A Four-Factor Performance Attribution Model for Equity Portfolios

Craig Heatter
JP Morgan Chase
craig.heatter@jpmorgan.com

Charles Gabriel
Empirical Modeling and Analytics, Inc.
cgabriel@empirics.com

Yi Wang
Empirical Modeling and Analytics, Inc.
yi@empirics.com

Abstract

In this paper, we discuss a four-factor performance attribution model for equity

portfolios. The model captures the risk and return characteristics of four
elementary equity investment strategies and can be used to identify and quantify
an equity portfolio’s risk and style exposures, sources of total return, and sources
of value added. It can also be used to help overcome the risk mismatch problem
of benchmarking and peer grouping.

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Introduction

Benchmarking and peer grouping as investment performance measurement tools,

while very well accepted and as intuitive as they are, are not sophisticated
enough to provide adequate information to help investors and plan sponsors in
searching for managers who can add value. It is not enough to know that a
manager beat the benchmark or was above the peer group median. Investors and
plan sponsors must also know how the manager beat the benchmark or the
median manager in the peer group. The sources of value added must be identified
and quantified. Benchmarking and peer grouping have so far failed in this regard.

And, with all the intuitive benefits associated with them, benchmarking and peer
grouping can mislead investors in important ways. For example, because
benchmarking and peer grouping do not appropriately and adequately
differentiate managers in terms of risk exposures, investors seeking
diversification may be taking unanticipated risk. In the volatile stock market
during the recent years, many investors have found that their portfolios were not
as diversified as they had expected, resulting in excess risk exposures and
significant performance shortfalls.

We believe that plan sponsors need to adopt a factor attribution analysis scheme
along with benchmarking and peer grouping. In this paper, we discuss a four-
factor performance attribution model for equity investments that enables us to
identify and accurately quantify a portfolio’s risk exposures, sources of excess
return, and sources of value added. [The excess return of a portfolio is the
portfolio return in excess of the one-month Treasury-bill return; and the value
added by a portfolio is the portfolio return less the benchmark return.]

The Four-Factor Performance Attribution Model

The four-factor model we discuss in this paper extends the Capital Asset Pricing
Model [CAPM] with three additional factors: the Fama-French size and book-to-
market [BTM] factors and the Carhart momentum factor. Published academic
studies show that the four-factor model represents a significant improvement

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over the [single market factor] CAPM in explaining equity portfolio performance
[see, for example, Fama and French (1992, 1993, and 1996), Carhart (1997),
Chan, Chen, and Lakonishok (2002)].

As a performance attribution model, the four-factor model captures the risk and
return characteristics of four elementary equity investment strategies:

• Investing in high versus low market sensitivity stocks

• Investing in small versus large market capitalization stocks
• Investing in value versus growth stocks
• Investing in momentum versus contrarian stocks

The four-factor performance attribution model can be mathematically represented

as

RP – RF = αP + βM(RM – RF) + βSRS + βBRB + βORO

RP - RF = Portfolio excess return

RM - RF = Market factor return
RS = Size factor return
RB = BTM factor return
RO = Momentum factor return
αP = Portfolio risk-adjusted return
βM = Portfolio market beta
βS = Portfolio size beta
βB = Portfolio BTM beta
βO = Portfolio momentum beta

The portfolio excess return, as defined earlier, is the portfolio return less the one-
month Treasury-bill return. The market factor return is the value-weighted average
return of all New York Stock Exchange, American Stock Exchange and NASDAQ
stocks less the one-month Treasury-bill return. The size, BTM, and momentum
factor returns are the return to a portfolio of small-cap stocks minus the return to a

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portfolio of large-cap stocks, the return to a portfolio of value stocks [stocks with a
high ratio of book to market value] minus the return to a portfolio of growth stocks
[stocks with a low ratio of book to market value], and the return to a portfolio of
momentum stocks [stocks that outperformed in the recent past] minus the return to
a portfolio of contrarian stocks [stocks that underperformed in the recent past],
respectively. [Refer to Fama and French (1993) and Carhart (1997) for
construction details for the Fama-French size and BTM factors and the Carhart
momentum factor.]

