EDHEC-Risk Institute October 2016

Multi-Dimensional Risk and Performance Analysis for Equity Portfolios — October 2016

1. Literature and Practice Reviews

Finally, alpha has a negative contribution in both cases.

of each sector. In what follows, we apply the previous method to the decomposition of “absolute” risk and performance that are respectively volatility and historical return, and to “relative” risk and performance, defined respectively as the tracking error and the excess return with respect to the market factor. Figure 6 shows the relative and absolute performance decomposition in the one-factor model augmented with pure sector effects and pure factor effects. Although the number of explanatory variables is greater than in the Carhart model, the market factor remains largely dominant to explain the realised performance, as it was for the long-only mutual funds in Section 1.2.1. It is only for relative performance that sector effects play a more significant role than the market: their contributions add up to 3.1%, versus only 0.1% for factor effects.

We perform the absolute and relative risk decomposition in Figure 7. Most of ex-post volatility is due to market risk, while pure sector effects are dominant in relative risk. By using more factors, the blended model has lower alpha and specific risk than the Carhart model. As a general comment, this method is easy to apply, and, as noted before, it requires minimal information on the portfolio that is decomposed since it only takes the returns as inputs (return-based approach). On the other hand, if and when available, holding- based information could serve as a useful prior and should not be discarded. In the next section, we precisely introduce a method that takes advantage of knowledge of the portfolio composition.

Figure 6: Absolute and Relative Performance Decomposition of the Equally-Weighted Portfolio of the S&P 500 Universe on Market, Carhart and Sector Factors Factor returns are from Ken French’s library. Sector returns are equally-weighted portfolios from the S&P 500 universe. We regress quarterly excess returns to each sector and factor portfolio on the market factor returns over the period 2002-2015 in order to extract pure sector and factor effects. We then regress equally-weighted portfolio excess returns on the market factor returns augmented with the pure sectors and factor effects, so as to obtain the factor exposures. For absolute performance, equally-weighted portfolio returns are in excess of the risk-free rate; for relative performance, they are in excess of market returns. We use formula (1.11) to make the performance attribution.

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