Friday, April 30, 2010

What happens when your classification is different than the index's?

I'm at the Spring meeting of the North American chapter of the Performance Measurement Forum in Boston. One of the issues that was raised deals with the case when a firm has a different classification structure than the index and the resulting impact this has on performance attribution. For example, if a firm assigns a stock that's in the index to a different industry than what the index has.

If we ignore this difference then the attribution results are questionable. If we change how the benchmark has the security assigned then we've manipulated the benchmark and arguably falsified the comparison. If we change our classification so that it aligns with the benchmark than we might feel that this doesn't truly represent how we manage. No good solutions.

Probably the best answer is not to have a different classification. But this may not always be practical. Perhaps in those cases where the firm feels that such differences are necessary we should have a new attribution effect: "classification effect." Just as we can have "pricing effect" to identify pricing differences between the benchmark and portfolio, we can have a "classification effect" to identify the impact of differences in how we classify our securities. To my knowledge no one has done this but it can't be that difficult to accomplish.

Thoughts?

2 comments:

  1. David,
    By my lights, any portfolio-level "classification effect" will be zero since moving an issue from one class to another does not change any portfolio-level returns.
    Of course, it is always formally possible to redistribute value among attributes in any way one wishes. But that points to the general problem of ensuring that each attribution value one reports corresponds to an actual decision rather than a to some kind of formal fudge.

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  2. Andre, thanks for your note.
    I haven't tested this but would expect to see differences. For example, if GICS has IBM as a information technology and I (for who knows what reason) make it industrials, we'd expect to see a disconnect would we not, because I'm using that investment in a sector that's different from the one in the index.

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