Custom Factor Attribution

Abstract

Portfolio analysts often use one set of decision variables for attributing portfolio returns and a different set for attributing risk. This practice obscures the relationship between the sources of risk and return. This article demonstrates how to align the attribution model with the investment process. The attribution methodology can be applied ex ante or ex post. A factor-based investment process illustrates the general framework. Specifically, active return, tracking error, and the information ratio are attributed to a user-defined set of factors that reflect the manager’s investment decision-making process. A concrete example with actual market data, a style portfolio, and a parsimonious set of custom factors illustrates how to apply the analysis.