Discuss the factors that guide the choice of a risk attribution method
The idea
The right risk attribution depends on two features of the mandate. First, is it judged against a benchmark or on absolute return? Relative mandates decompose active risk (tracking error); absolute mandates decompose total volatility. Second, how does the manager decide? A bottom-up stock picker is best served by each position's contribution to risk; a top-down allocator by the risk arising from each allocation and selection decision; a factor-based process by the risk explained by each factor exposure plus specific risk. A position's contribution to volatility is its weight × its covariance with the portfolio ÷ the portfolio's standard deviation, and these contributions sum to the total. An approach that does not mirror the process produces figures that nobody can act on.
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- Explain what performance measurement, attribution and appraisal each contribute to evaluating a portfolio and how the three link together
- Set out the features that make a performance attribution process effective
- Distinguish attribution of return from attribution of risk, and macro-level from micro-level return attribution
- Explain how transactions-based, holdings-based and returns-based attribution work, with the strengths and weaknesses of each
- Interpret where a portfolio's returns came from using a given attribution method
- Interpret the results produced by attribution analysis of a fixed-income portfolio
- Separate the part of investment results due to the asset owner's decisions from the part due to the manager, and interpret each
- Explain the purposes served by liability-based benchmarks
- Set out the main kinds of asset-based benchmark
- Discuss the tests used to judge whether a benchmark is sound
- Explain how a misspecified benchmark distorts attribution and appraisal analysis
- Set out the difficulties that arise when choosing benchmarks for alternative investments
- Compute and interpret maximum drawdown, drawdown duration, upside and downside capture ratios, the appraisal ratio and the Sortino ratio
- Explain where appraisal measures and associated metrics fall short
- Assess whether an investment manager's results reflect genuine skill