Performance Attribution

Performance attribution, in finance, is a market indicator that analyzes and evaluates the performance of the portfolio or fund against a benchmark. The main purpose of this method is to identify the return rate of the portfolio with that of the market or index.

The portfolio performance attribution helps in understanding the investment style of the investor. Also, it serves as an assessment tool for evaluating portfolios. In addition, it also highlights the strengths and weaknesses of the fund. However, it can cause complications as it requires various tools and calculations.

• Performance attribution, or attribution analysis, is a method of analyzing and evaluating the portfolio and its performance against the index.
• There are three basic methods of this attribution analysis: multi-factor, return decomposition, and style analysis.
• The factors that affect investment performance attribution are asset allocation, investment style and market timing.
• The concept originated in 1972 when American economist Eugene F. Fama discussed it in the book Components of Investment Performance.
• The effects of attribution analysis are asset allocation, security selection, and interaction effect.

Performance attribution, or attribution analysis, is an evaluation method to determine whether the performance of a portfolio is at par or below the required benchmark. Plus, it is a perfect evaluation tool for assessing the investment's returns. Here, fund managers tend to calculate the excess returns or active returns on the portfolio.

There are three basic forms of portfolio performance attribution analysis. It includes multi-factor, style, and return decomposition analyses. Let us look at them in detail:

#1 - Multi-Factor Analysis

It measures performance based on many indicators like P/E (Price to Earnings) ratio, economic factors, and durations. However, they are difficult to calculate plus require a lot of data.

#2 - Style Analysis

The American economist William F. Sharpe developed this method where portfolio performance gets compared with the investment style. Although it is easy to calculate, it does not have wide acceptance.

#3 - Return Decomposition

This method has wide acceptance in the finance industry. Here, the performance attribution and index benchmarks are compared together. The main focus remains on allocation and proper selection of portfolios. Plus, to use this method, returns of benchmarks and portfolios, along with weights, are returned.

Investment performance attribution is also known as return attribution. However, the history of performance attribution can be traced back to the 1960s. At that time (1966 to 1968), the finance consultant Peter O. Dietz and the Bank Administration Institute (BAI) worked on the pension fund's performance. A few years later, American economist Eugene F. Fama delved deep and first created the performance attribution.

In 1972, Fama published Components of Investment Performance. It suggested the removal of the observed return, thereby helping in better stock selection at a given risk level. While Fama considered three groups (fixed income, asset grouping, and return-based), others, like Wagner and Tito (1977), the UK Society of Investment Analysts (1972), William F. Sharpe (1992), Brinson and Fachler (1985), and others further explained them.

Let us look at the performance attribution formula to understand the concept better:

Performance Attribution =  Allocation Effect + Selection Effect + Interaction Effect

Let us look at the factors that influence investment performance attribution:

#1 - Asset Allocation

Fund managers are responsible for creating a portfolio out of all asset classes. Therefore, the right selection is crucial in determining the overall portfolio performance. It also balances the risk level and rate of return. Some of the assets include stocks, bonds, options, and cash.

#2 - Investment Style

The trader's investment style is also vital in performance attribution. Thus, the right choice of appropriate benchmarks can elevate return on investment.

#3 - Market Timing

Although the right asset selection can bring returns, the trading timing of the portfolios can boost the performance. Thus, market timings can impact portfolio performance.

Let us look at the examples of performance attribution analysis to comprehend the concept better:

Example #1

Suppose Samil has invested $25000 in an index-based fund. It has been seven years since he invested in this fund. Thus, the fund manager calculated the returns using the performance attribution formula by the decade's end. So, let us look at the calculation using the Brinson-Fachler model.

1. Invested amount (Initial Portfolio Value) = $150,000
2. Index or Benchmark = DJI (Dow Jones Industrial Average)
3. Average Rate of Index = 12%
4. Total Portfolio returns = 14%
5. Portfolio Weight = 10%
6. Asset Allocation:

• Stocks ($100,000)
  • Actual return (10%)
  • Benchmark weight (9%)
• Bonds ($10,000)
  • Actual returns (4%)
• Cash ($40,000)
  • Returns (6%)

Allocation Effect =

                               = =

                               = -2% or 0.02 basis points

Selection Effect =

                             =

                             = 18% or 0.18 basis points 

Interaction Effect =

                                 =

                                 = 2%

Performance Attribution =  Allocation Effect + Selection Effect + Interaction Effect

                                              = (-2%) + 1.8% + 2%

                                              = 1.8%

Thus, the total returns on Samil's portfolio are 1.8%.

Example #2

According to a news article of November 2022, the BST (Buy-Side Technology) awards rewarded the capital market firm MSCI Inc. for the best performance product. The latter have designed analytical models that help in proper performance attribution. Also, this product successfully hedges the risk and caters to the needs of buy-side institutions across various asset classes.

Let us look at the effects of performance attribution given by different authors:

#1 - Asset Allocation Effect

Fund managers use asset allocation effects to allocate the assets in the right indexes or benchmarks. It determines whether weights assigned to them deliver positive or negative returns. Positive returns indicate either the segment surpassed the index or vice versa. They usually group them into major sectors like equity, technology, debt, or other instruments.

The formula for the asset allocation effect is as follows:

Allocation Effect =

Here, weights refer to the certain numbers allocated to various asset classes.

#2 - Security Selection Effect

It identifies the right selection of assets that suit the requirements of the portfolio. Here, too, weights are assigned to the index and benchmark. Following is the formula for the selection effect:

Selection Effect =

#3 - Interaction Effect

It has a combined effect of asset allocation and the selection effect. Let us look at the formula of the interaction effect:

Interaction Effect =

Let us look at the importance of performance attribution for a better understanding of the concept:

• It helps in determining sources of excess returns for a portfolio.
• Acts as a tool for identifying the investment style, asset allocation and performance.
• Helps in evaluating the overall portfolio and benchmark risks associated with it.
• Fund managers can easily monitor the market and adjust the assets on behalf of the investors.
• In addition, they also optimize and update the portfolio frequently.

This article has been a guide to what is Performance Attribution. Here, we explain its examples, formula, factors, history, effects, and importance. You may also find some useful articles here -

• Attribution Bias
• Modified Dietz
• Abnormal Return