The importance of attributing active risk to benchmark-relative sources

ABSTRACT We demonstrate the importance of attributing active risk and return to the same underlying sources. We define and compare absolute and relative sources for securities, sectors and factors. We provide detailed examples and argue that benchmark-relative return sources are more appropriate for analyzing active portfolios. Usage of absolute return sources instead of relative return sources may lead to a number of problems, including a mismatch between risk and return sources, nonintuitive marginal contributions to risk, and flagging aggressive positions as risk reducing. These drawbacks are remedied by the use of benchmark-relative sources, which results in a set of consistent and intuitive effects.