Performance Measurement
What you must know
Time-weighted versus money-weighted return, annualisation, geometric versus arithmetic linking, risk-adjusted measures (Sharpe, Treynor, M-squared, Jensen's alpha, information ratio, Sortino, capture ratios), Brinson attribution of allocation, selection and interaction, macro versus micro attribution, fixed-income attribution by duration, curve and spread, GIPS requirements, and implementation shortfall with trading-cost measurement.
Traps
- Time-weighted return removes the effect of external cash flows; the money-weighted return (IRR) is shaped by their size and timing, so a client who adds money just before a rally looks better on MWR.
- TWR requires valuation at each large external cash flow; daily valuation is a GIPS recommendation rather than a universal rule.
- In Brinson attribution the allocation effect uses the benchmark total return as its base, and the interaction term is the easiest component to omit.
- GIPS is voluntary and firm-wide; 'must' items are mandatory for a compliance claim while 'should' items are recommendations. Never link simulated and actual results.
- Implementation shortfall equals paper return minus actual return, so it captures delay, execution and opportunity costs, not just commissions.
Worked example: Brinson attribution
Benchmark: sector A (60% weight, 10% return) and sector B (40%, 2%), giving 6.8%. Portfolio: A (50%, 12%) and B (50%, 4%), giving 8.0%. Allocation = (-0.10)(10 - 6.8) + (0.10)(2 - 6.8) = -0.32 - 0.48 = -0.80%. Selection = 0.60(12 - 10) + 0.40(4 - 2) = +2.00%. Interaction = (-0.10)(2) + (0.10)(2) = 0.00%. Total = +1.20%, matching 8.0% - 6.8%.