Return-Based, Holdings-Based and Transaction-Based Performance Attribution

Performance attribution may be either returns-based, holdings-based, or transactions based. The decision to use one set of inputs rather than another depends on the availability of data as well as the investment process being measured.

Returns-based Attribution

In returns-based attribution, the components that generated returns are identified only by the total portfolio returns. It is most appropriate to attribute returns to portfolio holdings when the underlying portfolio information cannot be readily and accurately retrieved at the required level of detail. For this reason, evaluating hedge funds, or private equity is often done using returns-based attribution.

Returns-based attribution is the least reliable or specific of the three approaches and the most vulnerable to data manipulation. It has the benefit of being the easiest method to implement.

Holdings-based Attribution

With holdings-based attribution, the portfolio is attributed to its beginning-of-period holdings, as opposed to returns. Using shorter time intervals improves the accuracy of holdings-based attribution calculated with monthly, weekly, or daily data. Linking the attribution results for multiple shorter measurement periods is necessary for longer evaluation periods. Transactions made during the measurement period are not accounted for by holdings-based attribution. In the absence of transactions, a residual may be described as a timing or trading effect.

Investing strategies with little turnover (e.g., passive strategies) are most appropriate for holdings-based analysis. To remove a distinct difference between the portfolio and benchmark returns that is not a management effect, the holdings-based process may be buttressed by valuing the portfolio with the same prices that were used to calculate the underlying index.

Transaction-based Attribution

According to a third method, referred to as transaction-based attribution, portfolio holdings are combined with transactions (purchases and sales) that took place during the evaluation to paint a picture of the attribution of risk and return. When transaction-based attribution is used, both weights and returns include transaction costs. In addition to being the most accurate type of attribution analysis, transaction-based attribution is also the most difficult and complex to use. It is important that the underlying data be accurate, complete, and reconciled from period to period; otherwise, understanding and relevant results from transaction-based attribution will not be possible.

Thus, attribution analysis can be used as a diagnostic tool as the return used in the attribution analysis matches the return presented to the client. In some cases, this style of attribution may be appropriate based on the availability and reliability of the data, the reporting requirements of the client, and the complexity of the investment process.

Question

Which of the following is the most accurate attribution method?

1. Holdings-based.
2. Returns-based.
3. Transactions-based.

Solution

The correct answer is C.

Transaction-based attribution analysis involves considering both the portfolio holdings and the transactions (buying and selling) that took place during the evaluation period. It factors in the impact of these transactions, including transaction costs, on the portfolio’s performance. While it offers the highest level of accuracy, it is also the most challenging and time-consuming to implement. To produce meaningful results, the data used must be complete, precise, and consistently reconciled from one period to another. This approach allows for a comprehensive quantification and explanation of the entire excess return, and the return used in the analysis matches what is presented to the client. It can also serve as a diagnostic tool to identify errors. The choice between attribution approaches depends on the availability and quality of data, client reporting requirements, and the complexity of the investment decision-making process.

A is incorrect. Holdings-based attribution differs from returns-based attribution by considering the initial portfolio holdings at the start of a period. It can be calculated using data at various time intervals, with higher accuracy achieved when using shorter intervals. When assessing longer timeframes, results from shorter measurement periods are connected. However, holdings-based attribution does not account for the impact of transactions made during the measurement period, which can lead to inconsistencies with the actual portfolio return.

B is incorrect. Returns-based attribution relies solely on the total portfolio returns during a specific period to ascertain the elements of the investment strategy responsible for generating those returns. This method is particularly suitable when detailed information about the underlying holdings in the portfolio is not consistently available.

Performance Measurement: Learning Module 1: Portfolio Performance Evaluation; Los 1(d) Describe returns-based, holdings-based, and transaction-based performance attribution, including advantages and disadvantages of each