The portfolio betas are the sensitivities of the portfolio excess return to the factor
returns and hence the model’s measures of the risk exposures of the portfolio. In
other words, the betas of a portfolio are measures of the extent to which the
portfolio return varies with the factor returns. Thus, for example, the realization of
the size factor return will impact a portfolio with a size beta of 0.50 twice as much
as it will impact a portfolio with a size beta of 0.25.

There are two well-known approaches for estimating betas for a portfolio: one is
return-based and the other holdings-based. The return-based approach estimates
betas by an ordinary least squares regression of the portfolio excess returns on the
factor returns. With the holdings-based approach, beta estimates for a portfolio are
obtained by first estimating the betas of the constituent stocks and then taking the
value-weighted average betas of the stocks as the betas of the portfolio. The betas
of the constituent stocks can be estimated by mapping them to constructed
portfolios with similar characteristics [market capitalizations and book-to-market
ratios, for example]. In the analysis that follows, the betas are return-based
estimates. Specifically, they were estimated by regressing monthly portfolio excess
returns on monthly factor returns over forty-eight month periods.

The four-factor performance attribution model thus decomposes the portfolio

excess return into five components:

• Risk-adjusted return [αP]

• Return attributable to market factor exposure [βM(RM – RF)]
• Return attributable to size factor exposure [βSRS]

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 • Return attributable to BTM factor exposure [βBRB]
• Return attributable to momentum factor exposure [βORO]

The risk-adjusted return is also referred to as the “alpha”. It is the return after
controlling for general market movements and other risk factor exposures and
hence a measure of the ability of the manager to generate return by stock selection
beyond the reward for taking risk. Therefore, we believe it should be the dominant
criterion for selecting a manager.

Quantifying Risk Exposures

At the heart of the modern portfolio theory is the notion of risk-return trade-off.
Too often investors who do not pay much attention to risk exposures find
themselves taking too much unanticipated risk and suffering significant
underperformance. Sound investment strategies build on a clear understanding of
risk exposures. Risk exposure analysis with the four-factor performance attribution
model allows investors to build more accurate risk profiles for the managers they
are interested in than either benchmarking or peer grouping.

Exhibit 1: Risk Exposures of US Equity Indices

Market Size BTM Momentum
Beta Beta Beta Beta
Wilshire 5000 0.99 0.01 0.00 0.00
S&P 500 0.99 -0.15 0.07 -0.03
S&P/BARRA 500 Value 0.98 -0.12 0.33 0.08
S&P/BARRA 500 Growth 1.01 -0.16 -0.16 -0.14
FRC 1000 1.00 -0.11 0.05 -0.01
FRC 1000 Value 0.87 -0.20 0.30 0.16
FRC 1000 Growth 1.18 -0.02 -0.14 -0.21
FRC 2000 0.86 0.70 0.01 0.20
FRC 2000 Value 0.68 0.48 0.31 0.33
FRC 2000 Growth 1.11 0.85 -0.19 0.07

The four-factor performance attribution model identifies and quantifies the risk
exposures of a portfolio by measuring the portfolio’s betas to the four risk factors.
Exhibit 1 shows the beta estimates for some US equity indices. [The beta estimates
for the indices were obtained from regressing the monthly excess returns of the

5
indices on the monthly factor returns over the forty-eight month period ending
December 31, 2001.]

The close-to-unit market beta and close-to-zero size, BTM, and momentum betas
of Wilshire 5000 confirm the robustness of the four-factor model. As a broad
market index, Wilshire 5000 behaves very much like the general US stock market,
which by definition has a unit beta to the market factor and a zero beta to each of
the other factors.

Examining the betas of the other indices, we notice the following patterns:

• Small-cap indices have positive size betas while large-cap indices have
negative size betas
• Value indices have positive BTM betas while growth indices have
negative BTM betas
• Small-cap and value indices have positive momentum betas while large-
cap growth indices have negative momentum betas

Exhibit 2: Risk Exposures of MorningStar US Equity Growth Mutual Funds

Market Size BTM Momentum
Beta Beta Beta Beta
Median 1.00 -0.02 -0.03 0.00
Maximum 1.70 0.95 0.68 0.43
Minimum 0.39 -0.46 -1.35 -0.48

One of peer grouping’s problems is the wide range of manager risk exposures even
within the peer group, as illustrated by Exhibit 2. [We estimated the betas for an
individual fund by a regression of the fund’s monthly excess returns on the
monthly factor returns over the forty-eight month period ending December 31,
2001.]

