Selecting the most appropriate risk metric for attribution analysis requires an in-depth understanding of the investment process of the portfolio manager. It is critical to identify whether the portfolio manager follows a top-down or bottom-up investment process and to define the portfolio’s appropriate benchmark.
Risk attribution identifies the sources of risk taken by the investment manager that resulted in the fund’s returns.
The following table summarizes investment process and type of attribution analysis.
| Investment Decision-Making Process | Type of Attribution Analysis | Type of Attribution Analysis |
|---|---|---|
| Absolute vs Relative | Absolute | Relative to bmark |
| Bottom up | Position’s marginal contribution to tracking risk | Position’s marginal contribution to total risk relative to bmark |
| Top down | Attribute tracking risk to relative allocation and selection decisions | Position’s marginal contribution to total risk relative to bmark |
| Factor based | Factor’s marginal contribution to tracking risk and active specific risk | Factor’s marginal contribution to total risk and specific risk |
Tracking risk (or tracking error) is the relevant risk measure to consider for relative attribution analysis, and the general objective is to determine the returns generated from active management and compare them to the amount of tracking risk assumed. For the bottom-up approach, each security in the portfolio has a marginal contribution to tracking risk, and that amount is multiplied by its active weight to determine the contribution to tracking risk. In contrast, the top-down approach takes a more macro approach and attributes active return to allocation; then it attributes tracking error to allocation and selection.
Absolute attribution analysis quantifies general risk arising from market, size, and style exposures and specific risk arising from stock picking. A common risk measure to use is standard deviation.
Risk attribution provides insight into the amount of risk that was introduced into the fund. Risk attribution must be combined with return attribution to fully understand the portfolio manager’s active investment decisions.
Position’s marginal contribution to total risk
Factor’s marginal contribution to total risk and specific risk