Measuring a Portfolio’s Performance
April 1, 2025
What is a Portfolio Performance?
One of the fundamental parts of the investment analysis and management process is measuring the portfolio’s performance. Investors would typically use performance analysis to assess the quality of an investment approach, while on the other hand portfolio managers will use it to communicate with investors their results. In addition, in some areas of the market such as hedge funds, managers’ compensation is also based on their performance against a pre-determined benchmark (also known as a “performance fee”). While the simplest approach is to evaluate the absolute and relative returns of the portfolio (against a relevant market index or a custom index) over a specific period, a proper, more detailed examination would include measuring the portfolio’s risk, its risk-adjusted returns and returns attribution (i.e. the drivers for these returns). Furthermore, other factors such as transaction costs and/or ongoing management charges can also impact performance.
Key Learning Points
Measuring the performance of a portfolio is fundamental to many aspects of the investment process such as fund selection and ongoing monitoring
There are various ways to evaluate the performance of a portfolio with the simplest being absolute returns and returns relative to a benchmark index returns
Investors would typically go further and explore the risk and risk-adjusted returns of the portfolio, as well as the drivers of the returns
How Do You Evaluate the Performance of a Portfolio?
To evaluate the performance of a portfolio, investors would generally apply the following steps:
Step 1- Benchmarking
The selection of an appropriate benchmark that will be used to measure the performance of the portfolio is critical. The benchmark must be investable, accessible, independent, and relevant. The number of options here is vast and can include a market index, a peer group of similar portfolios, a target-based return (such as the risk-free rate), or a custom designed index. For example, an equity portfolio that invests in global companies from developed markets would typically aim to outperform the MSCI World Index (MSCI), while on the other hand a US investment grade bond portfolio would target to outperform the S&P US Aggregate Bond Index (S&P Global).
Industry Example – The chart below shows the performance of the Fidelity Asia Fund, which aims to outperform the MSCI AC Asia ex Japan Index. It shows calendar-year and discrete annual returns, as well as cumulative performance over a five-year period.
Step 2 – Calculating Relative Returns
Relative (also known as “excess”) returns show whether the portfolio has outperformed its target benchmark over a specific time frame. There are two ways they can be calculated – arithmetic and geometric.
Both versions have their application. The arithmetic excess returns are typically easier to understand and provide large and absolute values in rising markets (it doesn’t account for compounding), suitable for shorter-term performance evaluation. The geometric excess returns on the other hand provide a compounded growth perspective, making it more suitable for long-term performance analysis.
Step 3 – Risk Assessment
While risk and return are positively correlated, a portfolio that is under or outperforming a benchmark would not necessarily do so with the same proportion of risk. In fact, the level of risk exposure could be greater than that of the benchmark, without delivering on the return objectives. The most popular measure of risk is the standard deviation of returns, which explores the volatility of the returns. Other risk measures include the tracking error – how closely a portfolio follows the benchmark – and the active share measured as the difference between a portfolio’s holdings and those of its benchmark.
As part of the risk assessment, investors would also look at various risk-adjusted returns measures that provide a better picture of whether the level of risk taken translated into a more attractive performance. We explore some of these ratios in the section below.
Step 4- Attribution Analysis
Performance attribution is typically used to establish the source of the portfolio’s excess returns (or underperformance). In active fund management, the decisions made by the portfolio managers are usually assessed through attribution analysis. The two most popular calculation approaches are returns-based attribution and holdings-based attribution (calculated periodically by using portfolio holdings data).
What are the 4Ps of Investment Selection?
The concept of the ‘4 P’s’ has been developed over the years as a best practice in manager due diligence and selection. Simply put, this is the optimal way to select funds, which are then included in a broader strategy. Institutions such as pension funds and sovereign wealth funds, where the size and complexity of assets is at the highest level, typically use this approach. The ‘4 P’s’ stand for:
1. People
This refers to the team that runs the strategy including the portfolio managers as well as analysts, sustainable investing professionals and any broader support. Some of the key areas for assessment are the managers’ level of experience and track record, the size of the team and its level of expertise as well as its stability. Key man risk (i.e. is the strategy highly reliant on one particular individual) is usually closely watched for.
2. Philosophy/Process
The philosophy and process cover the investment approach that managers use to achieve their objectives. What fund selectors would typically examine is how well the process is structured in terms of idea generation, stock selection, buy and sell disciplines, portfolio construction and risk management. It is also important for the process to be consistently executed, ideally over a full market cycle, to judge how successful it is.
3. Portfolio/Performance
The key in analyzing the performance of a strategy is whether it has performed in-line with expectations. To properly assess this, investment professionals consider its style (for example value or growth), its market cap and geographical exposure. Typically, relative returns against a benchmark and peer group average are the first step of evaluating performance, followed by risk-adjusted metrics and attribution analysis.
4. Parent
At this step there are multiple aspects of the broader business to be examined. These include things like the firm’s level of assets under management, its profitability, the support it has committed to the strategy, and the wider risk controls such as risk teams, middle office, compliance and trading. Incentives, talent retention, and business continuation also play an important role in the assessment of the business.
The approaches to how investors use the ‘4 P’s’ can vary and some might add other criteria such as price (i.e. is a fund fairly priced compared to its peers) or environmental, social and governance (ESG) factors.
Conclusion
To sum up, measuring a portfolio’s performance requires careful consideration of aspects such as the specifics of the strategy and its portfolio features, its investment universe and peer group. Over time, there have been various methodologies and best practices developed the serve as guidance, such as the ‘4 P’s’, and investors typically use them as a base and adapt them to their own needs and standards.