|
Consider a hypothetical case of a fund ABC Equity Fund. Its return in calendar year 2013 was let say 11.23% while its benchmark gave 12.67%. Most of the other funds in this category managed to outperform the benchmark - thus making ABC Equity Fund a poor performer vs peers. Some clients who hold this fund have started asking you questions about this fund, especially since other funds have comfortably outperformed the benchmark. Let say this fund had a previous good track record. As an advisor, you have a dilemma : should you exit this fund and move to better performers? Should you give this fund more time considering the past track record? What if you give it more time but the fund continues to underperform? Will you be doing your clients a dis-service by holding on? On the other hand, what if you exit only to find out that the fund bounces back after one bad year? You speak with the fund house - they give you their explanations. You have a niggling worry - the fund house will obviously talk up its own funds. Can you rely solely on that to make your call?
The question confronting most advisors is whether to finally take a call based solely on your gut feel or look for a more scientific method to come to a well reasoned call on hold versus exit. This is where attribution analysis can help you in a significant way.
What does investment performance attribution analysis mean?
Investment Performance Attribution Analysis is a technique that explains why a portfolio's performance differed from the benchmark for the performance. A fund or portfolio's returns are compared to a benchmark in order to determine whether a manager is actually skilled or just lucky - or on the other hand, skilled but got unlucky with a single call.
The difference between the portfolio return and the benchmark return is termed as the active return. The active return can be negative or positive. Active return arises from the fact that the portfolio is actively managed to earn an additional return. It is also known as active management effect.
This tool is used to analyze the abilities of portfolio or fund managers. Attribution analysis uncovers the impact of the manager's investment decisions with regard to overall investment policy, asset allocation, security selection and activity. A close examination of these additional factors can provide a true assessment of the fund manager's competence and ability.
Performance attribution enables the portfolio's excess returns i.e. active return to be decomposed into different components in order to identify the factors that contribute to the excess returns.
For pure equity portfolios, the attribution analysis breaks down the excess return into three components (or four if there is a currency effect):
1. Sector Allocation Effect
2. Security Selection Effect
3. Allocation Selection Interaction Effect
1. Sector Allocation Effect
The sector allocation effect measures an investment manager's ability to effectively allocate portfolio among various sectors. The approach first identifies whether a specific sector is an out-performer or an under-performer within a benchmark. Then whether the fund manager is over-weighted or under-weighted on such outperforming or under-performing sectors.
The fund manager is rewarded for overweighing out-performing sectors & under-weighing under-performing sectors. Similarly, the fund manager is penalized for over-weighing under-performing sectors & under-weighing out-performing sectors. The impact in nutshell:
2. Security Selection Effect
The security selection effect measures an investment manager's ability to select securities within a given sector relative to a benchmark. Selection skills are judged on the basis of the securities selected by the fund manager and the allocation made to such securities within the sector. The approach first identifies whether a security is out-performing or under-performing within the benchmark sector. Then whether the fund manager is over-weighted or under-weighted on such outperforming or under-performing securities. When a portfolio manager is bullish on a security, he will be overweight in the security compared to the benchmark's weight. Conversely, if a portfolio manager is bearish on a security, he will be underweight in the security compared to the benchmark's weight.
Lets say banking and financial services is 30% of the index. Within the index, there are 9 companies from this sector. Each company has a specific weight in the index. Lets say SBI has a 4% overall weight in the index. A fund manager could either own more or less than 4% of SBI in his portfolio, or no SBI at all. If SBI outperforms the sector and the fund manager had 5% of his portfolio in SBI, that would be a positive contribution to his alpha. If he had only 2% in SBI on the other hand, that would be a negative. If he bought say IndusInd Bank which is not in the benchmark, and had 2% of his portfolio in this stock, and the stock does better than the BFSI sector, that would be a positive in terms of security selection, because he chose a stock with 0% weight in the sector, which outperformed the sector.
The fund manager is rewarded for - overweighing out-performing securities & under-weighing under-performing securities. Similarly, the fund manager is penalized for - over-weighing on an under-performing securities & under-weighing out-performing securities.
