Performance measurement and evaluation
What is tested
Computing a return correctly, adjusting it for risk, and judging a manager against the right benchmark.
Core rules
- Time-weighted return removes the effect of client cash flows and measures the manager's skill. Money-weighted return (IRR) reflects the client's actual experience and is pulled around by the size and timing of contributions. Use time-weighted return to appraise the manager.
- Sharpe ratio = (portfolio return - risk-free rate) / standard deviation. It uses total risk, so it suits a portfolio that is the client's whole investment.
- Treynor ratio = (portfolio return - risk-free rate) / beta. It uses systematic risk only, so it suits a sleeve inside an already-diversified portfolio.
- Jensen's alpha = portfolio return - [risk-free rate + beta x (market return - risk-free rate)]. Positive alpha means the manager beat the return the portfolio's beta required; the beta taken was already paid for.
- Information ratio = active return / tracking error. It judges a manager against a benchmark and penalises inconsistency.
- Returns shown to a client should be net of fees and charges, and the benchmark must match the mandate in asset class, risk, liquidity and currency.
Worked example
A fund returned 12% with a standard deviation of 15% and beta of 1.2. The risk-free rate is 3% and the market returned 9%. Sharpe = (12 - 3) / 15 = 0.60. CAPM required return = 3 + 1.2 x (9 - 3) = 10.2%. Alpha = 12 - 10.2 = +1.8 percentage points. The manager added value after allowing for the beta taken.
Traps that cost marks
- Using beta in the Sharpe ratio or standard deviation in the Treynor ratio.
- Comparing Sharpe ratios of portfolios with different mandates or constraints as if the higher number were automatically the better manager.
- Quoting gross returns to a client and calling that performance.
- Ignoring survivorship bias when a track record is presented - failed funds quietly disappear.
- Comparing a fund to an index it was never allowed to hold.