An investor needs to evaluate his own performance with that of the benchmark portfolio performance to assess how his portfolio is faring
A majority of investors measure the success of their portfolios on the basis of returns they have generated whereas others consider the quantum of risk taken to achieve these returns. Both approaches, however, aren’t appropriate.
The first major goal of portfolio management is to derive rates of return that equal or exceed the returns on a naively selected portfolio with equal risk.
The second goal is to attain complete diversification relative to a suitable benchmark.
We essentially compare the return of our owned and managed portfolio over a particular period with that of the return of a benchmark portfolio. The benchmark portfolio should represent a feasible investment alternative to your portfolio that is being compared and evaluated. In reality, it is difficult to identify such a benchmark portfolio. So, often, such a portfolio is known as an otherwise equivalent (OE) benchmark portfolio.
An OE benchmark portfolio requires that it should have all characteristics of the portfolio that you own and manage.
Several techniques have been derived to evaluate equity portfolio in terms of both risk and return as a composite measure. The Treynor measure considers the excess returns earned per unit of systematic risk whereas the Sharpe measure indicates the excess return per unit of total risk. The Jensen and Information Ratio measures likewise evaluate performance in terms of systematic risk involved and show how to determine whether the difference in risk-adjusted performance is statistically significant.
A model by Fama divided the composite return into measures related to total risk, systematic risk, diversification and selectivity, in addition to measuring overall performance. Finally, attribution analysis seeks to establish whether market timing or security selection skills (or both) are the source of an investor’s performance.
A vast majority of the above mentioned tools of portfolio performance evaluation were based on the notion of the existence or creation of OE benchmark portfolio. Let’s discuss below how to create an OE portfolio.
The names and weights of securities comprising the benchmark portfolio need to be clearly delineated. It is investable as the option is available to forgo active management and simply hold the benchmark. It is possible to calculate the return on the benchmark on a reasonably frequent basis. It is reflective of current investment opinions.
The investor has current investment knowledge of the securities that make up the benchmark. It is better to create the benchmark well in advance, i.e., prior to the start of an evaluation period. If a benchmark does not possess all of these properties, it is considered flawed.
Total return, including realised and unrealised gains plus income, must be used when calculating the investment performance. Time-weighted rates of return must be used. Portfolios must be valued at least monthly, and periodic returns must be measured by geometric mean return instead of arithmetic mean returns. For past returns performance evaluation, the geometric return is a better measure than arithmetic average. For estimating the expected future return, using historic average, arithmetic average is a better as it is an unbiased estimator.
Composite results may not link simulated or model portfolios with actual performance. Performance must be calculated after the deduction of trading expenses. Taxes on income and realised capital gains must be recognised in the same period they were incurred and subtracted from results regardless of whether taxes are paid from assets outside the account. Annual returns for all years must be computed. Performance of less than one year must not be annualised. Return calculations should also consider use of leverage, if any, which will amplify the gain or loss.
The writer is associate professor, finance & accounting, IIM-Shillong