Performance Analysis: Measurement, Attribution and Risk Adjustment
Measuring returns
Time-weighted return strips out the effect of external cash flows and is the correct measure of manager skill; money-weighted return (IRR) reflects the client's actual experience and is dominated by flow timing. Know holding-period returns, geometric annualization, and the difference between gross and net-of-fee results.
Benchmarks and attribution
A valid benchmark is specified in advance, investable, measurable and matched to the manager's style. Brinson attribution splits active return into allocation, selection and interaction effects. Returns-based style analysis and holdings-based analysis reveal style drift; survivorship and look-ahead biases distort databases.
Risk-adjusted measures
Sharpe = (Rp - Rf) / standard deviation of portfolio returns (total risk); Treynor = (Rp - Rf) / beta (systematic risk); Jensen alpha = Rp minus [Rf + beta(market return - Rf)]; Sortino uses downside deviation; information ratio = active return / tracking error; M-squared rescales Sharpe to market volatility. GIPS governs fair, comparable presentation: composites, asset-weighted returns and required disclosures. Compliance is firm-wide and does not certify skill.
Traps
Using Sharpe for an undiversified sleeve; comparing returns over different periods or against a mismatched benchmark; quoting arithmetic averages; assuming GIPS verification is mandatory (it is not) or that GIPS covers every portfolio.
Worked example
Rp = 10%, Rf = 3%, standard deviation = 15%, beta = 1.2. Sharpe = 7 / 15 = 0.47; Treynor = 7 / 1.2 = 5.83%. If the market returned 8%, alpha = 10 minus [3 + 1.2(5)] = 1.0%.