Selectivity

When a fund beats its benchmark, there are only a few places the extra return can have come from.

One is the sectors it chose to hold more or less of than the benchmark. That is the allocation effect.

Another is the individual securities it picked inside those sectors. That is selectivity.

The workbook defines it in one line: selectivity is the ability of the fund manager to select securities that will generate extra returns.

It works in two directions, and the second is easy to forget. Owning the winners helps. So does avoiding the losers that are in the benchmark. The workbook says even avoiding the poor performing securities can lead to a big improvement.

Selectivity is the rival explanation to market timing, which is about anticipating what the whole market will do. The workbook reports what the research found. Market timing is not the factor that results in better performance. On selectivity the results are mixed, with some managers having the ability.

So the honest reading is this. Stock picking may work. Calling the market apparently does not.

Where it sits (section 16.6, Performance attribution analysis). Attribution is the second phase of performance evaluation. The underlying theme of every attribution approach is to dissect the return into two components: the return driven by the benchmark, and the differential return. The next task is identifying and quantifying the sources of that differential return — and specifically whether it came from the skill of the portfolio manager or from random factors, which the workbook glosses in layman's terms as luck.

The 2 sources of differential return the chapter names.

1. Assets and sector allocation (16.6.1). Differential return can be achieved by over-investing in a sector that outperformed the total benchmark, or under-investing in or avoiding an asset category that underperformed it. This is critical because all parts of the benchmark do not perform in the same proportion at all times.
2. Selection (16.6.2). Differential return can also be achieved by selecting securities that performed well relative to the benchmark, or avoiding benchmark securities that performed relatively poorly. There are several individual factors that affect the performance of a security, and being able to have exposure to the winners is another factor that leads to better performance. Even avoiding the poor performing securities can lead to a big improvement in the overall relative performance of the portfolio.

Selectivity against market timing (16.6.3). Market timing is the ability of the fund manager to anticipate developments in the market and then invest to take advantage of them and generate superior performance. Selectivity is the ability of the fund manager to select securities that will generate extra returns. The workbook records a long-standing debate over which is the route to extra returns, and then the evidence: most studies have shown that market timing is not the factor resulting in better performance, while the results are mixed on the selectivity front, with some having this ability.

How selectivity gets measured. The chapter's answer is the next section: net selectivity, the Fama measure, which strips out the return the market would have paid for the risk the portfolio carried and leaves the part attributable to selection. Selectivity is the ability; net selectivity is the number.

Sections 16.6.2 and 16.6.3 carry no figures at all — no attribution formula, no worked split, no percentage. The workbook gives the allocation side a named calculation and leaves the selection side in words. The figures in the example below are illustrative and built on the workbook's stated definitions.

Illustrative figures; sections 16.6.2 and 16.6.3 give none.

A large cap fund returns 16.2% against a benchmark's 12.0% — a differential return of 4.2 percentage points. Where did it come from?

The fund holds two sectors. Assume these weights and returns:

Allocation. At benchmark returns, the fund's own weights would have produced (0.55 x 15) + (0.45 x 10) = 12.75%, against the benchmark's 12.0%. So 0.75 points came from being overweight the better sector. That is the allocation effect.

Selection. Holding benchmark weights but the fund's own stocks would have produced (0.40 x 18) + (0.60 x 14) = 15.6%, or 3.6 points over the benchmark. That is selectivity — and it is nearly 5 times the allocation contribution.

On a Rs 25,00,000 investment the 4.2-point differential is Rs 1,05,000. Of that, Rs 90,000 is stock picking (3.6 points) and Rs 18,750 is sector weighting (0.75 points) — which overshoots by Rs 3,750, because the interaction of the two is negative here: the fund's best stock picking sat in the sector it was underweight.

The avoidance half, which the arithmetic above hides. Take a separate illustration. Suppose a stock carrying a 4% benchmark weight falls 40% over the year, and the fund simply does not own it. Relative to the benchmark that single omission is worth roughly 0.04 x 40 = 1.6 percentage points, or about Rs 40,000 on a Rs 25,00,000 portfolio. The manager did nothing at all.

That is the workbook's point about avoiding the poor performing securities. Selectivity is not only a list of good buys; it is also the list of things in the index that a manager declined to hold.

Chapter 16 (Portfolio Performance Measurement and Evaluation), section 16.6.2 (Selection) and section 16.6.3 (Market timing versus selectivity), with the allocation side at 16.6.1 and the Fama measure at 16.6.4. Expect a question distinguishing allocation from selection — which is about how much of a sector was held, and which about which securities were chosen — and a question on the workbook's stated evidence: market timing does not drive better performance, while selectivity results are mixed. Candidates lose the second one by picking market timing.

• Selectivity is the ability; net selectivity is Fama's measure of it. One is a skill, the other a number in percent. The exam offers both.
• Selection is about which securities, allocation is about how much of a sector. Allocation effect answers the second question.
• Avoiding a benchmark loser counts as selectivity. The workbook says so explicitly, and candidates read selection as buying only.
• The evidence runs against market timing, not against selectivity. Most studies show market timing is not the factor resulting in better performance; on selectivity the results are mixed, with some managers having the ability.
• Attribution splits skill from luck, which is the reason the chapter bothers. A differential return is not proof of either until it is decomposed.
• The workbook gives no formula for selection. It names a calculation for the allocation effect and leaves selection in words — so a question asking for the selection formula from this paper has no answer in the text.