Beruflich Dokumente
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44 Wall St.
New York, NY 10005
jorge.mina@riskmetrics.com
www.riskmetrics.com
Abstract
In this article we present a risk attribution methodology that segments the total tracking error of
a portfolio into allocation and selection components that are consistent with traditional return
attribution systems. Our approach consists of applying standard risk statistics (e.g., standard
deviation, VaR, and incremental VaR) to the stochastic excess returns vis--vis a benchmark
attributed to each investment decision.
JEL classifications: G10, G11, G23
Keywords: Risk attribution, return attribution, VaR, relative VaR, incremental VaR
Introduction
Return attribution is a diagnostic tool that attributes past excess returns vis--vis a benchmark
to active investment decisions such as sector allocation and security selection. Return
attribution is a valuable tool for assessing the skill of asset managers and determining how
excess returns were generated in a specific period of time. However, return attribution does
not tell the whole story. In particular,
Return attribution does not take into account the risks that were taken in order to
generate excess returns. In current practice, as investors become more disciplined,
realized returns are increasingly evaluated relative to the risk taken.
Return attribution only presents an ex-post analysis of returns, but it cannot be used
in the portfolio construction phase to understand the bets taken.
Risk attribution is a technique to segment the relative risk of a portfolio into components
that correspond to active investment decisions. Risk attribution can be used not only as a
diagnostic tool, but also in the portfolio construction and rebalancing phases.
Risk and return are the determinants of performance. Returns can only be attained by taking
risk, and hence controlling the amount of risk taken is just as important as generating high
returns. Asset managers must understand the amount of risk contributed by each decision
in order to evaluate how good returns really are. In order to facilitate the comparison of
return and risk figures, risk attribution should be consistent with return attribution.
In this article we present a risk attribution methodology that segments the total tracking error
of a portfolio into allocation and selection components that are consistent with traditional
return attribution systems. Our approach consists of applying standard risk statistics (e.g.,
standard deviation, VaR, and incremental VaR) to the stochastic excess returns attributed to
each investment decision. In other words, we can construct a risk attribution report given a
certain return attribution model and a specific risk statistic.
Return attribution
In this section we describe the most common equity return attribution method. Our risk
attribution methodology is consistent with the return attribution described here. For ease
of exposition, we will work with a two-step investment process where we attribute return
to allocation and selection decisions. However, this method can be generalized to include
multiple decision layers, as shown in Appendix B.
The allocation attribution measures the impact of decisions to allocate capital across groups
of assets differently from the benchmark. These groups can be defined arbitrarily as long
as they are mutually exclusive and contain all the assets in a predefined universe. The most
common choices for these groups are sectors, industries and countries. A positive allocation effect means that the manager overweighted outperforming groups and underweighted
underperforming groups.
The selection attribution measures the impact of decisions to select different securities from
the benchmark within a group. A positive selection effect means that the manager overweighted securities that outperformed relative to their group and underweighted securities
that underperformed relative to their group. In other words, a positive selection effect means
that the active managers group returns were higher than the benchmarks group returns.
The selection effect isolates the skill of the manager in picking securities within each group.
Without loss of generality, we use sectors as the groups that partition the universe of securities. We need some notation to formalize these concepts:
Notation
T denotes the universe of securities.
A denotes the set of securities in sector A.
Ps is the portfolio position in security s, where 1 s n.
PA = sA Ps is the portfolio position in sector A, where 1 A N.
Bs is the benchmark position in stock s.
BA = sA Bs is the benchmark position in sector A.
rs is the return of security s.
rA = B1A sA Bs rs is the benchmark return in sector A.
rT = sT Bs rs is the total return of the benchmark.
PT = BT = 1 is the total position of the benchmark and the portfolio.
ws = Ps Bs is the bet (i.e., over/underweight) in security s.
Table 1 shows the allocation and selection attribution at the sector level. For each sector A the allocation attribution is the over/underweight in the sector (PA BA ) times
the over/underperformance of the sector relative to the total benchmark return (rA rT ).
The selection attribution for sector A is the sum over all securities in the sector of the
over/underweight in the security (Ps Bs ) times the over/underperformance of the security
relative to the sector return (rs rA ). The sum over all sectors of the allocation and selection
returns is equal to the total excess return over the benchmark.