The market betas of the US equity growth funds, as categorized by MorningStar,

ranged from 0.39 to 1.70, the size betas ranged from –0.46 to 0.95, and the
momentum betas ranged from –0.48 to 0.43. Even worse, within this supposed
growth peer group, the BTM betas covered a range of –1.35 to 0.68. Comparing

6
the BTM betas of the funds in this group to those of the US equity indices, we find
that about 7 percent [84 out of 1258], with a BTM beta greater than 0.35, should
definitely be considered as value funds and 45 percent [561 out of 1258], with a
BTM beta greater or equal to 0.00, should be considered as value-growth neutral or
value funds.

Needless to say, peer grouping with such wide ranges of risk exposures does not
provide especially meaningful comparisons. Rather it misleads investors and in
many instances is unfair to the managers being evaluated. Meaningful peer
grouping requires that we first quantify managers’ risk exposures and then form
peer groups of managers with similar risk exposures.

Similarly, meaningful benchmarking requires that there is no severe risk exposure

mismatch between the manager and the benchmark. The main purpose of
benchmarking is to measure the manager’s ability to generate value on the top of
the return from assuming the risk of the benchmark. [This is perhaps why many
investors identify the differential return between the manager and the benchmark
with the alpha, that is, the risk-adjusted return]. Benchmarking thus serves its main
purpose well as long as the risk exposures of the manager are close to those of the
benchmark. When there is severe risk exposure mismatch, however, benchmarking
becomes very misleading. Exhibit 3 illustrates this phenomenon.

Exhibit 3: Benchmarking with Risk Mismatch

Panel A: Excess Returns and Differential Returns between Manager and Benchmark
Excess Manager - Benchmark
Return ("Benchmarking Alpha")
S&P 500 10.15
Manager A 12.33 2.18
Manager B 12.38 2.23
Panel B: Risk Exposures and Risk-Adjusted Returns
Beta
Market Size BTM Momentum
S&P 500 0.99 -0.15 0.07 -0.03
Manager A 1.00 -0.16 0.05 -0.02
Manager B 0.99 -0.14 0.95 -0.04
Risk-Adjusted Return Attributable to Risk Factor Exposure
Return Market Size BTM Momentum
S&P 500 -0.05 11.85 -1.65 0.17 -0.17
Manager A 2.11 11.97 -1.76 0.12 -0.11
Manager B 0.03 11.85 -1.54 2.26 -0.22

7
Manager A’s risk exposures are very close to those of the benchmark, S&P 500. As
a result, the differential return between Manager A and the benchmark, 2.18%, is
very close to the true alpha [risk-adjusted return] of Manager A, 2.11%. However,
Manager B has a substantially higher exposure to the BTM factor than the
benchmark. Consequently the differential return between Manager B and the
benchmark, 2.23%, represents a truly remarkable overestimate of Manager B’s true
alpha, 0.03%.

To accurately measure the ability of a manager to generate value in addition to the

return from assuming risk, we need to use a robust factor attribution model, such as
the one discussed here. If one wants to keep benchmarking as an alternative tool
because investors are still more used to it, one must make sure that the benchmark
matches the manager well in terms of risk exposures. Factor analysis can be used to
quantify the manager’s risk exposures and the risk exposures of available indices to
find or construct a benchmark that results in minimum risk mismatch.

Quantifying Sources of Excess Return

Needless to say, investors and plan sponsors are ultimately concerned about the
total return a portfolio manager delivers. They want to select managers who can
consistently deliver good total returns. In evaluating and selecting managers, it is
important to know what returns a manager has delivered so far. However, in
order to succeed in the future, it is even more important to know how the
manager achieved those returns.

Benchmarking and peer grouping are mainly concerned about how a manager has
fared relative to the benchmark and peers. They do not aim to explain the
manager’s return. By decomposing the manager’s return, however, the four-
factor performance attribution model presents a clear picture of its sources and
their relative importance.

Exhibit 4 illustrates such a return decomposition. Here the manger’s excess

return, 25.51% is decomposed into a risk-adjusted return or alpha, -0.28%, a
return component from exposure to the market factor, 3.46%, a return component

8
 from exposure to the size factor, 5.83%, a return component from exposure to the
BTM factor, 13.13%, and a return component from exposure to the momentum
factor, 3.37%.

