Why do we need Attribution Analysis?
When searching for someone to invest your money, whether it is your own personal portfolio or a large institutional account, your first step is to look at how well that person has performed over various time periods. However, simply looking at performance numbers alone does not tell the whole story. Was the portfolio manager's performance skillful, or lucky? And if we can determine that the manager was actually lucky, would we be as eager to have them manage our money going forward?
What is Attribution Analysis anyway?
Attribution analysis is a popular tool amongst institutional money managers seeking a way to better evaluate the investment talent of portfolio managers. Simply put, this type of analysis segments investment returns into 4 categories: Returns due to 1) style allocation, 2) sector allocation, 3) stock selection, and 4) activity.
A portion of every return is due to the sectors in which the portfolio invested. Looking at returns due to sector performance is helpful in finding if the portfolio manager was just in the right place at the right time. Ex: A portfolio manager running a Technology fund in 1999 may have had a one-year return of 20%, but if the Technology sector was also up 20%, we can infer that the manager's performance was entirely due to sector allocation. Should the sector fall out of favor, we cannot be certain that the manager will be able to outperform his/her Technology peers.
During 2001, Small Cap Value stocks delivered some of the highest returns in the market. Accordingly, an investor with that particular style should have expected higher returns than a Large Cap Growth investor would have generated over the same period. Again, a 20% return within a style that averaged a 20% return tells us that the portfolio manager may not be expected to perform better than average against his/her peers in the next year.
Though some investors employ a buy and hold strategy, many make buy and sell decisions throughout a given period. These decisions are bound to effect performance one way or another based on the subsequent performance of the stocks being bought and sold. Segmenting returns by Activity compares how movements in and out of particular investments contributed to the final return versus a simple buy and hold strategy. It tells you if a manager's decisions to add or subtract positions from the portfolio helped or hurt the final return.
The most telling sign of investment talent can be found in the return due to stock selection. This is calculated by removing the returns due to the allocation of the portfolio to a particular style or sector, which leaves an excess return due to stock selection. For example, if a portfolio manager's actual return was 20% for a given period, and his sector of choice had returned 10% over that period, we can determine that his stock selection contributed an additional 10% of returns to achieve the 20% for the period. In other words, that portfolio manager was picking the best stocks in the sector.
What we should hope to find is that the portfolio manager's stock selection contributed positively to the portfolio's performance. That means that within that manager's chosen sector and style, he/she was able to pick the right stocks to deliver returns above and beyond those expected by the style and sector allocations. The higher the return due to stock selection, the higher the degree of skill that the portfolio manager is exhibiting to find the right stocks in the market, regardless of sector and style.
The Attribution reports within the Premium Toolkit (for more info about Premium Membership, click here) focus specifically on Sector returns (instead of Style). You can apply the definitions above to the sample table below showing the break-down of a portfolio's returns:
One's return begins with the Market's return, or the expected return by just being invested in the market in the first place. Your stock Selection, your sector Allocation, and trading Activity all add up to represent your Skill. Add (or subtract) your Skill to the Market, and you get your total return.
How can I use Attribution Analysis?
Marketocracy's Premium members have the opportunity to use this powerful attribution analysis tool on their own virtual portfolios. Within a fund, selecting the Attribution by Sector report will generate the numbers, and a graphical representation of them, that detail exactly where a manager is generating his/her performance.
When viewing the report, there are a couple of key points to understand. The graph may appear confusing at first, but once defined it provides a simple summary of the attribution data. The orange bars demonstrate how much of your portfolio was allocated to a particular sector at the beginning of the given period. The blue and green floating bars represent the range of returns that were likely for each sector over the given period. These bars are known as Portfolio Opportunity Distributions (PODS)- we define PODs at the end of this article. Finally, the gray circle represents the actual return for your portfolio in a particular sector for the given period. You can easily see how well you performed versus what you might have been expected to do, given your sector orientation.
In all, you would like to see your circle appear near the top half of the POD, or even above it. This shows you that your stock selection is high- or more simply, it says that you are performing even better than could have been expected. Also, you would want to see that you are allocated most heavily to the sectors where your performance is the strongest.
The data behind the bar chart graph can be found in a table format within the Attribution report:
Again, Total is the portfolio's return in the given sector, Market is the entire sector's return, and Selection, Allocation and Activity collectively represent the skill of the manager in that sector.
Get access to these Attribution reports for your virtual funds by subscribing to our Premium Membership. You'll get these attribution reports, plus all the rest of our Premium Research and Premium Toolkit reports.
PODs: One more piece of information that aids in calculating sector and style returns is something that is known as a Portfolio Opportunity Distribution (POD). Represented in the Attribution report as a floating blue and green shaded bar, a POD is defined as the range of returns, for a given sector and time period, that were possible for a portfolio of stocks. This range, or distribution of returns is calculated by generating thousands of hypothetical portfolios, and observing what those portfolios would have returned. The bars are segmented into percentiles- the top of the bar is the 95th percentile, and the bottom is the 5th percentile. That means that 90 percent of the returns available in the market for that sector are captured in the POD, but there are returns possible both above and below the POD. Where you end up relative to the POD gives you an idea of how skillful you were in the given sector.
Attribution analysis is acknowledged as the definitive way to separate skill (stock selection and activity) from luck (style or sector allocation). We've designed our attribution analysis after the methodologies employed by Ron Surz and his firm PPCA Inc. For more information on attribution analysis, check out his website.