thommo77

there are 2 components to each return.

Year 1 Manager = 5%
Year 1 benchmark = 3%

Year 2 Manager = 8%
Year 2 Benchmark = 7%

So one would think that total excess return = 2% + 1% = 3% or 1.02 * 1.01 = 3.02%

It doesn't - lets call the excess returns - attribute

In reality, we made (1.05 * 1.08) -1 = 13.4%
The benchmark made (1.03*1.07)-1 = 10.21%
Excess Return = 3.19%

So if we take attribute of year 1 * ( 1+ benchmark return yr 2) we get . 02 *1.07 = 2.14%
If we take attribute of year 2 *( 1 + portfolio year 1 ), we get 01 * 1.05 = 1.05%

Excess return = 3.19%

The bottom line is this: the excess return of year 2 is compounded by the portfolios return in year 1 - this gives the contribution of the portfolio in year 1 to the 2 year portfolio excess return and the the excess return of year 1 is compounded by the benchmark in year 2 to give the contribution of the portfolio's excess return in year 1 to the 2 year portfolio excess return.