Advanced Portfolio Management

Chapter 8Understand Your Performance

• What will you learn here: How to understand your realized performance. What you are good at, and what you can improve upon.
• Why do you need it: No unexamined portfolio is worth investing. In order to become a better portfolio manager, you want to understand how much of your past performance is due to luck vs. skill (factor PnL vs. idiosyncratic PnL), and how selection, sizing and timing contribute to your performance.
• When will you need this: On a monthly or quarterly basis.

8.1 Factor

The Earth rotates around the Sun at a speed of 67,000mph. When I go out for my occasional run, my own speed is in the tens of thousands of miles per hour. Should I take credit for this amazing performance? I wouldn't be completely lying if I bragged about this with friends (which I do); but it would be more transparent if I mentioned that my speed record is in the frame reference of the Sun. In this frame of reference, my speed is indistinguishable from Usain Bolt's. This factoid obscures the vast difference in skill between the two of us. To really understand the difference, we need to change the frame of reference. Another way to interpret the decomposition of returns is a method to change the frame of reference in investing. Total returns – and a portfolio's total PnL – live in the Sun's frame of reference. It is easy to fool ourselves with the belief that we beat birds, airplanes and supermen at their own game. Idiosyncratic returns and PnL live ...