I had a conversation with a client last week, where we addressed a variety of aspects regarding performance attribution. They asked how common it is for firms to report their interaction effect. While I don’t believe we’ve addressed this question in any of our surveys, my gut tells me that most firms avoid doing so, in order to avoid having to explain it.
What is interaction? All one need to is to look at the formula to answer this: it’s the difference in weights (portfolio minus benchmark) times the difference in returns (again, portfolio minus benchmark); and these components represent allocation and selection, respectively. And so, it’s the interaction of these two decisions.
Why is it needed or why does it appear? Because the individual effects (allocation and selection) are isolated from one another, so as to not allow the influence of the other to impact its results (e.g., the selection effect is the difference in returns times the BENCHMARK weight, not the portfolio, since portfolio weight would reflect allocation). But this answer fails to mean much to most folks, thus the desire to avoid it.
The topic of whether it should be included or not is often hotly debated, as there are passionate voices on both sides of this issue. I’ve written an article on the topic, as have others, including my friend, Steve Campisi. In the end it’s up to the firm to decide how they wish to handle it.
We will include a question on this topic in our upcoming attribution survey; more details to follow. We hope you’ll join in, as we want as many participants as possible, all of whom will receive a complimentary copy of the results.