In my most recent post, I began looking at how to determine how your portfolio was performing. For most investors, the primary aim is that their portfolio earns a long-term return that is high enough for them to meet their financial goals. We determine this target return as part of the planning process, and we use historical returns of the various asset classes that comprise portfolios, less any fees.
While the plan return is the most important benchmark, we still want to assess a portfolio return versus the broader market return. We do this because we want to confirm the portfolio is performing in line with relevant, objective market benchmarks in addition to meeting plan needs. The latter comparison helps us to assess the impact of the investment decisions we make.
The process we use to perform this additional comparison is called attribution analysis. Attribution analysis assumes there are two key decisions an investor makes — how to allocate the portfolio and the choice of investments to use to build the allocation. To do this, the analysis begins with a long-term strategic allocation that will remain constant over a fairly lengthy period. There is no universally agreed upon strategic allocation, so different financial advisors will choose different allocations as their starting point. Because of this, and because the strategic allocation is the benchmark against which performance is measured, two advisors with the same return can have very different answers on how their portfolios performed versus benchmark.
Once the strategic allocation is established, an advisor may decide to deviate from that allocation. If, for example, the advisor is concerned a recession might be in the offing, she may choose to overweight bonds. If bonds perform well during the period in question, attribution analysis will capture the additional return earned because of the decision. Most of the time, allocation decisions have a larger impact on relative return than decisions about which investments to use within a particular asset class.
Attribution analysis measures the impact of investment choice as well. It does so by assigning a benchmark to each asset class – the S&P 500 to the large cap U.S. asset class, for example – and then measuring performance of funds against that benchmark. We go a bit further by measuring fund performance against a narrow benchmark as well. For example, for a large cap value fund, we would also assess performance against the iShares Russell 1000 benchmark as that is the fund’s specific focus. Stocks in a particular segment often move in concert, so measuring a manager’s performance against a narrow benchmark allows us to determine how a manger truly performed.
The end result of attribution analysis is a clear understanding of the impact of our decisions on portfolio return, and this feedback helps us improve our decisions making. This, coupled with a plan return target, gives us a clear view of how client portfolios are performing.