Investment Performance: Metrics, Attribution, and Standards
Abstract
Performance measures, essential for assessing portfolio effectiveness, offer numerical insights into returns. Return attribution, dissecting factors like asset allocation, is key to understanding performance. Regulatory efforts in developed countries emphasize transparent reporting. The Global Investment Performance Standards (GIPS) by the CFA Institute stand out as the gold standard, ensuring ethical and reliable reporting in the financial landscape. Investors navigating complexities in investment management find understanding these measures, especially return attribution, crucial, with GIPS as the trusted framework.
Time to read: 5 to 7 minutes.
Level: Fundamental.
Category: Education Note.
How to Measure and Improve Your Portfolio Performance: A Three-Stage Process Based on Timeless Principles
Measuring portfolio performance is integral to the investment decision process, whether managing assets personally or relying on professionals. This process encompasses activities like benchmarking, asset allocation, security analysis, portfolio construction, and transaction execution. The measurement of portfolio performance is an inherent part of this decision-making, providing valuable insights to investors, asset managers, and other stakeholders involved in the process. Stakeholders include consultants, custodians, independent performance measurers, and audit firms.
The primary questions addressed by portfolio performance measurement are the return on assets, the reasons behind the portfolio's performance, and strategies to enhance performance. It serves as the quality control mechanism for the investment decision process, offering crucial information for assessing investment strategies and outcomes. The foundation of performance measurement, as established by the Bank Administration Institute in 1968, emphasizes the importance of basing returns on market values, incorporating total returns (including income and changes in market value), adopting time-weighted returns, and considering both risk and return in the measurement process. These principles, outlined decades ago, remain relevant today, guiding effective performance evaluation and decision-making in the dynamic landscape of investments.
The process of performance measurement involves three key stages:
Measurement:
Calculation: This stage focuses on computing returns, benchmarks, and peer groups, essential for assessing investment performance.
Distribution of Information: Involves disseminating the calculated information to relevant stakeholders.
Attribution:
Return Attribution: Identifies and analyzes the components contributing to the portfolio's return.
Risk Analysis (Ex Post and Ex Ante): Evaluates risk both retrospectively and prospectively, providing insights into the risk factors associated with the investment.
Evaluation:
Feedback: This stage entails providing feedback based on the measurement and attribution stages, offering insights into the performance outcomes.
Control: Involves implementing control mechanisms to enhance performance based on the evaluation feedback.
In essence, this three-stage process ensures a comprehensive evaluation of investment performance, covering measurement, attribution, and evaluation to facilitate informed decision-making and continuous improvement.
Portfolio Performance Measures: A Comprehensive Guide to Return, Risk, and Benchmarking
Performance measures assess how well an investment portfolio meets its objectives and benchmarks, taking into account returns over investments. Common measures include:
Return measures are methods of calculating the profit or loss of an investment over a period of time. They help investors evaluate the performance and risk of different investments or portfolios. There are different types of return measures, such as absolute, relative, risk-adjusted, arithmetic, and geometric returns, each with its own advantages and disadvantages.
Absolute return is the return that an asset achieves over a certain period, regardless of market conditions or benchmarks. It measures the actual gain or loss of an investment in percentage or dollar terms. Absolute return is useful for assessing the standalone performance of an investment, but it does not account for the risk or opportunity cost involved.
Relative return is the return that an asset achieves over a period of time compared to a benchmark or market index. It measures the excess or shortfall of an investment’s return over the expected return based on the benchmark. Relative return is useful for comparing the performance of different investments or portfolios, but it may not reflect the true value of an investment if the benchmark is inappropriate or inaccurate.
Risk-adjusted return is the return that an asset achieves over a period of time after considering the degree of risk involved. It measures the return per unit of risk of an investment, compared to a risk-free rate of return or a benchmark. Risk-adjusted return is useful for evaluating the efficiency and quality of an investment, but it may depend on the choice of risk measure and risk-free rate.
Arithmetic return is the simple average of a series of returns generated over a period of time. It is calculated by adding up all the returns and dividing by the number of returns. Arithmetic return is easy to compute and understand, but it does not consider the effects of compounding or the volatility of returns.
Geometric return is the compound average of a series of returns generated over a period of time. It is calculated by multiplying all the returns and taking the nth root, where n is the number of returns. Geometric return considers the effects of compounding and volatility, and it is more accurate than arithmetic return for measuring the long-term performance of an investment.
Modern performance measurement dates to 1966 when William Sharpe introduced the Sharpe ratio, a one-dimensional measure for performance based on mean-variance theory. Jensen later introduced alpha in 1969, the first benchmark-based measure. These, along with related measures like the information ratio and M-squared, are commonly used for ranking investment managers and assessing investment strategy attractiveness.
Sharpe ratio: This is a measure of the excess return per unit of risk of an investment or a portfolio. It is calculated by subtracting the risk-free rate from the expected return and dividing by the standard deviation. The higher the Sharpe ratio, the better the risk-adjusted performance. Some key issues with the Sharpe ratio are:
It assumes that returns are normally distributed, which may not be true for some investments, especially alternative strategies.
It only considers the total risk of the portfolio, not the sources or types of risk, such as market, credit, liquidity, etc.
It may not be comparable across different time periods, asset classes, or investment styles, as the risk-free rate and the standard deviation may vary significantly.
