Evaluating portfolio performance is an important aspect of measuring whether an investor’s investments are in line with broader financial targets. With a number of metrics, investors can assess their portfolio returns, risk, and relative efficiency to make adjustments as needed. This blog will examine the theoretical aspects of a sampling of performance metrics, focusing on return metrics, risk metrics, risk-adjusted return metrics, and comparisons to benchmarks, for the purposes of evaluating overall portfolio performance.
Measuring Returns
Return metrics measure the growth of a portfolio over time. The simplest is the absolute return, which reflects the percentage change in portfolio value (ending value – beginning value)/beginning value over a specified time period. For example, if a portfolio with a value of $10,000 grew to $11,000 over a period of one year, that portfolio would have an absolute return of 10%. The annualized return measure builds on this concept by allowing for compounding over multiple years, providing a standardized return measure. CAGR or the compound annual growth rate, accounts for volatility by smoothing returns, to provide a better picture of performance over extended periods. These measures provide investors with a means to measure dollar growth, but will not provide insights into relative risk or market circumstances.
Evaluating Risk
Risk indicators assess the exposure and likely losses of your portfolio. Standard deviation is the first of the many indicators we can work with, its meaning is that it shows just how much return is deviating from the average return. Assuming you have portfolio of stocks, for example, if the market volatility affected by individual stocks increased, then that portfolio had a broadening standard deviation, and more price swings would be anticipated. Maximum drawdown is another rate of risk but in a way that quantifies how much it allowed you to lose at the most from its peak depending on risk taken. A maximum drawdown of 20% would mean the portfolio dropped by 20% of value only from its peak to trough. Beta is a measure of risk that has gained considerable popularity regarding a portfolio’s tendency to have monthly or daily return sensitive to overall market movements. A beta coefficient of 1.2 would expose that the portfolio was experiencing 20% more volatility than the market. Risk measures assist investors in determining how much exposure they are taking on uncertainty.
Assessing Risk-Adjusted Returns
Risk-adjusted metrics determines how a return portfolio is relative to the risk that was taken. The Sharpe ratio, for example, is the (portfolio return – risk free return)/standard deviation which tells you how much additional return you receive for a unit of risk. Using this logic, a
Sharpe ratio of 1.5 is obviously better than one of 0.8. The Sortino ratio is similar to the Sharpe but it only takes downside into account ignoring any positive volatility. The Treynor ratio on the other hand would have you use beta rather than standard deviation, and measure whether excess returns were being generated relative to market risk. All of these risk metrics allow investors able to look at portfolios with different risk ratings as well making sure they are using risk efficiently enough.
Benchmarking Performance
Using a more familiar tone, comparing the portfolio against a benchmark will put performance in context. Alpha calculates the portfolio’s excess return on the benchmark adjusted for risk. An alpha of 2% is positive and indicates the fund beat the benchmark while a negative alpha of 2% indicates the fund lost to the benchmark. Tracking error measures, the excess return relative to the benchmark in terms of standard deviation, or how consistently the portfolio is replicating the performance of the benchmark. A low tracking error indicates that the portfolio is tracking the benchmark closely, which is decidedly the case in index funds. Benchmarking allows investors to assess whether the costs of active management are justified, or if broad passive management is a better option.
Considering Costs and Taxes
Expenses and taxes can have a surprisingly large impact on total performance. The expense ratio, which represents the management and trading fees, will reduce net returns. For example, if you have a $100,000 portfolio and the fund has a 1% expense ratio, the fund charges you $1,000 per year. A 1% fee compounds over time, eating away at the accumulation value of long-term investments. Taxes reduce value too; capital gains taxes may be incurred on a champions portfolio with substantial turnover and trading activity. Normally, stated returns are before taxes; after tax return reflects the amount that adjusts for tax liability. Investors should seek to minimize costs, so low-cost vehicles like ETFs are leading investment vehicles and tax-advantaged accounts lead to the most efficient outcomes.
Monitoring and Frequency
Frequent appraisal of your goals is important so that you know your metrics are tied to something. Even quarterly or annual reviews can give investors perspective, especially from where they started, regarding their performance against their goals, investments Vs market conditions, and changes in the economic environment. We can all have a fundamental mind shift in our investment regardless of the reason, if we don’t evaluate and understand the costs of returns, risk, risk-adjusted metrics, and benchmark metrics (while also understanding the taxes we ultimately have to pay), we will never know where we stand in our portfolio performance or our ability to adhere to our long-term investment plan. There are automated or via financial independent route, but understand where we are going gives us the knowledge to leverage.
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