Performance attribution is key to understanding how various investment decisions contribute to returns: in a previous post, we explored the basics of Brinson analysis and how to utilize it for performance analysis.
This blog goes a step further by examining a different perspective—using a bottom-up approach within Brinson analysis. This method focuses on how individual stock selection drives performance, offering a valuable tool for managers who emphasize stock-picking over broad allocation decisions.
The bottom-up approach in Brinson analysis shifts the focus from macro-level allocation to the impact of security selection. Unlike the top-down approach, which first evaluates regional or sector allocation decisions, the bottom-up approach zeroes in on the success of individual stock picks. In this framework, the weighting effect—the influence of allocation choices—takes a backseat to the selection effect, which highlights the performance of specific stocks.
This approach is particularly suited to managers whose core expertise lies in finding outperforming stocks. It attributes portfolio gains (or losses) directly to these decisions, making it a valuable tool for those whose primary strategy is stock selection rather than market or sector timing.
In the bottom-up model, the selection effect takes precedence, while the weighting effect becomes secondary. Here’s how they play out:
- Selection Effect: : This measures the portion of excess return generated by choosing individual stocks that outperform their counterparts in the benchmark. It isolates the impact of stock selection by assuming constant weightings between the portfolio and the benchmark.
- Weighting Effect: This reflects the difference between the actual allocation to individual stocks versus the benchmark’s allocation. While still relevant, the weighting effect plays a secondary role in the bottom-up approach, as the focus remains on the success of stock-picking.
By focusing on stock selection, the bottom-up approach aligns directly with the decision-making process of managers who prioritize security-level decisions over broad allocation strategies.
In traditional Brinson analysis, an interaction term represents the overlap between allocation decisions and stock selection. In the bottom-up approach, this interaction is instead simplified and folded into the weighting effect. This allows managers to focus primarily on selection, while still accounting for the residual impact of allocation decisions.
For stock-pickers, this makes the bottom-up model more intuitive, as it directly correlates portfolio performance with stock-picking choices. The weighting effect remains, but it plays a supporting role, ensuring the analysis reflects reality without overshadowing the key focus—stock selection.
For managers focused on individual stock choices, the bottom-up approach is the most effective tool for analyzing performance. It offers granular insights into how specific stock-picking decisions contribute to returns, making it far more relevant for those who prefer to focus on security-level strategies.
- Precision in Stock Selection: The bottom-up model provides clear attribution for the success or failure of individual stock picks, making it ideal for managers who prioritize selecting top-performing stocks across sectors or regions.
- Secondary Role of Weighting: While weighting decisions are still reflected, they are secondary. For stock-pickers, this structure better aligns with their strategy by placing the primary focus on selection, where the real value is added.
This approach also allows managers to see how much of their portfolio’s success can be attributed to broader allocation decisions versus their ability to choose winning stocks.
We use advanced techniques like the bottom-up approach to Brinson analysis to give our clients deeper insights into their portfolios and help them understand the true drivers of their portfolio performance.
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