The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

MEASURING AND EVALUATING PERFORMANCE

Finally, there is the task of measuring and evaluating investment performance. Performance measurement involves the calculation of the return realized by a portfolio manager over some time interval, which we refer to as the evaluation period. There are several important issues that must be addressed in developing a methodology for calculating a portfolio’s return and we discuss them below.

Performance evaluation is concerned with three issues: (1) determining whether the portfolio manager added value by outperforming the established benchmark; (2) identifying how the portfolio manager achieved the calculated return; and (3) assessing whether the portfolio manager achieved superior performance (i.e., added value) by skill or by luck. There are two approaches that have been employed in evaluating the performance of portfolio managers: single-index performance measures and performance attribution models.

Despite their popularity, single-index performance measures do not specify how or why a portfolio manager may have outperformed or underperformed a benchmark. Two popular measures are the Sharpe ratio¹ and information ratio. These two ratios are return/risk ratios. At this junction, an explanation of the information ratio is not easy to understand but it will be described in Chapter 9. The Sharpe ratio is equal to

The numerator of the Sharpe ...