1
Introduction

We learn more by looking for the answer to a question and not finding it than we do from learning the answer itself.

Lloyd Alexander (1924–2007)

Who questions much, shall learn much, and retain much.

Francis Bacon (1561–1626)

WHY MEASURE PORTFOLIO PERFORMANCE?

Whether we manage our own investment assets or choose to hire others to manage the assets on our behalf we are keen to know “how well” our collection or portfolio of assets is performing.

The process of adding value via benchmarking, asset allocation, manager selection, security analysis, portfolio construction and executing transactions is collectively described as the investment decision process. The measurement of portfolio performance should be part of the investment decision process, not external to it.

Clearly there are many stakeholders in the investment decision process; this book focuses on the investors or owners of capital (asset owners) and the firms managing their assets (asset managers1 or individual portfolio managers). Other stakeholders in the investment decision process include asset consultants tasked with providing advice to asset owners, custodians, independent performance measurers and audit firms (asset servicing firms).

Portfolio performance measurement answers the three basic questions central to the relationship between asset managers and asset owners:

1. What is the return on their assets?
2. Why has the portfolio performed that way?
3. How can we improve performance?

Portfolio performance measurement is the quality control of the investment decision process providing the necessary information to enable asset managers and asset owners to assess exactly how the money has been invested and the results of the process. The US Bank Administration Institute (BAI) laid down the foundations of the performance measurement process as early as 1968.2 The main conclusions of their study hold true today:

1. Performance measurement returns should be based on asset values measured at market value, not at cost.
2. Returns should be “total” returns, that is, they should include both income and changes in market value (realised and unrealised capital appreciation).
3. Returns should be time weighted.
4. Measurement should include risk as well as return.

THE PERFORMANCE MEASUREMENT PROCESS

Performance measurement is essentially a three‐stage process:

1. Measurement

   Calculation of portfolio and benchmark returns

   Distribution of information

2. Analysis

   Return attribution

   Risk attribution (ex‐post and ex‐ante)

3. Evaluation

   Feedback

   Control

Note

Performance is at the very least two dimensional – the combination of both risk and return.

THE PURPOSE OF THIS BOOK

The writing of any book is inevitably a selfish activity, taking precious time not only from family who suffer in silence but also work colleagues and friends, driven by the belief that you have something to contribute in your chosen subject.

The vocabulary and methodologies used by performance analysts worldwide are extremely varied and complex. Despite the development and global success of performance measurement standards there are considerable differences in terminology, methodology and attitude to performance measurement throughout the world.

The main aims of the first edition were to:

1. Provide a reference of the available methodologies and to hopefully provide some consistency in their definition.
2. Promote the role of performance measurers.
3. Provide some insights into the tools available to performance measurers.
4. Share my practical experience.

The motivation to write the first edition was simply to provide the book I most wanted to read as a performance analyst, which did not exist at the time. The motivation to write the second edition came from the readers of the first edition. Their praise, comments, corrections and requests encouraged me to expand and improve the material in the second edition. The gap between the first and second editions was a mere 4 years; 14 years later I write this third edition. The motivation for this third edition is more intense: I wish to share the invaluable experience gained from running performance measurement and risk control teams for an entire career, chairing a performance analytics company for 17 years, setting standards with the CFA Institute for 27 years, and above all teaching performance analytics worldwide for 25 years. That experience shouldn't go to waste.

Since the first edition I'm pleased to say that the CFA Institute have launched the Certificate in Investment Performance (CIPM)3 designation, which further reinforces the role of performance measurement and is a major step in developing performance measurement as a professional activity. I can certainly recommend the CIPM course of study, and I'm pleased to say I have successfully achieved the CIPM designation.

The CIPM curriculum has also to some degree influenced the content of this third edition.

With practical examples, this book should meet the needs of performance analysts, portfolio managers, senior management within asset management firms, custodians, verifiers and the ultimate asset owners. I'm particularly pleased that this third edition provides access to an Excel spreadsheet that includes all of the practical examples used throughout the book. Apologies to readers who believe there are slightly too many worked examples in this text, but I regard worked examples as an essential part of the learning and explanation process.

THE ROLE OF PERFORMANCE ANALYSTS

Performance measurement is a key function in an asset management firm; it deserves better than to be grouped with the back office. Performance analysts provide real added value, with feedback into the investment decision process and analysis of structural issues. Since their role is to understand in full and make transparent and communicate the sources of return and risk within portfolios, they are often the only independent source equipped to understand the performance of all the portfolios and strategies within the asset management firm.

Performance analysts are in effect alternative risk controllers able to protect the firm from rogue managers and the unfortunate impact of failing to meet client expectations.

My aim has been to present all approaches and methodologies as fairly as possible. It is not always possible to hide my preferences, prejudices and ignorance but in this edition, I've attempted to highlight my views as clearly identified notes, cautions and interpretations.

BOOK STRUCTURE

Chapter 2 is naturally a brief description of the asset management industry from the perspective of a performance analyst. The remaining chapters are structured in the same order as the performance measurement process itself, namely:

• Chapter 3: Calculation of portfolio returns
• Chapter 4: Comparison against an appropriate benchmark
• Chapter 5: Proper assessment of the reward received for the risk taken
• Chapter 6: Attribution of the sources of excess return
• Chapter 7: Global Investment Performance Standards
• Chapter 8: Bringing it all together, presentation and communication

In Chapter 3 the “what” of performance measurement is introduced, describing the many forms of return calculation including the relative merits of each method together with calculation examples. Performance gross and net of fees is discussed as well as performance fee structures.

Performance returns in isolation add little value; we must compare these returns against a suitable benchmark. Chapter 4 discusses the merits of good and bad benchmarks and examines the detailed calculation of commercial and customised indexes. Excess return is discussed in detail.

Chapter 5 is an attempt to catalogue and describe all the available ex‐post risk measures used by performance analysts, including suggestions for consistent definitions where such definitions are lacking. The chapter concludes with an attempt to illustrate the relationship of risk measures to each other in terms of a periodic table of risk measures.

Together with Chapter 5, Chapter 6 is the core of this edition, attempting to answer the “why” of performance measurement. Attribution is a broad subject; the early development of return attribution is covered, leading to a fundamental examination of the Brinson model. With the foundations in place, security level attribution, off‐benchmark attribution, attribution including derivative instruments, multi‐currency attribution, fixed income attribution, multi‐period attribution, multi‐level attribution and balanced attribution are explained in detail with multiple worked examples.

Chapter 7 discusses the Global Investment Performance Standards (GIPS®) in detail. Focusing on GIPS for investment firms, the provisions are listed together with commentary providing the rationale and context for the provision (from my perspective), including tips and pitfalls to avoid.

Chapter 8 brings all the analytical tools together to address the “how” of performance measurement in the...