Risk Attribution

Description

In this article, the authors propose a methodology to measure the effective contribution to the total risk and tracking error due to asset allocation or selection. They demonstrate that the portfolio historical volatility is explained, first by the asset’s volatility and correlation and second by the holding’s volatility. The results highlight that what matters for effective risk contribution is the time series of contribution to return; applying these results to effective contribution to tracking error (TE) shows that what matters is the time series of excess return times weight differences. This result is different from marginal contributions to the TE, which depends solely on time series of excess return and not on changes in portfolio’s holdings. The results in risk attribution give an exact decomposition of the portfolio’s total risk and TE that complement the return attribution analysis. Exact decomposition refers to the fact that the sum of the contributions is exactly equal to the portfolio’s volatility and TE.