Exhibit 4: Components of Excess Return

30

25

20

15

10

-5
Excess Return
Alpha + Market + Size + BTM + Momentum
=
25.51 -0.28 3.46 5.83 13.13 3.37

Why is it so important to quantify the sources of a manager’s return? Exhibit 5

explains why. For the first quarter of 2000, the manager in the exhibit performed
extremely well relative to the broad market: the manager delivered an excess
return of 25.51% while the excess return to the general market was only 3.46%.
Investors in the fund might get exited with such a superb performance. But what
they really ought to do was to carefully look into the sources of the manager’s
return.

Exhibit 5: Performance Explained by Quantifying Its Sources

Panel A: Manager Risk Exposures
Market Size BTM Momentum
Beta 1.00 1.09 -0.78 0.34
Panel B: Risk Factor Returns
Market Size BTM Momentum
1Q/00 3.46 5.35 -16.83 9.91
1Q/01 -13.94 6.10 23.78 -36.62
Panel C: Manager Return Components
Excess
Return = Alpha + Market + Size + BTM + Momentum
1Q/00 25.51 -0.28 3.46 5.83 13.13 3.37
1Q/01 -39.02 -0.73 -13.94 6.65 -18.55 -12.45

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The manager made a heavy bet on small-cap, growth, and momentum stocks, as
indicated by the significant, positive size and momentum betas and the
significant, negative BTM beta. The manager’s bet paid off during the first three
months of 2000, as those stocks faired much better than large-cap, value, and
contrarian stocks. As the attribution of the return for the quarter shows, the
manager’s outperformance over the market, 22.05% [25.51% - 3.46%], came
entirely from the manager’s risk bet. The risk-adjusted return or alpha was
slightly negative, -0.28%. The bet on small-cap stocks returned 5.83%, the bet on
growth stocks returned 13.13%, and the bet on momentum stocks returned
3.37%.

The heavy bet on growth and momentum stocks ran the manager into the
doghouse a year later during the first quarter of 2001. During this period, value
stocks outperformed growth stocks by 23.78% while momentum stocks
underperformed contrarian stocks by 36.62%. [The BTM and momentum factor
returns for the quarter were 23.78% and –36.62%, respectively.] As a result, the
bet on growth and momentum stocks cost the manager an astonishing –31.00%
[-18.55% + (-12.45%)], which was mainly responsible for the manager’s
underperformance relative to the general market, -25.08% [-39.02% - (-13.94%)].

The lesson from the manager in Exhibit 5 is clear: tracing good-performing funds
without a clear view on how they delivered returns may result in severe
unanticipated losses in the future.

Quantifying Sources of Value Added

Merely knowing that the manager beat the benchmark is not enough. Investors
must also know how the manager managed to beat the benchmark in order to
make prudent decisions. Benchmarking measures the extent by which the
manager outperformed the benchmark but does not aim to explain it. If a risk
exposure mismatch existed between the manager and the benchmark, as in most
cases of active managers, it would be difficult to determine whether the
outperformance was by stock selection, by deviation in risk exposures, or by both
without factor attribution analysis.

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The four-factor performance attribution model decomposes the value added by
quantifying the risk exposures and return sources of both the manager and the
benchmark so that it becomes immediately clear how the manager added the
value. Exhibit 6 provides an illustration.

Exhibit 6: Quantifying Sources of Value Added

Panel A: Manager A - S&P 500
Excess Return
Manager A 12.33
S&P 500 10.15
Value Added 2.18
Beta
Market Size BTM Momentum
Manager A 1.00 -0.16 0.05 -0.02
S&P 500 0.99 -0.15 0.07 -0.03
Risk Factor Return
Market Size BTM Momentum
11.97 10.97 2.38 5.61
Excess Risk-Adjusted Return Attributable to Risk Factor Exposure
Return = Return + Market + Size + BTM + Momentum
Manager A 12.33 2.11 11.97 -1.76 0.12 -0.11
S&P 500 10.15 -0.05 11.85 -1.65 0.17 -0.17
Difference 2.18 2.16 0.12 -0.11 -0.05 0.06
Panel B: Manager B - S&P 500
Excess Return
Manager B 12.38
S&P 500 10.15
Value Added 2.23
Beta
Market Size BTM Momentum
Manager B 0.99 -0.14 0.95 -0.04
S&P 500 0.99 -0.15 0.07 -0.03
Risk Factor Return
Market Size BTM Momentum
11.97 10.97 2.38 5.61
Excess Risk-Adjusted Return Attributable to Risk Factor Exposure
Return = Return + Market + Size + BTM + Momentum
Manager B 12.38 0.03 11.85 -1.54 2.26 -0.22
S&P 500 10.15 -0.05 11.85 -1.65 0.17 -0.17
Difference 2.23 0.08 0.00 0.11 2.09 -0.06

