Fixed Income Performance Attribution - The Struggle Continues

Published equity attribution models have matured and do an effective job of measuring the sources of excess return of a portfolio relative to a benchmark. Industry-wide consensus has emerged, and standard methodologies have been adopted. For many asset managers, with equity attribution capabilities solidly in place, their focus has shifted to solving the complexities of fixed income attribution. Attribution in the fixed income markets, however, is less mature, and the industry continues to struggle with models, data and derivatives.


Is there a single model that is the right model?
Fixed income attribution models should measure the success or failure of the risk judgments made by a portfolio manager.

Over the last few years some software vendors have launched fixed income attribution products that can analyze a bond’s price return by removing the proportion of price that can be attributed to duration. The methodologies then decompose a portfolio’s excess return into bond-specific factors based on a Brinson methodology. However, the majority of systems do not provide the flexibility to change the underlying model to match the management style of many portfolio managers and hence are deemed inappropriate. Consequently, investment firms continue to develop proprietary solutions and build technology and business infrastructures to support their attribution requirements. Some firms also use the attribution capabilities of a fixed income analytic system as an adjunct to their existing infrastructure.

The future looks brighter. Vendors are increasingly offering multiple attribution models and calculations to their systems, moving away from offering only a single approach. In addition, some vendors are taking it one step further by enhancing their systems to support user-defined models and calculations. As a result we see more asset management firms launching new initiatives to review the vendors’ capabilities.

It’s about the data
Another key component of fixed income attribution is data. Sourcing consistent, accurate security master, pricing and index data is a consistent challenge for the industry and adds further complexity to the process. Once a firm has data, it is then a matter of understanding it, validating and cleansing it, and correctly integrating it into attribution calculations.

Market data providers are improving their abilities to provide constituent-level index data. This is a major breakthrough for the industry, enabling firms to decompose excess return down to the security level.

Derivatives – the next challenge
According to the Bank of International Settlements, at the end of June 2006, the outstanding notional volume of over-the-counter derivatives was 369,906 trillion USD, a staggering 80% growth rate in six months. Just to put that into perspective, the outstanding exchanged traded volume at the end of September 2006 was 25,824 trillion USD. As the market continues to invest in these complex instruments, attribution will increase in complexity in order to capture the impact these instruments have on a portfolio’s return. In addition, each type of derivative instrument requires a deeper level of specialized data to generate attribution.

Today asset managers are struggling to find adequate solutions to support accounting and other back office processes associated with derivatives. These issues must be solved before firms can even consider embarking on performance attribution. Complex data requirements begin with deal pricing and carry through to accounting, valuation, and collateral management, with performance attribution needing even greater granularity and accuracy. The lack of functionality in investment accounting systems to support derivatives poses additional challenges for attribution and further limits a firm’s ability to properly attribute a derivative to a portfolio’s return. In some cases derivatives are represented in a separate portfolio and therefore do not represent the impact of hedging strategies in attribution as they should. Others integrate manual processes and spreadsheets to represent a hedging strategy. Either way, data is a common problem across asset management firms and is becoming more of an issue as volumes increase and structures become more complex.

Vendor solutions are evolving
There are some vendors that have been proactive in enhancing their systems to support over-the-counter derivatives. In some cases proprietary models have been expanded to support new data requirements and calculations, while others offer an open framework for user-defined models. However, even with these development efforts, the problem of matching a model to a portfolio manager’s investment process remains a significant technology challenge.

On April 26, 2007, CutterResearch will be presenting a detailed review of performance measurement and attribution systems and information on the various attribution models for fixed income and derivative instruments. The presentation will also be an opportunity to hear how large global investment firms are tackling these challenges.