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

EVALUATING RESULTS AND UPDATING THE PROCESS

Once an investment process is up and running, it needs to be constantly reassessed and, if necessary, refined. The first step is to compare actual results to expectations; if realizations differ enough from expectations, process refinements may be necessary. Thus, managers need systems to monitor realized performance, risk, and trading costs and compare them to prior expectations.

A good performance monitoring system should be able to determine not only the degree of over- or underperformance, but also the sources of these excess returns. For example, a good performance attribution system might break excess returns down into those due to market timing (having a different beta than the benchmark), industry tilts, style differences, and stock selection. Such systems are available from a variety of third-party vendors. An even better system would allow the manager to further disaggregate returns to see the effects of each of the proprietary signals used to forecast returns, as well as the effects of constraints and other portfolio requirements. Any system will be more accurate if it can account for daily trading and changes in portfolio exposures. Currently, such systems are not available from outside vendors and need to be developed in-house.

Investors should also compare realized risks to expectations. If realized risk is within a reasonable band around the target, then the manager can assume the risk management techniques are working ...