Performance Attribution

Performance Attribution or Investment Performance

Attribution is a set of techniques that performance
analysts use to explain why a portfolio's
performance differed from the benchmark. This
difference between the portfolio return and the
benchmark return is known as the active return.
The active return is the component of a portfolio's
performance that arises from the fact that the
portfolio is actively managed.

 Different kinds of performance attribution

different ways of explaining the active return.

provide

Attribution analysis attempts to distinguish which of the

two factors of portfolio performance, superior stock
selection or superior market timing, is the source of the
portfolios overall performance. Specifically, this method
compares the total return of the managers actual
investment holdings with the return for a predetermined
benchmark portfolio and decomposes the difference into
a selection effect and an allocation effect.

History
In 1972, A Working Group of the Society of Investment
Analysts (UK) published a paper about analysing the
performance of investment portfolios. This paper,
although never verified, claims to have introduced the key
concept
in
performance
attribution,
that
active
performance can be analysed by comparing the returns of
different notional portfolios. In particular, if one examines
the performance of a portfolio that holds each sector at
the active weight, while earning a passive return within
each sector, one can measure exactly the amount of value
that is added by asset allocation decisions.

 The 1972 paper, if in fact it exists, introduced the key elements of

modern performance attribution: notional portfolios, asset
allocation, and stock selection. The perhaps fictional paper
presents this analytic paradigm as an extension of previously
known concepts. Since it was not an academic publication, it did
not claim novelty, even though the approach introduced was new
and novel. An excerpt from the fictional paper reads:
The working group recommend that the notional fund concept be
extended to cover the whole fund, i.e. fixed interest, equity and
cash investments and by using appropriate indices the actual fund
is compared with a notional fund chosen such that the proportions
in the different investment sectors follow those laid down by the
trustees.

 The 1972 paper is ignored, because there is not any evidence that it was
actually published and may be a fictional creation, by many of the
standard texts on performance attribution
It is believed that Gary P. Brinson's Brinson et al. 1985 introduced the
idea of using notional portfolios to attribute investment performance. For
this reason, many of the standard texts correctly acknowledge their work
and devote copious numbers of pages to "Brinson Fachler attribution"
(pp. 177-180) and "Brinson Hood Beebower attribution" (pp. 29-51). The
Brinson-Fachler methodology underpins many public performance
attribution analyses. Morningstar, for example, includes a whitepaper[1]
on their mode of employing the Brinson-Fachler methodology.
Morningstar is known for its analysis of long-only mutual funds, but the
Brinson-Fachler analysis is also applicable to hedge ranking funds.

Geometric attribution
The most common approach to performance attribution (found in
sources such as Brinson et al. 1985 and Carino 1999) can be
described as "arithmetic attribution". It is arithmetic in the sense
that it describes the difference between the portfolio return and the
benchmark return. For example, if the portfolio return was 21%, and
the benchmark return was 10%, arithmetic attribution would
explain 11% of value added.
In Europe and the UK, another approach (known as geometric
attribution) has been common. If the portfolio return was 21% while
the benchmark return was 10%, geometric attribution would
explain an active return of 10%. The reasoning behind this is that
10% of active return, when compounded with 10% of benchmark
performance, produces a total portfolio return of 21%.

 Adherents of the geometric approach consider it to

be highly intuitive. See, for example, Bacon (2002).
However, not everybody agrees on this.
One advantage of doing attribution in geometric
form is that the attribution results translate
consistently from one currency to another. It is
plausible that this explains the popularity of
geometric approaches in Europe. This is discussed
further in the external link by Davies.

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