite the ongoing debate regarding its relevance.

Assessing the influence of market timing on returns involves comparing a manager’s performance against benchmarks during market upturns and downturns to gauge effectiveness.

While measuring market timing can be challenging, analysts generally place greater emphasis on asset selection and investment style over market timing due to its perceived randomness and the role of luck in performance outcomes.