Sector
..
.
Sector Allocation
..
.
A
..
.
(PA BA )(rA rT )
..
.
A (PA BA )rA
Total
2.1
Security Selection
..
.
sA (Ps
Bs )(rs rA )
..
.
sT (Ps Bs )rs
A (PA BA )rA
Total
..
.
sA (Ps
Bs )(rs rT )
..
.
sT (Ps
Bs )rs
Measuring the selection return at the sector level is not sufficient for a manager trying to
identify the bets with the highest return contribution. We can identify a large selection
return for a certain sector using the formulas in Table 1, but we still need to find how much
each individual stock in the sector contributed to the total selection return. The selection
attribution can be reported at the individual security level, but in contrast with the sector level
attribution which has a unique interpretation, the security level attribution can be interpreted
in two ways (see Table 2).
For those institutions where the investment process starts with the security analysts selecting
securities before making a sector allocation decision (i.e., bottom-up approach), the preferred
view is that the return contribution of a security is the over/underweight in the security
(Ps Bs ) times the over/underperformance of the security relative to the sector return
(rs rA ). This reflects the fact that the sector allocation is a result of the individual security
selection decisions for which security analysts are responsible.
For institutions where the investment process starts with the asset allocation and ends with
security selection (top-down approach), the over/underweight in the security is measured
relative to the weight of the security in the benchmark scaled by the ratio between the port-
folio and benchmark sector weights. In other words, the calculation of the over/underweight
compensates for the fact that the weight allocated to the sector in the portfolio might be
different from the benchmark sector weight (Ps BPAA Bs ). The difference between portfolio
and benchmark sector weights is the result of a decision taken prior to the security selection
process and the team responsible for the selection decisions has no control over it.
Note that the sum of the selection attribution over all securities in a sector is equal to the
total selection attribution for the sector for both the bottom-up and top-down approaches.
Table 2: Security selection return attribution at the security level in sector A
Security
..
.
Bottom-Up
..
.
s
..
.
(Ps Bs )(rs rA )
..
.
Total
sA (Ps
Top-Down
..
.
Bs )(rs rA )
(Ps
sA (Ps
PA
B )r
BA s s
..
.
Bs )(rs rA )
Risk attribution
Relative VaR is defined as the percentile of excess returns at a certain confidence level.
Forward-looking tracking error is a special case of relative VaR under normality assumptions when the confidence level is 84.13% (i.e., one standard deviation).1 Without loss of
generality, we will define our risk measure to be the tracking error of the portfolio.
The excess returns of the portfolio vis--vis the benchmark is
(Ps Bs )rs .
sT
1 See Mina and Watson (2000) and Mina and Xiao (2001).
(1)
If we think of returns as random variables (as opposed to realized quantities), we can write
the forward looking tracking error of the portfolio as the standard deviation of excess returns
in (1):
TE = std
ws rs
2
2
= P + B 2P B = P2 + B2 (1 2P ),
(2)
Figure 1 shows the geometric representation of the tracking error of two portfolios. In the
top panel, we show a portfolio with a beta smaller than one, where beta is represented by the
ratio of the length of the orthogonal projection of the portfolio onto the benchmark and the
length of the benchmark itself (B ). Note that for this portfolio, an increase (decrease) in
benchmark volatility (the length of the base) would lead to an increase (decrease) in tracking
error (the distance between the two sides). When beta is greater than one (see bottom panel),
we have that the opposite relationship holds, that is, an increase (decrease) in benchmark
volatility (the length of the base) would lead to a decrease (increase) in tracking error (the
distance between the two sides). By symmetry, we can use the same argument to infer the
relationship between the portfolio volatility and tracking error, simply replacing the beta of
the portfolio relative to the benchmark P with the beta of the benchmark relative to the
portfolio B = PB . Since we are not really used to think in terms of B , we can express
the conditions in terms of P . For example, B 1 is equivalent to P (P /B )2 , which
is exactly the condition we derived from (2).
