Once we have measured the returns and risks taken, we can evaluate the
composite risk and return efficiency of the portfolio. We are interested
in whether the fund is being managed efficiently, and in the case of
actively managed portfolios, discovering evidence of the manager’s skill.
The statistics representing efficiency and skill are used to help answer
questions that include:
■ Did the fund return as much as other funds, or the benchmark, that
exhibited a similar degree of risk?
■ How did the investment perform on a risk-adjusted basis?
■ Were manager deviations from benchmarks rewarded on a riskadjusted
basis?
■ What was the manager’s risk-adjusted value added over the period?
■ Is there any evidence of manager skill in the historical return series?
In Part III we look at measures of the efficiency of the portfolio in a
mean-variance framework, including the Sharpe ratio, M2 return, and
the Information Ratio. We look at the measurement of value added via
the calculation of the portfolio’s Alpha and Beta in the context of the
Capital Asset Pricing Model (CAPM). We then cover some methods to
analyze the time series of returns to determine whether there is statistical
evidence of manager value added over the period.


PERFORMANCE ATTRIBUTION


By comparing fund and benchmark returns, we can determine whether
the manager has added value over the period. We are also interested in
how the value added was achieved. For example, if we overweighted the
technology segment of a diversified equity portfolio during a period
when technology stocks were in favor, this decision added incremental
value. Using performance contribution and attribution analysis techniques,
we can quantify the value added by this and similar decisions.
Performance attribution is used to help answer questions such as:
■ How did the different securities and segments within the fund perform
over the period?
■ What was the impact of using instruments that modify segment exposures
such as currency forward contracts and futures?
■ How were the contributions to total fund return attributable to these
securities and portfolio segments?
■ How much did the fund’s asset allocation relative to the benchmark,
as well as other decisions, contribute to the value added?
■ Were the management factors that contributed to value added over
the benchmark in accordance with the manager’s stated investment
style?
To understand how fund performance was achieved, we first need to
calculate the returns for the securities that comprise the portfolio. In
this section we look at the calculation of security and portfolio segment
returns. We cover the calculation of performance on an effective exposure
basis for funds employing derivatives.