Performance Attribution

Section: Performance Attribution Estimated study time: 45 minutes Content: Performance attribution explains the sources of a portfolio's return relative to a benchmark. At Level 3, candidates must understand both the Brinson-Hood-Beebower (BHB) model and its extensions, be able to interpret attribution results, and distinguish between return attribution and risk attribution. Attribution is essential for evaluating active managers — it answers the question: "Where did the alpha come from?" The Brinson-Hood-Beebower attribution model decomposes active return (portfolio return minus benchmark return) into three effects: allocation effect, selection effect, and interaction effect. Allocation effect measures the value added (or lost) from overweighting or underweighting sectors relative to the benchmark, using benchmark sector returns to isolate the pure sector-weighting decision. Allocation effect for sector i = (w_pi − w_bi) × (R_bi − R_b), where w_pi is portfolio weight, w_bi is benchmark weight, R_bi is benchmark sector return, and R_b is total benchmark return. A manager adds value from allocation if she overweights sectors that outperform the overall benchmark. Selection effect measures value added from choosing better securities within each sector. Selection effect for sector i = w_bi × (R_pi − R_bi), where R_pi is portfolio sector return. If the manager's stock picks outperform the benchmark sector return within that sector, selection is positive. Interaction effect captures the joint impact of overweighting a sector where selection was also positive: interaction = (w_pi − w_bi) × (R_pi − R_bi). Some attribution frameworks combine selection and interaction into a single "selection + interaction" term to avoid the ambiguity of attributing interactive effects separately. Fixed income attribution is more complex than equity attribution because returns are driven by multiple factors: the overall level of interest rates…