By Reuben Alberto
AS I promised in my previous article, this week I am looking at techniques that can be used by both fund managers/investors in assessing the performance of their portfolios.
Performance measurement is aimed at quantifying and qualifying change in the investment value of an asset or group of assets over a defined period. Generally speaking, a minimum of three years performance history should give a good indicator of how an investment manager or portfolio is performing.
Performance measurement can be carried out using an array of factors and ratios as yardsticks. Among them are the money weighted average rate of return and the time weighted average rate of return. On the other hand, the investor can consider risk return measures like the Sharpe ratio and the Treynor ratio in measuring performance.
Money weighted average rate of return – is a measure of the rate of growth of all the funds that do determine the value of the portfolio at the end of the required/stated period. The method has a weakness of not taking into account the cash-flow movements either into or out of the fund;
Time weighted average rate of return – using this measure, performance is measured by breaking up the total time periods into smaller sub-periods determined by cash-flow movements. As a result of its nature, there is need for the fund manager to market the portfolio each time there is a transaction affecting the value of the portfolio;
Sharpe ratio – in finance the risk of any investment/portfolio is measured by its standard deviation, that is the movement of the portfolio’s returns away from the expected return. The Sharpe ratio is then calculated using the standard deviation and excess return of the fund to determine reward per unit of risk. The higher the ratio, the better the portfolio’s returns relative to the amount of risk taken; and The Treynor ratio – this measure makes use of the systematic risk, that is the risk associated with the market as a whole and is not specific to the portfolio and the portfolio’s beta coefficient which is a measure of the fund’s sensitivity to market movements.
Using Treynor ratio, portfolio returns are measured against the entire systematic risk. The risk is calculated by the portfolio’s beta coefficient and the higher the value/ratio, the greater the return per unit of risk.
Apart from the technical methods highlighted, there are other more simple methods that can be used to measure performance. An example would be portfolio benchmarking. A benchmark can be defined as an index or blend of indices that can be used to compare investment decisions.
It also allows the creation of like funds which allows comparisons to be made between two portfolios/fund managers.
Investors should, however, note that it is important to carry out an attribution analysis after performance measurement. This is a process of trying to qualify the over/under performance of the portfolio resulting in the investor taking appropriate action. It involves identifying those assets that are contributing to the performance of the portfolio as well as identifying where the excess returns are coming from such as asset allocation effect.
The investor should note that performance measurement should be executed within the context of objectives of the portfolio.
In our article next week, focus will be given to the concepts of an investment policy statement.
*Reuben Alberto is the general manager (investments) for Imperial Asset Management Company and can be contacted on firstname.lastname@example.org or 091 295 089.