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

PERFORMANCE EVALUATION

Performance evaluation is concerned with three questions: (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. As explained in Chapter 1, single-index performance measures such as the Sharpe ratio does not help us address these three questions. Performance attribution models, which decompose the portfolio return so that a client can determine how the portfolio manager earned the return, are commonly used for this reason.

In broad terms, the return performance of a portfolio can be explained by three actions followed by a portfolio manager. The first is actively managing a portfolio to capitalize on factors that are expected to perform better than other factors. The second is actively managing a portfolio to take advantage of anticipated movements in the market. For example, the manager of a common stock portfolio can increase the portfolio’s beta when the market is expected to increase, and decrease it when the market is expected to decline. The third is actively managing the portfolio by buying securities that are believed to be undervalued, and selling (or shorting) securities that are believed to be overvalued.

The methodology for answering these questions is called performance attribution analysis. There are ...