3.1
We can derive the risk attribution directly from the return attribution in the same way we
derived total tracking error from excess returns. It is important to understand that the
attribution risk is the risk of the attributed return based on a return attribution system, and
not the risk of the excess return on the portfolio. This point will be further discussed in
Section 3.3. The allocation and selection risks are defined as the standard deviation of the
allocation and selection returns.
Let us define the relative sector return for sector A as
rA =
ws
rs .
wA
sA
(3)
Figure 1: Triangles
P < 1
Tracking
Error
P
-1
cos
B
P > 1
P
Tracking
Error
B
Note that the relative sector returns are defined in such as way that the total excess return
equals the weighted sum of relative sector returns. In other words,
ws rs =
wA rA.
sT
(4)
AT
(5)
sA
std [ws (rs rT )] = |ws | s2 + B2 (1 2s ),
(6)
where s and B are the volatilities of the security and benchmark respectively, and
s is the beta of the security relative to the benchmark.
As the security bet increases, the risk increases. As the correlation between the benchmark
and the security increases, the risk decreases. As the volatility of the benchmark increases,
9
the risk increases if s 1, and decreases if s > 1. As the volatility of relative sector
returns increases, risk increases if s (s /B )2 and decreases if s > (s /B )2 .
The stand-alone sector allocation risk for sector A is
std [wA (rA rT )] = |wA | A2 + B2 (1 2A ),
(7)
where A is the volatility of sector A and A is the beta of the sector relative to the
benchmark.
The stand-alone security selection risk for sector A is
2 + 2 (1 2 ),
ws (rs rA ) = |wA | A
std
A
A
(8)
sA
where A is the beta of the relative return of sector A (rA) with respect to the return
(9)
(10)
Note that the bottom-up selection risk for a security depends on the correlation between
that security and its sector. This reflects the fact that in a bottom-up investment process the
selection decisions are not independent of the allocation decisions. On the other hand, the
top-down security selection risk only depends on the size of the relative bet (|Ps
and the volatility of the security (s ).
10
PA
BA Bs |)
(Ps Bs )rs ,
(11)
w w,
(12)
A (s) =
(PA BA )( BBAs Bs ) s A,
(PA BA )Bs s A.
(13)
(14)
Once again, thinking of returns as random variables, the stand-alone sector allocation risk
for sector A can be calculated as the standard deviation of sector allocation returns:
A A .
3Appendix A generalizes the method for the case where each security is a function of multiple risk factors.
11
(15)
(Ps Bs )(rs rA ),
(16)
sA
A (s) =
(Ps BPAA Bs ) s A,
0 s A.
(17)
(18)
Bs
(Ps Bs )(1 BA ) i = s,
s (i) = (Ps Bs ) BBAi i A, i = s,
0 s A.
(19)
(20)
s (i) =
PA
Bs )rs ,
BA
(Ps BPAA Bs ) i = s
0 i = s.
(21)
(22)
sA
s )r =
(Ps Bs )(rs rA ).
sA
12
(23)
(24)
s (i) =
(Ps Bs )(1 Bs ) i = s
(Ps Bs )Bi i = s.
(25)
(26)
(27)
sT (Ps
COV (, )
TE2
=
,
TE
TE
Bs )rs .
13
(28)
The total excess return can be written in terms of the allocation and selection returns:
=
(PA BA )rA +
(Ps Bs )rs
(PA BA )rA = rAA + rSS , (29)
A
sT
where rAA is the allocation return and rSS is the selection return. Plugging (29) into (28),
we can write the tracking error as
TE =
(30)
where the first term corresponds to the contribution of asset allocation to the total tracking
error and the sector term corresponds to the contribution of security selection to the total
tracking error. In other words, the contribution of asset allocation to the total risk is the covariance of the total excess return and the asset allocation return divided by the total tracking
error. Using a similar procedure, we can split the total security selection contribution into
individual security components. That is, the security selection contribution of an individual
security is the covariance between total excess return and the security selection return on
that security divided by total tracking error.
