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Analyzing Returns: A Guide to Effective Attribution Analysis

Last updated 03/19/2024 by

Rasana Panibe

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Summary:
Attribution analysis, also known as return attribution or performance attribution, is a sophisticated method for evaluating portfolio or fund manager performance. It focuses on investment selections, asset allocation, investment style, and market timing. This article delves into how attribution analysis works, its key components, and the role of market timing in evaluating fund managers. Understanding this tool is crucial for both portfolio managers assessing strategies and investors evaluating fund or money managers.

How does attribution analysis work?

Asset class and allocation

Asset classes play a pivotal role in attribution analysis. Identifying the types of investments a manager chooses and the allocation of these assets helps establish a benchmark for performance comparison. This benchmark often takes the form of a market index, ranging from broad indices like the S&P 500 to more specific ones focusing on sectors or industries.

Analysing investment style

Determining the manager’s investment style is the next crucial step. This involves assessing the nature of the manager’s holdings. Are they large-cap or small-cap stocks? Value- or growth-oriented? Returns-based style analysis (RBSA), introduced by economist Bill Sharpe, provides another dimension, charting a fund’s returns against an index with comparable performance history.

Explaining alpha

Once a customised benchmark is formulated, analysts can delve into explaining alpha—the excess returns that a manager enjoys over benchmarks. This involves identifying whether alpha stems from stock picks, sector selection, or market timing. Quantifying this allows a clearer understanding of a manager’s skill in generating returns.

Market timing and attribution analysis

Market timing, the third factor in attribution analysis, involves gauging a manager’s decisions to add or subtract positions from the portfolio. While the importance of market timing is debated, it adds a layer of complexity to understanding fund manager performance. Scholars emphasise the need to measure market timing against benchmarks reflective of market trends.
WEIGH THE RISKS AND BENEFITS
Here is a list of the benefits and drawbacks of attribution analysis.
Pros
  • Comprehensive evaluation of performance
  • Identification of sources of excess returns
  • An effective tool for portfolio managers and investors
Cons
  • Difficulty in quantifying market timing impact
  • Debate on the significance of market timing
  • Randomness and luck involved in timing decisions

Frequently asked questions

What is attribution analysis?

Attribution analysis is a method for evaluating the performance of a portfolio or fund manager, focusing on investment selections, asset allocation, investment style, and market timing.

How does attribution analysis work?

It works by identifying the asset class, analysing asset allocation, determining the investment style, and assessing the impact of market timing on a manager’s decisions and trades.

Why is market timing debated in attribution analysis?

There is debate on the importance of market timing, with some emphasising its difficulty in quantitative terms and the randomness involved, attributing less significance compared to asset selection and investment style.

Key takeaways

  • Attribution analysis evaluates a manager’s performance comprehensively.
  • Asset class, allocation, and investment style are pivotal components of the analysis.
  • Market timing, though debated, adds complexity to understanding fund manager performance.

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