Deciphering attribution analysis in gauging fund performance

By Kaustubh Belapurkar |  30-06-21 | 
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About the Author
Kaustubh Belapurkar, Director of Manager Research, Morningstar Investment Adviser India.

The performance of any fund is the outcome of the process that went behind managing the fund. A fund manager’s return performance can be gauged by the return of the fund vis-à-vis that of the benchmark. Was it due to skill or market performance? One way to look at the contribution to the performance is sector and stock level attribution.

An active fund manager’s job is to take active bets on sectors and stocks vis-à-vis the fund’s benchmark. Performance attribution breaks down the outperformance/underperformance of a fund into three main pillars:

  • Allocation effect
  • Selection effect
  • Interaction effect

Allocation Effect

It tells you how the sector calls taken by the fund manager are working for the fund. If a fund manager is taking an overweight or underweight position in a sector, then how have those calls helped the fund. For instance, if a manager had been overweight Information Technology (IT) sector which has performed well during the pandemic, it will have a positive attribution. Similarly, if the fund manager has been underweight consumer defensive/FMCG sector which has not performed relatively well over the last one year compared to other sectors, that will be positive attribution.  On the contrary, if the fund manager had been overweight consumer defensive which hasn’t performed relatively well, this would be negative attribution. Similarly, if one is underweight a particular sector that has done well (say IT), that would be negative attribution.

Selection Effect

This shows the stock level calls that a fund manager is taking relative to a benchmark. For instance, if a fund manager had been overweight a particular stock that has performed well, it would be a positive attribution. Similarly, if the fund manager had been underweight a particular stock that has done well, it would be a negative effect.

Interaction Effect

It measures the combined impact of a fund manager’s selection and allocation decisions within a segment. For instance, if the fund manager had superior selection and overweight that particular segment, the interaction effect is positive. If the fund manager had a superior selection but underweighted that segment, the interaction effect is negative.

Role of luck versus skill in evaluating fund performance

Ideally, fund performance should be evaluated over a long-term horizon. A sector or stock allocation might not work in the short run. But if it has worked in the long run and the fund manager has held to his conviction by holding the stock despite it getting battered, we know it is due to the fund manager’s skills.

A fund might not take too extreme overweight or underweight calls in a sector. For instance, if financials account for 40% weightage in a benchmark, then the manager might go overweight or underweight in a range of say 5-10%. Some fund managers would have gone overweight IT and Pharma three years back and it would have had a negative attribution effect in their portfolio back then. In 2020, their sector calls would have worked, which would turn the attribution effect positive. This shows that the manager judiciously took that call on a sector and it worked well for the fund. One should look if a large part of stock and sector allocations are adding positive contribution over a long period of time. If a lot of stock calls or selection effect are on the positive side then it would show that there is a process in place.

A note of caution

There can be times when a fund’s returns can be lumpy for a short period because of the fund manager going overweight on certain sectors or stocks. There could be a risk here because that performance might not sustain going ahead as no fund manager can get all the calls right all the time.

Based on the excerpts from CNBC MF Corner show. Watch the full interview here.

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