The risk contribution concept defined above is closely related to a statistic called relative
incremental VaR. Incremental VaR (IVaR) is a risk statistic that adds up across securities and
sectors to the total VaR of the portfolio. This additive property of IVaR has been exploited
in sell-side institutions to allocate risk to different business units (desks, sectors, countries),
where the goal is to keep the sum of the risks equal to the total risk.4 Buy-side institutions
can use the IVaR of excess returns (relative IVaR) for risk attribution.5
Incremental VaR can be also understood as the sensitivity of the total risk to small changes
in portfolio weights. In other words, we can define the relative IVaR of instrument s as
relative IVaRi = wi
4 See Garman (1997) and Hallerbach (1999).
5 See Mina (2002).
14
VaR
,
wi
(31)
(32)
where
=
w
w w
(33)
One can verify that the sum of the relative IVaRs is equal to the total relative VaR (tracking
error) of the portfolio:
n
relative IVaRi =
w w.
(34)
i=1
wA (s) =
ws s A,
0 s A.
(35)
(36)
We can show that the sum of the relative IVaRs for each sector is equal to the total relative
VaR. In other words,
relative IVaRA =
w w.
(37)
A
6 Denault (2001) uses results from game theory to provide conceptual justification for risk allocation based on the
gradient of the risk measure. Tasche (1999) demonstrates that under a broad definition of suitability, the only definition
of risk contribution suitable for performance measurement is given by the gradient of the risk measure.
15
It is easy to see that the same concept applies to any partition of the portfolio. In particular,
since the allocation and selection returns add up to the total excess return, we can use (32)
and exploit our vector notation to calculate the allocation and selection contributions using
the weight vectors and defined above.
For example, the sector allocation contribution for sector A can be calculated as
A .
(38)
(39)
It can be shown that the sector level contributions one would obtain from (30) are equal to
the contributions in (38) and (39).
The sum over all sectors of the allocation and selection contributions is equal to the total
tracking error
(A + A ) = w w.
(40)
In a similar fashion, we can obtain the contribution for the selection in security s using the
vector s .
Given the similarity of risk contribution and incremental VaR, we will use the term incremental risk attribution to refer to risk contribution in the next section.
3.3
We have used the relative IVaR machinery to obtain the incremental risk attribution for the
allocation and selection decisions. We have also seen that the sum of relative IVaRs and
incremental risk attributions is equal to the total tracking error. However, at the sector level,
16
the total incremental risk attribution is usually different from the relative IVaR of the sector.
In other words,
relative IVaRA = A + A .
(41)
The reason for the difference is that relative IVaR is calculated based on the excess return
for the sector sA (Ps Bs )rs , while incremental risk attribution is calculated based on
the attribution of total excess return for the sector sA (Ps Bs )(rs rT ).
We can write the total incremental risk attribution for security s in terms of relative IVaR as
Total incremental risk attributions = relative IVaRs + ws relative IVaRB ,
(42)
where relative IVaRB is the relative IVaR of the benchmark. In other words, relative IVaRB
is the benchmark contribution to the volatility of the difference between portfolio and benchmark returns.
The sum of the total incremental risk attribution over all securities in a sector is equal to
the sum of the allocation and selection incremental risk attributions for the sector. In other
words,
sA
(43)
B
=
w w
B2
=
(1 P ).
TE
(44)
(45)
We can gain some intuition on (42) by looking at a simple example. Let us assume that
the benchmark is the S&P 500 and the portfolio is 95% invested in the S&P 500 and 5%
17
invested in cash. Let us further assume that the volatility of the S&P 500 is 20%. This
implies that the volatility of the portfolio is 19% (.95 20%) and the tracking error is 1%.
Since cash has no volatility, the relative IVaR of cash is 0% and the entire tracking error is
allocated to the 5% underweight in the S&P 500. However, one can argue that all the risk is
actually coming from the 5% overweight in cash. Since we are overweight in cash, the beta
of the portfolio is smaller than one (P = 0.95), which means that relative IVaRB 0 and
the adjustment to relative IVaR in (42) (ws relative IVaRB ) will be positive for cash and
negative for the S&P 500. As we can see in Table 3 the resulting incremental risk attribution
assigns all the tracking error (1%) to the cash bet.
