Risk Attribution Approach

Risk attribution identifies the sources of risk in portfolios.

• For absolute mandates, it identifies the sources of portfolio volatility.
• For benchmark-relative mandates, it identifies the sources of tracking risk. (e.g., portfolio volatility or tracking risk).

$$ \textbf{Type of Attribution Analysis} \\
\begin{array}{c|c|c}
\textbf{Process} & \textbf{Relative} & \textbf{Absolute} \\ \hline
\textbf{Bottom-up} & {\text{Position’s contribution to} \\ \text{tracking risk}} & \\ \hline
\textbf{Top-Down} & { \text{Analyze relative} \\ \text{allocation and selection} \\ \text{decisions based on} \\ \text{tracking risk}} & {\text{Factor’s marginal contribution} \\ \text{to total risk and} \\ \text{specific risk}} \\ \hline
\textbf{Factor-Based} & {\text{Factor’s marginal} \\ \text{contribution to tracking } \\ \text{risk and to active} \\ \text{specific risk}} &
\end{array} $$

Risk attribution is meant to be combined with return attribution in order to give the full picture of the manager's active decisions. Risk attribution alone will only identify where risk has been introduced.

Variations of Risk Attribution Analysis

This same level of analysis can also be applied to country allocation, sector allocations, or any other relevant choices made by the investment manager. The important consideration is that the analysis is performed with consideration to the manager's investment process. As an example, a European equity investment strategy might use a country allocation process with security selection within each country or a sector allocation process with security selection within each industrial sector. 

Question

Which of the following mandate types identifies sources of tracking risk?

1. Absolute.
2. Benchmark-relative.
3. Bottom-up.

Solution

The correct answer is B.

A “benchmark-relative” mandate type specifically involves comparing a portfolio's performance to a benchmark index. It identifies sources of tracking risk, which is the difference between the portfolio's return and the benchmark's return.

A is incorrect. An “absolute” mandate type typically does not focus on tracking risk or relative performance to a benchmark. Instead, it aims to achieve positive returns or meet a specific target without direct reference to a benchmark.

C is incorrect. A “bottom-up” mandate type typically pertains to the investment approach used in security selection and analysis, focusing on individual securities rather than tracking risk. It is more related to the process of security selection and fundamental analysis.

Reading 12: Portfolio Performance Evaluation

Los 12 (g) Discuss considerations in selecting a risk attribution approach