[MUSIC] Learning outcomes. After watching this video, you will be able to, one, understand performance attribution, [MUSIC] >> Now we move onto something called performance attribution. The idea here is to say find there is a certain set of out performance, that is in numbers, over and above some benchmark. Whatever the benchmark the manager might chose to benchmark himself, or herself, against the point now is to ask where does this out performance, or for that matter under performance, coming from. At the most basic level, out performance can come from two places. One, it can come from asset allocation. That is to say picking where you want to allocate your money to, that is to say, stocks, bonds, cash etc. Right, in the case of a mixed fund, you will choose to willingly allocate x percent to stock, x percent to bond and so on. And for preferred perhaps leave some portion in cash, right? Now, the other way to make money, if you will, is to basically, within each of these asset classes, that is, within stocks, within bonds, etc, choosing the right securities. So within the stock component, have I out-performed the stock benchmark? So basically what you have is essentially a two-way grid, basically saying, starting from the passive portfolio benchmark, all the way to the active portfolio return. You can get there in two ways. One is by timing, that is by allocation, being in the right market at the right time. Maybe you want to be in the stock market at the right time and stock markets are expected to outperform bond markets and vice versa right? The other way to make money, along the horizontal axis here, is by selection. That is to say, within each asset clause, I will pick the right securities. Both are ways of potentially making money right? Now I've given you a small example here of a blended firm, an equity plus bond firm and you'll notice that the benchmark here is a 60 30 10 portfolio. Which happened to have a performance last year according to the numbers in the third column of this table. And so the portfolio benchmark has an older performance of 3.97%. Now, my portfolio manager did two things. One is he deviated from the weights and the benchmark, whereas the benchmark specified 60, 30, and 10 to stock, bond, and cash. He prefered to hold 77 and 23. For whatever reason, in his or her wisdom, they chose to hold 70% equities, only 7% in bonds and chose to not invest 23%, that is hold it in cash. Now, also of course, cash is cash so the performance of the bench mark, cash is the same as active cash it's cash, right. But with stock and bond you will observe that his performance in the stock part and the bond part again defers from that each sector in the benchmark. So the question is after all this is accounted for we know that the managed portfolio out performed by 1.37% or 137 basis points. The question is how much of this 137 basis points is attributable? And hence the name attribution. Is attributable to security selection and how much is it attributable to asset allocation. Now, the point we're trying to make here is there is two ways to make money, as I said before. So the asset allocation part is right there in front of you right? So here what we are saying is, here I'm only going to take into account the fact that my manager, for whatever reason, chose to deviate from the weight specified in the bogey or benchmark portfolio. And of course, the difference is in weight, so the deviations have to sum up to zero. Because if you over-allocated relative to the benchmark in one, you will necessarily have under allocated in some other component. Now take that and multiply that with the performance at the benchmark and this is important to note. Multiply this each components performance by the benchmark and what you end up with is the weighted average number of 31 basis points. In other words, out of the total out performance, 31 basis points is clearly attributable to simply the deviations of my asset allocation compared to the so called benchmark asset allocation. Now for the other part, right? So obviously the 106 basis points that left over after we've accounted for this particular as an allocation must be coming from selection. In other words, now I take the activate rate of my manager and say the stock part of the benchmark performed 5.81%. Whereas the stock part of my active fund manager actually performed by 7.81% why? Presumably he picked the better stocks compared to simply holding a passive portfolio of equities. Now that difference of 7.28 minutes, 5.81% is attributable to his security selection ability and so also in bonds. Of course in cash there can be no security selection ability as I said before cash is cash. Now the net impact of this, when you do the numbers is a 106 basis points. So in other words basically 106 basis points is coming from the skill of the manager in selecting securities. And the earlier part was really the skill of the manager in waiting under waiting or over waiting relative to the benchmark. So that's really the way to, so we have studied performance measures and now we have also studied basically how to analyze where the money is coming from. Out-performance or under-performance, in other words, where is the money being gained or where is the money being lost.