Table 3: Incremental risk attribution vs. relative IVaR
Benchmark
Portfolio
Bet
Relative IVaR
Adjustment
Risk Attribution
S&P 500
Cash
100%
0%
95%
5%
-5%
5%
1%
0%
-1%
1%
0%
1%
Risk
20%
19%
1%
1%
0%
1%
Case study
In this section we present a case study for an active equity portfolio managed against the
Canadian TSE 300. The problem faced by our asset manager is to measure the tracking
error incurred by taking certain bets against the benchmark, and perhaps more importantly,
whether or not the chosen portfolio actually conforms to the asset managers view. In other
words, they need to know how each decision will contribute to the total risk and whether or
not the bets taken in the implementation process are intended.
Table 4 shows the stand-alone risk attribution report at the sector level. The total risk
(tracking error) is 378 bp, the total allocation risk is 83 bp, and the total selection risk is
18
385 bp.7 As we can see, most of the risk is coming from selection bets, particularly from
Communications and Media (176 bp), Gold and Silver (174 bp), Industrial Products (147
bp), and Financial Services (142 bp). One shortcoming of the stand-alone numbers is that
they do not reflect offsetting bets or correlation effects. This means that the bets with the
largest stand-alone risk are not always the bets that contribute the most to the total risk.
For example, the attribution of allocation and selection returns contain the offsetting term
(PA BA )rA (see Table 1), which appears with positive sign in the allocation return and
negative sign in the selection return.
Table 5 shows the incremental risk attribution for the portfolio at the sector level. The total
tracking error is 378 bp, of which 2 bp are contributed by allocation decisions and 376 are
contributed by security selection decisions. We can see that the incremental allocation risk
at the total as well as sector levels is much lower than its stand-alone counterpart. This is
due to the offsets discussed above as well as a diversification effect across sectors, which
explains why some of the allocation numbers are negative. A negative allocation incremental
risk means that increasing the sector bets in those sectors (while keeping the selection bets
constant) would decrease the tracking error of the portfolio. For example, Communications
and Media contributes -8 bp in allocation risk to the total tracking error of the portfolio,
meaning that an increase of 10% in the sector allocation (from 1.54% to 1.7% overweight)
would decrease the tracking error of the portfolio by approximately 1 bp (.1 8bp).8
The incremental report clearly shows that security selection bets dominate the total risk.
One of the largest risk contributors is the stock selection in Communications and Media
with 79 bp. Table 6 shows the selection risk for each one of the stocks in Communications
and Media. In our example, the manager decided to underweight Nortel Networks by 1.5%
and overweight Quebecor World, Rogers Communications, Shaw Communications, and
The Thomson Corporation by 1.2% each. Due to volatilities and correlations, a larger bet
7 Since these are stand-alone numbers, the sum of the allocation and selection risks is always smaller than the total risk.
8 To balance the portfolio we need to short the TSE 300 by 0.16% = 1.7% 1.54%.
19
does not necessarily imply a larger risk contribution. For example, the bets in Thomson and
Shaw are the same size (1.2%), but the risk contribution of Thomson (39 bp) is much larger
than Shaws (7 bp). Finally, it is important to emphasize that while the manager made only
explicit bets in the five stocks mentioned above, they are implicitly going short the stocks
for which they did not make an explicit decision. These implicit short positions will also
contribute to the overall tracking error of the portfolio.
20
Bets
1.54%
0.73%
1.02%
-1.35%
0.32%
-2.31%
-0.48%
2.07%
-1.82%
0.97%
0.08%
0.64%
0.92%
-0.59%
-0.98%
-2.03%
1.27%
48
13
18
10
8
22
5
27
24
11
1
12
13
19
13
29
13
176
97
77
142
174
147
21
135
28
111
19
70
57
26
14
38
5
162
107
82
141
179
150
21
136
27
110
20
66
59
21
15
45
12
Total
0.00%
83
385
378
Figure 2 shows the incremental risk attribution for the portfolio. Each dot represents a
sector. The height represents the risk contribution of the sector to the total risk, and the
position of the dot represent whether most of the risk comes from allocation or selection
bets. A sector closer to the asset allocation line would have most of its risk contributed by
allocation bets, while a sector closer to the security selection line would have most of its
risk contributed by selection bets. If a sector lies exactly on one of those lines, all of its
risk would be coming from only one kind of bet. If a sector lies outside the triangle formed
by the allocation and selection lines then its contribution from the bet represented by the
21
Bets
1.54%
0.73%
1.02%
-1.35%
0.32%
-2.31%
-0.48%
2.07%
-1.82%
0.97%
0.08%
0.64%
0.92%
-0.59%
-0.98%
-2.03%
1.27%
-8
-1
0
1
2
0
-1
-1
4
3
0
1
1
3
0
-2
1
87
7
21
57
78
51
1
33
-3
26
0
-4
11
2
3
5
0
79
6
21
58
80
52
0
32
0
28
0
-3
12
5
3
3
1
Total
0.00%
376
378
farthest line would be negative. For example, Communications and Media has a height of
79 bp and it is situated to the right of the security selection line because most of its risk is
coming from security selection and it has a negative risk contribution to sector allocation.