Treynor ratio: This is a measure of the excess return per unit of systematic risk of an investment or a portfolio. It is calculated by subtracting the risk-free rate from the expected return and dividing by the beta. The higher the Treynor ratio, the better the risk-adjusted performance. Some key issues with the Treynor ratio are:
It assumes that the beta is a reliable and stable measure of systematic risk, which may not be true for some investments, especially alternative strategies.
It only considers the systematic risk of the portfolio, not the unsystematic or diversifiable risk, which may also affect the performance.
It may not be comparable across different time periods, asset classes, or investment styles, as the risk-free rate and the beta may vary significantly.
Jensen’s alpha: This is a measure of the excess return above the expected return of an investment or a portfolio, given its level of risk. It is calculated by subtracting the expected return based on the capital asset pricing model (CAPM) from the actual return. A positive Jensen’s alpha indicates that the investment or portfolio has outperformed its expected return, while a negative alpha indicates underperformance. Some key issues with Jensen’s alpha are:
It relies on the CAPM, which may not be a valid or accurate model for estimating the expected return, especially for alternative strategies.
It depends on the choice of the market index and the risk-free rate, which may affect the results and the comparability across different investments or portfolios.
It does not provide any information on the sources or drivers of the excess return, such as allocation, selection, or timing effects.
M-squared, or Modigliani-Modigliani measure: This is a financial performance metric that assesses the risk-adjusted returns of an investment portfolio relative to a chosen market index. Calculated by comparing the excess return of the portfolio over the risk-free rate with the excess return of the market index over the same rate, M-squared incorporates beta values to measure systematic risk. A positive M-squared indicates that the portfolio has outperformed the market, considering the additional risk taken, while a negative value suggests underperformance. This metric provides a comprehensive evaluation of a portfolio manager's ability to generate value, considering both returns and risk in relation to a specified benchmark.
Asset Allocation and Security Selection Formulas
Performance attribution is a technique used to quantify the excess return of a portfolio against its benchmark into the active decisions of the investment decision process.
Performance measures are the tools used to analyze and quantify how well a portfolio is meeting its objectives. At their core, these metrics provide a numerical representation of the returns generated by a portfolio over a specified period. This analysis goes beyond mere numbers, offering a comprehensive view of a portfolio's performance in relation to its goals and benchmarks.
Crucial to understanding the performance puzzle is return attribution. This analytical process is the key to unraveling where returns originate and why. It dissects the components that contribute to a portfolio's performance, such as asset allocation, security selection, and market exposure. By peeling back these layers, return attribution provides valuable insights for both investors and asset managers, guiding strategic decisions.
Return attribution: This is a process of analyzing the sources of performance of a portfolio relative to a benchmark. It helps to identify and evaluate the contribution of different investment decisions, such as asset allocation, security selection, market timing, currency exposure, etc. to the portfolio’s return. Some key issues with return attribution are:
It requires a clear and consistent definition of the portfolio’s objectives, strategy, and benchmark, which may not be available or agreed upon for some investments, especially alternative strategies.
It involves various methods, models, and assumptions, which may affect the results and the interpretation of the attribution effects, such as arithmetic or geometric, Brinson or factor, top-down or bottom-up, etc.
It may produce residuals or unexplained effects, which may reflect the limitations or errors of the attribution model, the data quality, or the portfolio manager’s skill.
In the notional model, the fundamental formulas governing asset allocation and security selection, as per the framework proposed by Brinson, Hood, and Beebower, are clearly outlined. For an in-depth exploration of these concepts, a comprehensive discussion can be found in the recommended literature, particularly in Bacon's work from 2012 and 2020.
Regulatory Efforts Across Developed Countries: Recognizing the importance of standardized and transparent performance reporting, various developed countries have undertaken substantial regulatory efforts. These initiatives aim to establish guidelines that ensure accuracy and consistency in performance measurement practices. Regulatory frameworks play a pivotal role in fostering investor confidence and maintaining integrity in the financial industry.
The Emergence of GIPS as the Pinnacle Standard: Among the diverse standards and frameworks, the Global Investment Performance Standards (GIPS) stands out as the pinnacle. Developed and maintained by the CFA Institute, GIPS offers a comprehensive set of principles guiding investment firms in presenting performance data. This standard not only emphasizes transparency but also upholds ethical standards, making it a trusted framework in the financial landscape.
As investors navigate the complexities of investment management, a solid understanding of performance measures becomes imperative. Return attribution emerges as the linchpin for unraveling the intricacies of returns. Moreover, the regulatory landscape, marked by efforts in various developed countries, highlights the commitment to transparency. In this landscape, GIPS takes center stage as the gold standard, setting benchmarks for ethical reporting and ensuring a reliable framework for the investment community.
References:
Carl R. Bacon, Practical Portfolio Performance Measurement and Attribution, 3rd ed. (Chichester: Wiley, 2020).
CFA Institute, Global Investment Performance Standards (GIPS).
Recommended Readings:
Bacon, Carl R. Practical Risk-Adjusted Performance Measurement. 2nd ed. Hoboken, NJ: John Wiley & Sons, 2012.
Christopherson, Jon A., David R. Carino, and Wayne E. Ferson, eds. Portfolio Performance Measurement and Benchmarking. 1st ed. Hoboken, NJ: John Wiley & Sons, 2009.
David Spaulding, The Handbook of Investment Performance: A User’s Guide, 2nd ed. (Charlottesville: CFA Institute, 2017).