Manager A and Manager B had the same benchmark, S&P 500, and they both
beat it and added value by about the same amount, 2.18% and 2.23%,
respectively. Taking a closer look by quantifying the sources, we find that the
values were added by the two managers through very different avenues. Manager
A took almost identical risk exposures to those of the benchmark, and added
value almost entirely by stock selection: the differential risk-adjusted return,

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2.16%, between Manager A and the benchmark accounts for almost the entire
value added by Manager A, 2.18%. Manager B, on the other hand, showed little
stock selection ability, and generated the value added, 2.23%, mainly by taking
an excess exposure to the BTM risk factor relative to the benchmark [Manager
B’s BTM beta of 0.95 versus the benchmark’s 0.07], which added 2.09%.

Exhibit 7 graphically decomposes Manager B’s value added.

Exhibit 7: Components of Value Added

14

12

10

-2
Excess
Alpha + Market + Size + BTM + Momentum
Return =
Manager B 12.38 0.03 11.85 -1.54 2.26 -0.22
S&P 500 10.15 -0.05 11.85 -1.65 0.17 -0.17
Difference 2.23 0.08 0.00 0.11 2.09 -0.06

Performance Attribution at the Composite Level

Most plan sponsors enlist a number of managers within different categories

[large-cap value, mid-cap core, and small-cap growth, for example]. Given the
diverse investment styles and risk characteristics of the manager team, peer
grouping is not practically feasible for performance measurement at the
composite level. [By composites, we mean aggregates of managers enlisted by a
plan sponsor; for example, the US equity composite consists of all US equity
managers in the plan.] While benchmarking is still feasible, it will not give us a

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clear risk picture of the composite. Nor will it give us a clear view of the benefit
from diversification, which is the main reason for hiring managers of different
investment styles in the first place. Moreover, performance measures from
benchmarking normally do not provide an especially meaningful comparison
between managers in the composite because, as we discussed before, the sources
of the values added by the managers can be very different. The economically
meaningful way to compare managers is to compare them by risk-adjusted return,
which is the return after controlling for risk exposures and which measures the
ability to generate return by selecting stocks undervalued relative to their risk
characteristics.

Exhibit 8: Performance Attribution at the Composite Level

Panel A: Risk Exposures of the Composite
Beta
Weight Category Market Size BTM Momentum
Manager A 0.40 Large-Cap Growth 1.18 -0.22 -0.19 -0.21
Manager B 0.30 Mid-Cap Core 0.95 0.18 0.05 0.18
Manager C 0.30 Small-Cap Value 0.98 0.48 0.31 0.33
Composite 1.05 0.11 0.03 0.07
Panel B: Risk Factor Returns
Risk Factor Return
Market Size BTM Momentum
11.97 10.97 2.38 5.61
Panel C: Attribution of the Composite Return
Excess Risk-Adjusted Return Attributable to Risk Factor Exposure
Return = Return + Market + Size + BTM + Momentum
Manager A 9.52 -0.56 14.12 -2.41 -0.45 -1.18
Manager B 14.49 0.02 11.37 1.97 0.12 1.01
Manager C 20.82 1.23 11.73 5.27 0.74 1.85
Composite 14.40 0.15 12.58 1.21 0.08 0.39

The four-factor performance attribution model provides a unified approach to

performance measurement. It uses the same set of risk factors in measuring
performance of managers, whether they are large-cap, mid-cap, or small-cap
managers and whether they are value, core, or growth managers. As a result, the
four-factor performance attribution model provides performance measures that
are perfectly comparable across managers in the composite, and it quantifies the
risk exposures and decomposes the return for the composite just as for any
individual manager in the composite. Exhibit 8 is an illustration of performance
attribution at the composite level. The risk exposures of the composite are simply

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the value-weighted average risk exposures of the managers constituting the
composite.
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