The total risk is represented by a dot with a height of 378 bp that lies almost on the selection
line because selection contributes 376 bp and allocation contributes only 2 bp.
22
350
300
250
200
Asset Allocation
Security Selection
150
Gold and Silver
100
Communications and Media
Financial Services
Industrial Products
50
50
23
Bets
-0.04%
-0.10%
-0.04%
-0.17%
-0.08%
-0.04%
-0.06%
-0.02%
-0.15%
-0.01%
-0.01%
-0.01%
-1.50%
-0.03%
-0.16%
1.20%
-0.29%
1.20%
-0.05%
1.20%
-0.04%
1.20%
-0.01%
-0.17%
-0.01%
-0.27%
0
-1
0
0
0
0
0
0
1
0
0
0
28
0
0
8
3
7
0
7
0
39
0
-1
0
-1
Total
1.54%
87
24
m
i ri ,
(46)
xi Vs
,
Vs xi
(47)
where
i =
(48)
1
! = ... ,
(49)
r = !r .
(50)
= !
(51)
= !.
(52)
r = r
(53)
r = r .
(54)
n
we can write
such that
25
We can now use all the calculations described above, substituting for , which is the
covariance matrix of risk factors.9
Asset managers with international mandates might want to separate country allocation,
sector allocation, and security selection effects and create multiple attribution levels. In this
section we generalize the sector allocation and security selection attribution to include an
arbitrary number of attribution levels.
Lets assume that we have n levels. At level i we will attribute risk due to "allocation"
decisions at levels i, i 1, . . . , 1, where level 1 corresponds to the security level. Each level
i contains mi mutually exclusive groups that we will denote by Li,j , where j = 1, . . . , mi .
i
For every i, m
j Li,j is the set of all securities contained in either the portfolio or the
benchmark. Also, each group Lk,j is contained in one and only one group Li,l at each level
i k.
For bottom-up attribution let us define
Fk,j = (PLk,j BLk,j )(rLk,j rLk+1,j ).
Equivalently, for top-down we define
PLk+1,j
(P
BLk,j )rLk,j . k = n
Lk,j BL
k+1,j
Fk,j =
(P
Ln,j BLn,j )(rLn,j rT ) k = n.
The return allocation due to decisions at level k i for group Li,j is given by:
Fk,j k i.
Gi,j,k =
Lk, Li,j
9 For equities = .
26
(55)
(56)
(57)
If the bottom level in the attribution is k = 1 we can add up the contributions of all levels
j k at level k (e.g., if we do country and sector, but not security level attribution).
k1
i=1 Gk,j,i + (PLk,j BLk,j )(rLk,j rLk+1,j ) for bottom-up.
k1
PLk+1,j
Fk,j =
(58)
B.1
Bottom-up example
(59)
(60)
C(C
(PA BA )rA .
(61)
(62)
Security :
(Ps Bs )rs
s(C
A(C
s(A
(63)
A(A
(64)
C(C
27
(65)
(66)
(Ps Bs )rs (PA BA )rC .
s(A
28
(67)
References
Denault, M. (2001). Coherent allocation of risk capital, Journal of Risk 4(1): 134.
Garman, M. (1997). Taking VaR to Pieces, RISK 10(10): 7071.
Hallerbach, W. (1999). Decomposing Portfolio Value-at-Risk: A General Analysis, discussion paper TI 99-034/2, Tinbergen Institute.
Litterman, R. (1996). Hot Spots and Hedges, The Journal of Portfolio Management, Special
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