Research from MSCI’s Jose Menchero was recently published in the Journal of Performance Measurement. This paper provides an intuitive foundation for understanding and interpreting factor models. It shows every factor can be represented by a factor-mimicking portfolio, whose return exactly replicates the payoff to the factor. Pure factors provide a way of placing surgical bets and disentangling the often confounding effects of multi-collinearity.

While performance analysis is typically conducted on a benchmark-relative basis, risk analysis is often presented on an absolute-return basis. This mismatch between sources of risk and return leads to the pitfall that active management decisions cannot be evaluated on a risk-adjusted basis. In particular, usage of absolute return sources in risk attribution may lead to non-intuitive marginal contributions to risk and flagging aggressive positions as risk reducing. These pitfalls can be...

Brinson sector-based attribution explains active return in terms of intuitive allocation and selection decisions. However, it cannot easily disentangle competing industry and style effects. We introduce a special type of factor model with five defining characteristics that exactly replicates the classic Brinson model. We show that this “Brinson-replicating” factor model easily extends to explain more general types of investment processes. In this extension,...

The two main drivers of global investment performance are local asset returns and currency exchange rate returns. These two sources represent distinct investment decisions, and should be attributed independently, as argued by Singer and Karnosky. This article presents a refined and generalized version of the Singer-Karnosky model  for multi-currency attribution.

This Research Insight introduces a general risk attribution framework known as the x-sigma-rho methodology.  Given any return attribution scheme, this approach attributes the corresponding risk as a product of exposure, volatility, and correlation.  Several examples are provided to illustrate application of the technique.