Performance Attribution

Performance attribution is a method used to analyze the performance of an investment portfolio by breaking it down into its individual components to determine the source of returns.

Understanding Performance Attribution

Performance attribution helps investors and portfolio managers understand how and why their portfolio performed over a specific period. It typically assesses the contribution of different assets, sectors, or investment strategies to the overall performance of the portfolio.

Key Components of Performance Attribution

– Allocation Effect: This measures how much of the portfolio’s return can be attributed to the decision to allocate assets to different sectors or investment styles. It evaluates whether the asset allocation choices were beneficial compared to a benchmark.
– Selection Effect: This examines the performance of individual securities within those asset classes. It assesses the effectiveness of stock selection by comparing the performance of selected securities against the benchmark.
– Interaction Effect: This is the combined effect of allocation and selection, highlighting how the interaction of these choices affects overall performance.

Calculation of Performance Attribution

Performance attribution can be calculated using the following formulas:

1. For the Allocation Effect:
– Allocation Effect = (Weight of Portfolio in Sector – Weight of Benchmark in Sector) × (Return of Benchmark in Sector)

2. For the Selection Effect:
– Selection Effect = (Weight of Portfolio in Sector) × (Return of Portfolio in Sector – Return of Benchmark in Sector)

3. The Total Attribution can be expressed as:
– Total Attribution = Allocation Effect + Selection Effect

Real-World Example

Consider an investment portfolio containing two sectors: Technology and Healthcare.

– Portfolio Returns:
– Technology: 15%
– Healthcare: 10%

– Benchmark Returns:
– Technology: 12%
– Healthcare: 8%

– Weights in Portfolio:
– Technology: 60%
– Healthcare: 40%

– Weights in Benchmark:
– Technology: 50%
– Healthcare: 50%

Calculating Allocation Effect:
– Technology: (60% – 50%) × 12% = 0.6%
– Healthcare: (40% – 50%) × 8% = -0.8%
– Total Allocation Effect = 0.6% – 0.8% = -0.2%

Calculating Selection Effect:
– Technology: 60% × (15% – 12%) = 1.8%
– Healthcare: 40% × (10% – 8%) = 0.8%
– Total Selection Effect = 1.8% + 0.8% = 2.6%

Total Attribution:
– Total Attribution = -0.2% + 2.6% = 2.4%

This means that overall, the portfolio outperformed the benchmark by 2.4%, attributable to stock selection, despite a negative allocation decision. Performance attribution provides key insights to managers to optimize investment strategies moving forward.