What is attribute analysis?
The performance of a portfolio or fund manager may be evaluated in a sophisticated manner using a technique known as attribution analysis. It is also known as “return attribution” or “performance attribution.” It attempts to statistically examine various elements of an active fund manager’s investment picks and decisions. The goal of this endeavor is to discover sources of excess returns, particularly in comparison to an index or any other benchmark.
Attribution analysis for evaluating investment strategies may be a valuable tool for portfolio managers and investment firms. The attribution analysis provides investors with a way to assess the effectiveness of the performance of fund or money managers.
The Process Behind Attribution Analysis
The investment selections and asset allocation of the management, the investing style of the manager, and the market timing of the decisions and trades made by the manager are the primary foci of attribution research.
The first step in the process is to determine the asset class(es) in which fund management will invest their money. In general, an asset class is used to refer to the several kinds of investments that a manager may choose to make. However, within this larger concept, an asset class may also refer to a geographical marketplace from which investments come and an industrial sector. Examples include both European fixed-income debt as well as American technology stocks and shares.
The distribution of the various assets is another important consideration; this refers to the proportion of the total value of the portfolio invested in multiple markets, fields, or businesses.
Examining the Different Types of Investments
Finding out the management’s investing strategy is the next step in the attribution analysis process. Similar to identifying classes covered before, a style will serve as a standard against which the manager’s performance may be evaluated.
The type of the manager’s assets is the primary focus of the first way of examining investment style. If they are stocks of corporations, for instance, does it mean that they are large-cap or small-cap stocks of companies? Are we more concerned about value than growth?
In 1988, American economist Bill Sharpe was the one who first presented the second form of style analysis. Returns-based style analysis, often known as RBSA, involves charting the returns of a fund and looking for an index with a performance history that is comparable. Sharpe perfected this process by employing a strategy that he referred to as quadratic optimization. This enabled him to assign a combination of indices that were most closely linked to the returns that a manager generated.
The Explanation of Alpha
When an attribution analyst has identified that mix, they can create a personalized return benchmark against which they may assess the manager’s performance. An investigation of this kind ought to shed light on the extra returns, also known as alpha, that the manager enjoys in comparison to those benchmarks.
The next stage of attribution analysis involves attempting to explain that alpha. Is it a result of the manager’s stock choices, their choice of sectors, or their ability to time the market? An analyst has to identify and deduct the fraction of the alpha that is related to industry and timing before they can calculate the amount of alpha that was created by their stock choices. Again, this may be accomplished by generating customized benchmarks depending on the specified mix of sectors and the timing of the trades made by the manager. If the fund has an alpha of 13%, then it is conceivable to attribute some portion of that 13% to the choice of sectors to invest in and when to enter and leave those sectors. The remaining will be used as alpha for stock selection.
Analysis of Market Timing and Contributing Factors
Although some managers use a strategy known as “buy and hold,” the vast majority trade continuously, making choices to purchase or sell within a specific period. It might be helpful to segment returns by activity since this will tell you if a manager’s actions to add or eliminate positions from the portfolio benefited or damaged the ultimate recovery compared to a more passive method known as buy-and-hold.
The time of entry into the market is the third significant aspect considered in attribution analysis. However, there is a considerable degree of controversy around its relevance.
Putting this aspect of attribute analysis into quantitative terms is, without a doubt, the most challenging aspect of the process. To the degree that the ability to time the market can be quantified, academics stress the significance of comparing a manager’s performance to benchmarks that account for rising and falling markets. In an ideal world, the fund will increase in value when bullish conditions prevail and will suffer a loss that is less severe than that of the market when adverse conditions prevail.
Despite this, several academics have observed that a large percentage of a manager’s effectiveness in terms of timing may be attributed to randomness or luck. Because of this, most experts believe that asset selection and investment style are more important than market timing regarding overall relevance.
- An attribution analysis is a type of assessment technique that may be used to explain and analyze the performance of a portfolio (or the performance of a portfolio manager), particularly in comparison to a particular benchmark.
- The investment selections and asset allocation of the management, the investing style of the manager, and the market timing of the decisions and trades made by the manager are the primary foci of attribution research.
- The examination of investment options includes consideration of asset class and the weighting of assets within a portfolio.
- The characteristics of the assets, such as low-risk, growth-oriented, and so on, are reflected in the investment style.
- The influence of market timing is difficult to measure, and the majority of experts consider it to be of lesser importance in attribution analysis than in the selection of assets and investing strategies.