3. Allocation Selection Interaction Effect
The allocation selection interaction effect measures the combined impact of an investment manager's security selection and allocation decisions within a sector. For example, if an investment manager had superior security selection, but underweighted that sector, the interaction effect is negative. If an investment manager had superior security selection and overweighted that particular sector, the interaction effect is positive.
The following diagram explains the analysis:
So, in our above example, if the fund manager got his individual stock picks right within the BFSI space, but was overweight in the sector while the sector as a whole underperformed the index, he has a positive on stock selection but a negative on sector selection within BFSI.
Lets apply attribution analysis to ABC Equity Fund
Armed with these insights, you can now ask your ABC fund house RM to provide you with the attribution analysis of ABC Equity Fund's performance for the year 2013. The RM speaks with the product team and gets all the information you need. Here is how the performance of ABC Equity Fund can be de-constructed.
1. Sector Allocation Return for Power Sector
(W Power Portfolio - W Power Benchmark) (R Power Benchmark - R Benchmark)
= (30%- 13%) (-4%- 12.6788%) = -2.83%
The fund manager took an aggressive call to go significantly overweight in Power sector, with a 30% weightage against the benchmark weight of 13%. The power sector underperformed the benchmark significantly, thus contributing negatively to overall fund performance. As we observe, the decision to overweight a sector that underperformed the overall benchmark resulted in a negative contribution to the fund performance.
In both the sectors that outperformed the market - IT and FMCG, the fund manager was overweight, which contributed positively to performance.
2. Security Selection Return for Automobile Sector
W Automobile Benchmark (R Automobile Portfolio - R Automobile Benchmark)
= 20% (11%- 10%) = +0.2 %
The fund manager superior stock selection in automobiles sector contributed +0.2% to active return, as seen from the above computation. As can be seen from the tables, the fund's returns in all sectors was better than the respective sector performances - which indicates superior stock selection across all sectors.
3. Allocation Selection Interaction Return for Banking Sector
(W Banking Portfolio - W Banking Benchmark) (R Banking Portfolio - R Banking Benchmark)
= (20% - 21%) (9.5%- 9%) = -0.005%
Generally, the allocation selection interaction impact tends to be relatively small if the benchmark is appropriate.
Based on such a detailed calculation for each stock and each sector in the portfolio, the fund house provides this as the final attribution analysis of ABC Equity Fund for 2013:
What conclusion will you reach from this data?
The fund's active return was -1.44. Once you see the attribution analysis, it becomes very clear that :
The fund manager's individual stock picking skills have yielded positive alpha, across all sectors The fund manager's biggest call and only call that performed badly was his overweight call on one sector
With this insight, you as an advisor are in a much better position to take a call on holding or exiting this fund. If you believe that this sector should see much better days in the near future for whatever reasons, there is perhaps good reason to stay invested. Alternatively, if you find that in recent weeks, the fund manager has decided that the call was wrong and has trimmed his positions in the sector, then again you have a basis to stay invested as the only sore point in the portfolio has already been addressed. If there is no reason for you to draw comfort - if your view is that the fund manager is obstinately holding on to a position that can drag performance down further, you may choose to press the exit button.
Use attribution analysis to help you make buy, hold and sell decisions
A close examination of the performance attribution analysis helps you to understand exactly what drove out or underperformance of a fund in a particular period, which then helps you take a much better call for your clients' portfolios. This analysis can be used in different circumstances.
If you find an equity fund that has topped the performance charts by a wide margin last year but which previously had only a moderate record, an attribution analysis can help you understand whether it was just one or two stocks that drove all the outperformance (did the manager just get lucky?) or was it a broader based contribution from multiple factors.
If you find two funds having a similar performance record, and the attribution analysis shows that the first fund's outperformance vs benchmark was a result of getting contribution from several stock and sector calls while the second had only a couple of big bets that worked out, the first fund would seem a safer bet from a long term outperformance point of view.
The list of circumstances where you can use attribution analysis is endless. Suffice to say that when analysing fund performances, do look closely at attribution analysis to understand performance better and make your buy / hold / exit calls with a lot more conviction. If you don't readily have this data with you, do encourage RMs of your AMC partners to carry this with them the next time they visit your office to discuss their funds.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below ..... it's YOUR forum !
Share this article
|
