# Portfolio Performance: Understanding Attribution Analysis

## What Is Attribution Analysis?

Attribution analysis evaluates a portfolio's performance, focusing on a manager's investment choices, style, and market timing. Known as return or performance attribution, it identifies the sources of excess returns compared to benchmarks. This sophisticated method is crucial for both portfolio managers and investors in understanding the effectiveness of their strategies.

*   Attribution analysis evaluates a fund manager's performance by analyzing investment choices, asset allocation, and market timing against benchmarks.
*   The analysis highlights three factors: investment choices, asset allocation strategies, and the manager's timing of decisions and trades.
*   Asset class identification and portfolio weight allocation are critical in providing benchmarks to measure a portfolio's performance.
*   Returns-based style analysis, introduced by Bill Sharpe, evaluates a portfolio's returns to find the most relevant performance benchmarks.
*   Market timing is often considered less critical than asset selection and investment style, given its challenges in quantification and its potential randomness.

## Understanding the Mechanics of Attribution Analysis

Attribution analysis focuses on three factors: the manager's investment picks and asset allocation, their investment style, and the market timing of their decisions and trades.

The method begins by identifying the [asset class](https://www.investopedia.com/terms/a/assetclasses.asp) in which a fund manager chooses to invest. An asset class generally describes the type of investments that a manager chooses; within that, it can also get more specific, describing a geographical marketplace in which they originate and/or an industry sector. European fixed-income debt or U.S. technology equities could both be examples.

Then, there is the allocation of the different assets—that is, what percentage of the portfolio is weighted to specific segments, sectors, or industries. 

Specifying asset types helps identify a general benchmark, often a [market index](https://www.investopedia.com/terms/m/marketindex.asp), of similar assets, for performance comparison.

> **Fast Fact**
>
> Market indexes can be very broad, such as the S&P 500 Index or the Nasdaq Composite Index, which cover a range of stocks; or they can be fairly specific, focusing on, say, real estate investment trusts or corporate high yield bonds.

### Dissecting Investment Styles in Attribution Analysis

The next step in attribution analysis is to determine the manager's [investment style](https://www.investopedia.com/terms/i/investing_style.asp). Like the class identification discussed above, a style will provide a benchmark against which to gauge the manager's performance.

The first method of style analysis concentrates on the nature of the manager's holdings. If they are equities, for example, are they the stocks of [large-cap](https://www.investopedia.com/terms/l/large-cap.asp) or [small-cap](https://www.investopedia.com/terms/s/small-cap.asp) companies? Value- or growth-oriented?

American economist [Bill Sharpe](https://www.investopedia.com/terms/w/william-f-sharpe.asp) introduced the second type of style analysis in 1988. Returns-based style analysis (RBSA) charts a fund's returns and seeks an index with comparable performance history. Sharpe refined this method with a technique that he called quadratic optimization, which allowed him to assign a blend of indices that correlated most closely to a manager's returns.

### Unveiling Alpha: Measuring Excess Returns

Once an attribution analyst identifies this blend, they can formulate a customized benchmark of returns against which to evaluate the manager's performance. Such an analysis should highlight the excess returns, or [alpha](https://www.investopedia.com/terms/a/alpha.asp), that the manager achieves over the benchmarks.

The next step in attribution analysis attempts to explain that alpha. Is it due to the manager's stock picks, selection of sectors, or [market timing](https://www.investopedia.com/terms/m/markettiming.asp)? To determine the alpha generated by their stock picks, an analyst must identify and subtract the portion of the alpha attributable to sector and timing. Again, this can be done by developing customized benchmarks based on the manager's selected blend of sectors and the timing of their trades. If the alpha of the fund is 13%, it is possible to assign a certain slice of that 13% to sector selection and timing of entry and exit from those sectors. The remainder will be stock selection alpha.

## Assessing Market Timing: Its Role in Attribution Analysis

While some managers use a buy-and-hold strategy, most frequently trade, making buy and sell decisions regularly. Segmenting returns by activity can be useful, as it tells you whether a manager's decisions to add or subtract positions from the portfolio helped or hurt the final return compared to a more passive buy-and-hold approach.

Market timing, a key factor in attribution analysis, is debated for its importance.

Indeed, this is the most challenging aspect of attribute analysis to quantify. To the extent that market timing can be measured, scholars point out the importance of gauging a manager's returns against benchmarks reflective of upturns and downturns. Ideally, the fund will go up in bullish times and will decline less than the market in bearish periods.

Even so, some scholars note that a significant portion of a manager's performance with respect to timing is random, or luck. As a result, in general, most analysts attribute less significance to market timing than asset selection and investment style.

## The Bottom Line

Attribution analysis serves as a crucial tool for both investors and portfolio managers. It provides a detailed evaluation of a fund manager's performance, assessing investment style, asset allocation, and market timing. By understanding these components, investors can better gauge a manager's ability to generate excess returns, or alpha, over comparable benchmarks. While asset selection and investment style are key, market timing remains a challenging element to quantify. Nonetheless, attribution analysis empowers investors and managers alike to make more informed decisions.

> **Article Sources**
>
> 1.  Equitas Capital Advisors. "[Attribution Analysis](https://www.equitas-capital.com/services/attribution-analysis/)." Accessed Jun. 3, 2021.