Risk Attribution
It's nice to see a portfolio manager beat a benchmark in terms of returns.
What would you say is the easiest way to accomplish this?
Not really. That would likely reduce returns.
Absolutely. You can get more expected return if you assume more risk, and so the risk and return attributions really have to be considered together.
Probably not. Tracking the benchmark will get you right about the benchmark return.
Suppose you want to simply earn an absolute return by picking the right stocks. What sort of risk attribution approach sounds right?
No, this is more for managers doing sector allocation weightings.
Exactly.
If a manager uses a factor-based approach for making portfolio decisions, then a factor-based risk approach is obviously best. The top-down approach is used for managers focusing on sector allocations without attempting security selection. But for managers using a bottom-up approach to select securities, then a bottom-up risk approach is what to use.
No, factor-based approaches are for managers with a factor-based decision process.
But then there's the question of focusing on total risk or tracking risk (also called tracking error). What would you suggest for evaluating this manager?
Of course. You can't calculate tracking risk without a benchmark to track.
That's not it. You can't calculate tracking risk without a benchmark to track. So total risk is needed.
You'll want to see what the marginal contribution to total risk is for each security. That is, as you increase the weight on Stock A just a little, you want to see what happens to risk. Which risk?
No, that doesn't change just because it's weighting in a portfolio changes. Either way, you're concerned with portfolio risk. As always, that contribution will be related to the risk of the security and its correlation with the portfolio.
Absolutely. You're concerned with portfolio risk. As always, that contribution will be related to the risk of the security and its correlation with the portfolio.
When would risk attribution analysis focus instead on marginal contribution to *tracking* risk?
That's it! Tracking error when there's a benchmark to track.
Incorrect.
This is when you want to look at each factor's marginal contribution to risk.
Incorrect.
This is when you want a bottom-up approach, looking at each security's marginal contribution to total portfolio risk as just discussed.
In summary:
[[summary]]
Add risk
Hedge
Track the benchmark
Top-down
Bottom-up
Factor-based
Total risk
Tracking risk
The stock's standard deviation of returns
The portfolio's standard deviation of returns
When a manager takes a factor-based approach to portfolio design
When a manager follows an equity-market-neutral strategy
When a manager seeks to beat the S&P 500 index
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