Security Selection VS Asset allocation

CFA Level II Portfolio Management
#1

I need desperate help learning when active return is due to either security selection or asset allocation.

The book says the following…

  1. Asset allocation return = from deviations of asset class portfolio weights from benchmark weights. 2. Security selection return - from active returns within asset classes.

VERY confused on this - which is embarrassing because I feel like I could walk a third grader through valuing a swaption. Essentially, if weights to Equities & bonds for a fund are equal to those same weights of a benchmark portfolio and the fund either has positive or negative active return this is due to - and only to - security selection? but whenever active weights of the active portfolio don’t align with the benchmark portfolio active return is ALWAYS due to asset allocation return???

This is the most confusing thing to me in all of this curriculum. So what are your guys tricks on this one??

#2

The one scenario is easy, which is when weights are the same, because active return is only due to security selection. I get this.

But when weights are different, ALL OF A FUKKING sudden, it could be Security selection OR asset allocation.

#3

This is actually a lot harder than intuition, so understanding takes some getting used to. I took my a while to memorize the formula below.

But I believe the way you figure out if its asset allocation or security allocation is by calculating the difference in weights, difference in active returns, and difference in returns etc. I make a table with the following data, most of which is already provided in the problem.

R_P = return of portfolio

R_B = Return of benchmark

R_A - Return differential (difference of R_P and R_B)

W_P = weights of portfolio

W_B = weight of benchmark

W_A = weight differential (difference of W_P and W_B)

Then you use the formula of (W_A * R_B ) + (W_P * R_A) = total active return.

The first component is the asset allocation return and the second component is the security section return.

1 Like
#4

Lets do an example.

Background information

Portfolio A = 60 % Stock and 40 % Bonds

Benchmark = 50 % Stock and 50 % Bonds

Portfolio A: managed to return 20 % on their Stocks and 10 % on their Bonds

Benchmark: managed to return 18 % on their Stocks and 8 % on their Bonds.

Now to the fun part!

We know that Total value added can be decomposed into Asset Allocation and Security Selection, meaning that Total value added = Asset allocation + security selection

Total value added

What is then our Total value added? Well it is equal to the difference between the return on Portfolio A and the return on the benchmark, thus Total value added = Rport.a - Rport.b

What is the total value added? [(0.60*20 %) + (0,40*10%)] - [(0,50*18%) + (0,50*8%) = 3 %

So now we know that +3% = Asset allocation + Security selection, meaning that we either have to calculate asset allocation or security selection part.

Asset allocation part

How do we calculate Asset allocation part? We simply take the difference in weight between the Portfolio A and Benchmark when it comes to Stocks and Bonds. As you can see, we overweighed stocks (60 % instead of 50 %) and underweight bonds compared to the benchmark. To get the asset allocation part we simply have to calculate how much better the benchmark would perform if they had the same weights as we do in Portfolio A.

Asset allocation part = Benchmark portfolio performance with same weights as port A - Benchmark Portfolio performance as it is for now.

=> [0,60 * 18 % + 0,40 * 8 %] - [0,50 * 18 % + 0,50 * 8%] = 1 % is attributable to asset allocation

Security allocation part

So now we know that +3% = Asset allocation (=1%) + Security selection, meaning that we can simply break out security selection and see that it equal 2 %.

Hope it helped a little bit :slight_smile:

#5

Good exercise explanation Swe_Viking

:+1:

#6

Security Selection = Sum of Portfolio weights * Added value of each investment. (Eg. If investment A in your portfolio had a return of 10% and the benchmark had a return of 5% then the added value of Investment A is 5%)

Asset Allocation = Sum of Difference in weights * Benchmark returns.

#7

Thanks Everyone.

This is why I analystforum.