Tuesday, August 26, 2008

No Frills Attribution Analysis with Overlaps and Sub Categories


Attribution analysis becomes problematic when:

  • Overlap in asset classifications
    • Industry and company size (Individual Sector and Large, Mid, Small, Micro Cap classification)
    • Industry and market (Individual Sector and market like US, EU, Asia, etc.)
  • Main classification classes and sub classes are included
    • Sector sub sector
    • Market industry (E.g. US Stocks and sector S&P SPDR)

In the latter case the broader classifications exposure to the sub classification can be worked out. The portfolios exposure to the sub classification will be the sub classifications exposure to the broader classification scaled by the portfolio’s exposure to the broader classification. When there are overlaps things are not that straight forward though.

When there is an overlap, things become more tedious. In this case the exposure to each classification and the overlapping subset needs to be computed separately and the final analysis would have the individual exposures minus the sub exposures.

Broader analysis would be advantages and more informative despite the need of adjustments.

Simple summary of the process:

  1. Identify portfolio’s asset class exposure attributed returns - Portfolio’s exposure to asset classes simply by the weight or a market weighted index of the asset classes
    1. If the market weighted approach is used, certain part of excess returns are attributed to asset allocation among the asset classes
  2. Identify the asset classes exposure to its sub classifications
    1. Part of excess returns identified in 1 when a market weighted index is used can be attributed to this sub classification
    2. Adjustments mentioned above need to be applied.
  3. Any remaining excess returns are attributed to the individual stock selection

The exposure to each classification can be minimized to reduce the downside due to market fluctuations but such exercise should be combined with at least static hedging since these relationships would breakdown on adverse market events. If dynamic hedging is used the re adjustment frequency should be low and the hedge ratio should be selected such that it is greater than or equal for a static hedge and less than or equal to delta neutral hedge paying head to the other Greeks and the cost of hedging vs. the maximum loss the hedging would bound.

Please be good to share your thoughts on this.

Best regards, Suminda Sirinath Salpitikorala Dharmasena

Blogger Profile: http://www.blogger.com/profile/03835227536866539389

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