Knowing where your returns come from is vital for both managers and investors. For managers it serves to provide deep understanding of the effects of their decisions, and for allocators to evaluate and attribute managers’ performance. One of the most effective tools for this is performance attribution, specifically through the Brinson model (also known as Brinson-Fachler analysis). This method allows investors to break down their returns, understand where they are coming from, and make more informed decisions. In this post, we’ll explore the Brinson model, its key components, and why it’s an essential tool for guiding investment strategies.
At its core, the Brinson model divides portfolio performance into two primary effects: allocation and selection. These effects are then analyzed to determine how much of the portfolio's excess return over a benchmark is due to the decisions made by the portfolio manager.
- Allocation Effect: This measures how much a manager’s decision to overweight or underweight certain sectors affects performance compared to a benchmark.
- Selection Effect: The selection effect dives deeper, asking whether the manager chose the right stocks within each sector. It assumes that the manager's allocation matches the benchmark and then measures the performance based on stock selection within those sectors.
In practice, decisions aren’t always made in isolation. Often, a manager’s performance is influenced by how they combine allocation and selection decisions. This is where the interaction effect comes into play. It captures the synergy (or lack thereof) between the allocation to sectors and the selection of stocks within those sectors. For instance, if a manager overweights a sector and also picks the top-performing stocks within that sector, the interaction effect will highlight this contribution.
In our approach at Kiski, we simplify the analysis by combining the interaction effect with the selection effect. This simplification provides a clearer view of the total impact of allocation and selection decisions on the portfolio’s performance. Our output consists of a straightforward equation: Total Effect = Allocation Effect + Selection Effect.
This approach not only makes the results easier to interpret but also aligns more closely with the practical needs of our clients, who seek clear insights to guide their investment strategies.
Single-period attribution is useful, but most investment strategies are assessed over longer time horizons. The Frongello method is a technique that extends the Brinson analysis across multiple periods, ensuring that performance attribution remains accurate and consistent over time.
The Frongello method addresses the challenge of linking allocation and selection effects across periods without leaving residuals. By applying adjustments to returns at each period, this method ensures that the sum of effects over multiple periods equals the total difference in returns. This precise linking of returns is critical for investors looking to understand performance over time.
Consider a portfolio where the manager has overweighted the technology sector and selected a few high-performing stocks within that sector. Through Brinson analysis, we can break down how much of the portfolio’s excess return is due to the overweight in technology (allocation effect) and how much is due to picking the right stocks within that sector (selection effect).
Further, by applying the Frongello method, we can extend this analysis across multiple quarters, providing the investor with a detailed view of how these decisions have contributed to long-term performance.
1. Informed Decision-Making: Brinson analysis gives investors clear insights into which decisions are driving performance. This clarity enables better decision-making and strategy refinement.
2. Enhanced Accountability: By breaking down performance into allocation and selection effects, managers can be held accountable for their decisions. It provides a transparent way to evaluate whether a manager is adding value.
3. Improved Risk Management: Understanding the sources of returns also highlights potential risks. If a portfolio’s outperformance is heavily reliant on a single sector or a few stock picks, this concentration risk can be addressed proactively.
Performance attribution, particularly through Brinson analysis, is a powerful tool for understanding the sources of investment returns. At Kiski, we integrate this analysis into our investment process, providing our clients with the insights they need to optimize their portfolios and achieve superior performance. Whether through single-period attribution or multi-period analysis with the Frongello method, our approach ensures that every decision is carefully evaluated and understood.
This thorough understanding of portfolio performance empowers investors to navigate the complexities of the market with greater confidence and precision.
