Portfolio performance measurement
Analysing and evaluating investment portfolios
Investing in financial markets is an essential component of wealth creation and financial planning. However, it is not enough to simply invest; investors need to continuously monitor and evaluate the performance of their investment portfolios over time. Portfolio performance measurement provides valuable insights into the effectiveness of a particular investment strategy, enabling investors to make well-informed decisions and optimise their returns.
Risk-adjusted returns
When evaluating portfolio performance, it is crucial to consider the risk taken to achieve those returns. Risk-adjusted returns provide a more accurate measure of a portfolio's performance than returns in isolation by factoring in the level of risk taken on to generate those returns. By incorporating risk into the performance evaluation, investors gain a clearer picture of the efficiency and effectiveness of their investment decisions.
The Sharpe ratio
The Sharpe ratio measures the excess return earned per unit of risk taken. It considers both the portfolio's return and its risk or volatility. Risk/volatility is measured using the standard deviation.
The Sharpe ratio serves as a valuable tool for comparing the risk-adjusted performance of different investment portfolios. By evaluating the excess returns relative to the portfolio's standard deviation, investors can gauge the efficiency of their portfolio allocation and risk management strategies. A higher Sharpe ratio suggests that the portfolio is generating superior risk-adjusted returns. Consequently, investors can use the Sharpe ratio as a benchmark for selecting and comparing investment portfolios.
The inclusion of the risk-free rate in the formula allows investors to assess whether the excess return generated by the portfolio is adequately compensating them for the level of risk taken.
The Treynor ratio
Like the Sharpe ratio, the Treynor ratio is another risk-adjusted performance measure. However, instead of using total risk or standard deviation, the Treynor ratio incorporates systematic risk, as measured by beta. Beta measures the sensitivity of the portfolio's returns to the overall market movements. The formula for calculating the Treynor ratio is as follows:
The Treynor ratio helps evaluate whether a portfolio's returns are adequately compensating the investor for the systematic risk they are taking on. By assessing the relationship between the excess returns and the portfolio's systematic risk, investors can determine whether their investment strategy is effectively exploiting market opportunities or if adjustments are necessary.
Portfolio attribution
Portfolio attribution analysis examines the sources of a portfolio's returns and helps identify the factors driving its performance. By understanding the contributions from various asset classes, investment styles, or individual securities, investors can gain valuable insights into the effectiveness of their investment decisions and make appropriate adjustments.
There are several approaches to portfolio attribution, including the top-down and bottom-up approaches. The top-down approach focuses on macroeconomic factors and asset allocation decisions, analysing how these decisions have influenced the portfolio's performance. On the other hand, the bottom-up approach focuses on individual securities and their impact on portfolio returns. By studying the performance of individual securities, investors can assess the success of their equity selection or equity picking strategies.
Both approaches to portfolio attribution provide valuable information for portfolio evaluation and optimisation. In identifying the drivers of portfolio performance, investors can make informed decisions to enhance returns and manage risk effectively.
Performance benchmarks
To assess the performance of an investment portfolio accurately, it is crucial to compare it against relevant benchmarks. Benchmarks represent market indices or other investment vehicles that serve as a reference point for evaluating portfolio returns. By comparing portfolio returns to benchmarks, investors can gauge how well their investments have performed relative to the broader market or a specific investment strategy.
Selecting relevant benchmarks for evaluating investment portfolios in the South African context
When evaluating the performance of investment portfolios in the South African context, it is important to select benchmarks that are relevant to the local market and economic conditions. Common benchmarks used in South Africa include equity market indices such as the FTSE/JSE All Share Index, bond market indices like the JSE All Bond Index, or sector-specific indices like the FTSE/JSE Financials Index.
Comparing portfolio returns to benchmarks helps investors understand the value added by their investment decisions and the impact of their investment strategy. It also provides a basis for evaluating the effectiveness of active management. If a portfolio consistently underperforms its benchmark, it may indicate the need for adjustments or a reconsideration of the investment approach.
Selecting appropriate benchmarks depends on various factors, including investment objectives, asset classes, and strategies employed in the portfolio. A blended approach may also be required to account for offshore exposure and investments across asset classes.
Monitoring and reporting
Regular monitoring and reporting of portfolio performance are vital for investors. By establishing a consistent reporting process and setting a frequency for performance reviews, investors can stay updated on the progress of their investments and make timely adjustments if necessary. Monitoring includes reviewing the performance metrics discussed above, tracking investment returns, and assessing the progress towards achieving investment goals.
Investors should consider the time horizon for evaluating portfolio performance. Short-term fluctuations may not accurately reflect the success of a long-term investment strategy. Therefore, it is essential to assess performance over appropriate time periods while considering market cycles and economic conditions. Long-term investors may choose to evaluate performance over several years to capture the impact of market trends and economic cycles accurately.
