Performance Measurement — the ground floor

Return is only half the story

The workbook opens with a warning. The main problem in judging performance is the human tendency to focus on return, with little regard to the risk taken to get it. Proper measurement must recognise both return and risk.

Measuring return

Rate of return has many definitions, but one right definition for each purpose. First be clear why you are measuring, then pick the measure.

Holding period return (HPR)

The simplest measure. Also called total return or point-to-point return.

HPR = (E − B) ÷ B — without income

HPR = (I + (E − B)) ÷ B — with income

Here I = income, E = ending value, B = beginning value.

Workbook example: a portfolio worth ₹1,00,000 on 1 April 2018 is worth ₹1,20,000 on 31 March 2019. HPR = 20%. If the investor also got ₹5,000 of dividend and interest, HPR = 25%.

Its limitation: it assumes all income is paid at the end of the year. Even so, it is widely used and is the starting point of performance measurement.

XIRR — Extended Internal Rate of Return

XIRR gives the annualised return when cash flows are irregular and at different times. It refines the ordinary IRR by assigning specific dates to each cash flow.

XIRR is the annual rate at which the cumulative contributions grow over the period. In the workbook example, contributions of ₹5,000, ₹10,000, ₹15,000, ₹20,000 and ₹25,000 (₹75,000 in all) at the start of 2015–2019 grow to ₹1,05,920 by end-2019. XIRR = 15.15%.

TWRR — Time-Weighted Rate of Return

TWRR measures the compounded return over several periods while neutralising external cash flows — the investor's deposits and withdrawals.

How: split the period into sub-periods at each cash flow, work out each sub-period's return, then link them geometrically:

TWRR = [(1 + R1) × (1 + R2) × … × (1 + Rn)] − 1

Why it matters: a manager does not control when you add or pull money. TWRR judges the manager purely on investment decisions.

Gross vs net return

Gross return is before fees, expenses or commissions. Net return is after them — the return the investor actually makes. Focusing on gross return can mislead, though it helps judge investments at a broad level.

In the workbook's ₹1 crore example, gross return is 20% and net return is 13.88%.

Pre-tax vs post-tax return

Investors sit in different tax brackets, so performance is communicated pre-tax. Investors or advisers work out post-tax themselves:

Post-tax return = Pre-tax return × (1 − tax rate)

Pre-tax allows comparison across investments. But what really matters to the investor — and what drives decisions — is post-tax return.

Portfolio return

A portfolio's return is the weighted average of its securities' returns.

Measuring risk

Risk is a key dimension of performance and a decisive factor in selecting a portfolio manager.

Total risk is variability in expected return, measured by variance and standard deviation. Downside risk looks only at losses or worse-than-expected outcomes, measured by semi-variance / semi-standard deviation and their target versions.

Standard deviation is the square root of variance. It shows how much returns swing around their average. Higher standard deviation = higher risk. It is expressed in percentage terms, is the most widely used risk measure, and works the same for bonds, growth stocks or anything else.

Portfolio risk depends on the weights, the individual standard deviations and — more importantly — the correlation between securities.

Systematic vs unsystematic risk

Beta

Beta relates a stock's or portfolio's return to the market index — its sensitivity to market swings.

• Beta > 1: more volatile than the index.
• Beta < 1: less volatile than the index.
• Beta of cash = 0.
• Beta can be negative — the stock moves opposite to the market.

Portfolio beta is the weighted average of individual betas (the relationship is linear). Stocks with beta 1.2 and 1.1 held 60:40 give a portfolio beta of 1.16.

Risk-adjusted return

A manager may have earned more simply by taking more risk. So we look at return per unit of risk.

Sharpe ratio = (Rp − Rf) ÷ σp. Excess return over the risk-free rate, divided by standard deviation (total risk). It measures reward to variability. All three inputs must be for the same period, usually annualised. Higher is better. It is the simplest to compute and so the most widely used.

Treynor ratio = (Rp − Rf) ÷ βp. Same numerator, but divided by beta (systematic risk).

Sharpe vs Treynor. For a completely well-diversified portfolio they give identical rankings, since total risk equals systematic risk. For a poorly diversified portfolio, the Treynor ranking could be higher, because Treynor ignores unsystematic risk. Any difference in rankings comes from differences in diversification.

Benchmarks and peer groups

Performance evaluation is relative. It shows whether the manager beat a passive indexed strategy and whether the fees are justified. It uses benchmarking and peer group analysis.

A good benchmark:

• Has clearly defined constituents and weights.
• Is investable — passive exposure to it is possible.
• Is consistent with the investment approach (blue-chip portfolio → blue-chip benchmark; value style → value benchmark).
• Has the same risk-return profile.
• Has measurable performance.

When market indices do not fit — e.g. factor-based investing — a customised benchmark can be built from the manager's own investment universe. Advantage: it meets the tests of a valid benchmark. Disadvantage: construction and maintenance costs are much higher than the fee for market-based indices.

Attribution analysis

Attribution analysis breaks down excess return over the benchmark into three parts:

Total excess return = Asset allocation effect + Security selection effect + Interaction effect

• Asset allocation effect — impact of weighting differently from the benchmark.
• Security selection effect — impact of picking particular securities within each class.
• Interaction effect — the combined impact of both.

It helps evaluate manager skill, diagnose where returns came from, and inform future strategy.

Valuation of securities

APMI prescribes standardised valuation norms. Debt and money market securities must be valued as per those norms, using prices only from one or more APMI-empanelled valuation agencies. But the ultimate responsibility for fair valuation lies with the portfolio manager.

Choosing a portfolio manager

Selection needs due diligence — quantitative and qualitative analysis of the manager's reputation, key personnel and operations. Understand the process, strategies and styles to judge whether performance is likely to persist.

The first step in selecting a manager is to draft the IPS and determine the asset allocation. Then evaluate managers on philosophy, investment approach, process, strategies, styles, past performance against a benchmark or managers' universe, major contract provisions, and fees and costs.