Allocation effect
In performance attribution, the part of a portfolio's return over its benchmark from over- or under-weighting a sector versus the benchmark, separate from the return earned by picking securities.
In plain language
When a portfolio beats its benchmark, there are really two different reasons this can happen. One is picking better individual securities within a sector. The other is choosing to hold more or less of a sector or asset class than the benchmark does, ahead of that sector doing well or badly.
The allocation effect measures this second source of return. It captures how much of the outperformance came purely from being overweight in sectors that did well, or underweight in sectors that did badly, compared to the benchmark's own weights.
How it works
Performance attribution analysis splits a portfolio's return into two broad pieces: the return driven simply by the benchmark, and the differential return, the extra or shortfall return the portfolio manager achieved. The differential return is then split further, and the allocation effect is one of its two main components, alongside the selection effect.
The allocation effect is calculated from the difference in weighting between the portfolio and the benchmark, combined with how that sector or asset class actually performed. Being overweight a sector that outperforms the total benchmark, or underweight a sector that underperforms it, both add a positive allocation effect; the reverse, overweight a laggard or underweight a winner, subtracts from it.
A worked example
A benchmark index is 20% weighted to the banking sector, which returns 18% for the year while the overall benchmark returns 12%. A portfolio manager, anticipating the banking sector's strength, holds 35% in banking stocks, 15 percentage points overweight versus the benchmark.
Because banking outperformed the overall benchmark by 6 percentage points, and the manager held 15 percentage points more of it than the benchmark did, this overweight decision alone added a meaningfully positive allocation effect to the portfolio's return over the benchmark, separate from and in addition to whichever specific banking stocks the manager happened to pick, which would instead show up in the selection effect.
Why NISM asks about it
Chapter 16 (Portfolio Performance Measurement and Evaluation), section 16.6.1, 'Assets and Sector Allocation', introduces the allocation effect as one half of performance attribution, with section 16.6.2 covering the selection effect. Expect a question that distinguishes return earned from sector weighting decisions, the allocation effect, from return earned by picking specific securities within a sector, the selection effect.
Common exam traps
- Do not confuse the allocation effect with the selection effect — allocation is about how much of a sector or asset class was held versus the benchmark; selection is about which specific securities were chosen within it.
- A positive allocation effect requires being overweight a sector that beat the benchmark, or underweight one that lagged it — being overweight a sector that also underperforms the benchmark hurts the allocation effect, even if the sector itself had a positive return.
- The allocation effect is measured relative to the benchmark's own weights, not against some fixed or ideal allocation.
Where this is taught
Free preparation for NISM Series X-ARelated terms
- Benchmark portfolioA reference portfolio, typically an index, matched in composition to a client's own portfolio so the client's actual returns can be fairly compared against it, comparing 'apple with apple'.
- Beta returnUnder the CAPM, the part of a portfolio's return that comes purely from taking on market (systematic) risk, calculated as beta multiplied by the market's excess return over the risk-free rate.
- SelectivityThe fund manager's ability to select securities that generate extra returns — the stock-picking half of performance attribution, as against timing the market or weighting a sector.
- Interaction effectIn attribution analysis, the combined impact of asset allocation and security selection: Σ (Wp − Wb) × (Rp − Rb). It captures overweighting a sector and also picking better stocks in it.
- Security selection effectIn performance attribution, the part of excess return earned by choosing better securities within a sector, measured at the benchmark's own sector weights, separate from allocation and interaction effects.