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 four categories:
- Sector Returns: A portion of every portfolio’s return is due to the sectors in which the manager invested. Looking at returns due to sector performance is helpful in determining if the portfolio manager was skillful or just happened to be in the right place at the right time.
- Style Returns: Often, a particular style of asset will deliver better returns than other styles in the same asset class. Accordingly, an investor with that particular style should have expected higher returns than other investors would have generated over the same period by investing in the same asset class. 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 their peers in the next year.
- Activity Returns: Though some managers 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 securities 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.
- Security Selection: The most telling sign of investment talent can be found in the return due to security 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 security 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 security selection contributed an additional 10% of returns to achieve the 20% for the period. In other words, that portfolio manager was picking the best securities in the sector.
What we endeavor 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, they were able to pick the right securities to deliver returns above and beyond those expected by the style and sector allocations. The higher the return due to security selection, the higher the degree of skill that the portfolio manager is exhibiting to find the right securities in the market, regardless of sector and style.