Performance attribution is a critical component of the portfolio evaluation process. Effective performance attribution analysis requires a thorough understanding of the investment decision-making process and should reflect the active decisions of the portfolio manager.
An effective performance attribution process must
- account for all of the portfolio’s return or risk exposure,
- reflect the investment decision-making process,
- quantify the active decisions of the portfolio manager, and
- provide a complete understanding of the excess return/risk of the portfolio.
Performance attribution includes return attribution and risk attribution.
Return attribution analyzes the impact of active investment decisions on returns;
Risk attribution analyzes the risk consequences of those decisions.
Performance attribution can also be conducted at distinct levels, depending on which decisions within the investment process are analyzed. Attribution as described previously—understanding the drivers of a manager’s returns and whether those drivers are consistent with the stated investment process—is sometimes called micro attribution.
Attribution can also be conducted to evaluate the asset owner’s decisions. This level is sometimes called macro attribution.
Return-based attribution uses only the total portfolio returns over a period to identify the components of the investment process that have generated the returns.
Holdings-based attribution references the beginning-of-period holdings of the portfolio.
Transactions-based attribution uses both the holdings of the portfolio and the transactions that occurred during the evaluation period. For transaction-based attribution, both the weights and returns reflect all transactions during the period, including transaction costs.
The choice of attribution approach depends on the availability and quality of the underlying data, the reporting requirements for the client, and the complexity of the investment decision-making process.