CHAPTER 1
The Scope of Portfolio Performance

INTRODUCTION

The notion of “portfolio performance,” which is at the core of the present book, is related to the quality of the management process of a financial investment. Even though it is part of the control function, we view its importance as essential for the success of the whole venture. We claim in this chapter that the feedback loop generated by the performance evaluation process has implications for the preparation and execution steps in the process. This motivates the subtitle of our book: “Appraise–Analyze–Act.”

In the first section, we decorticate portfolio management by analogy with a production process. The important takeaway of this matching exercise is the identification of performance as a measure of how efficiently the inputs are transformed into an output being the terminal portfolio value. Accordingly, its inputs are cash outlay, costs, time, and, most critically, risk. According to this point of view, a risk-adjusted performance measure can be defined as an efficiency indicator or an output gap. These two structures are shared by many performance measures developed throughout the consecutive chapters.

Pursuing on the same logic, we are in a position to explain the structure of the rest of the book. It is split into four parts. The first two are dedicated to the identification and interpretation of the many portfolio performance measures that exist nowadays. This is the “appraisal” dimension. The second one, namely “analysis,” mostly tries to capture and understand the drivers of performance. This is the subject matter of the third part of the book. Finally, we dare a forward-looking dimension through the “act” motto. In the fourth part of the book, we use performance measures as a real adjuvant to the investor's or the manager's decision-making process. In doing so, we close the loop of the portfolio management cycle.

For the purpose of the book's technical developments, we need to clarify a certain number of notions. The third section is therefore dedicated to laying out some basic definitions regarding returns, risk, and benchmarks. Specifically, we briefly describe the different rules for compounding and averaging returns and for incorporating cash flows into the calculation of returns. We also review the economic and probabilistic foundations of risk, elaborate on some specific risks associated with combining assets into a portfolio, and present some axioms for relevant risk measures. Finally, we stress the relevance of portfolio benchmarking and discuss some practical issues related to a comparative assessment of portfolio performance.

1.1 FROM PORTFOLIO MANAGEMENT TO PORTFOLIO PERFORMANCE

Different reference books or summary articles devoted to portfolio performance address the scope of their subject matter in various ways. Since our book will be released perhaps decades later than some of them, we do not have the ambition to reinvent the wheel. Nevertheless, our critical reading of our peers' introductory chapters reveals very diverse standpoints and structuring of thoughts. There are some disagreements on the terms, the objectives, or even the definitions surrounding the notion of portfolio performance. Since our main goal is to propose a guided tour of the matter, it is necessary that we restart from a blank page and, notwithstanding the existence of many insightful contributions in the same field, come up with our own vocabulary and structure.

We first attempt to understand where the question of portfolio performance evaluation arises in the investment decision-making process. Then, we focus on what the notion of performance itself covers in that particular context. This allows us, in a third stage, to provide more explanations about the subtitle that we have chosen for this book: “Appraise–Analyze–Act.”

1.1.1 The role of portfolio performance in the investment management process

Like any well-constructed management process, the investment in a financial portfolio generally obeys a three-stage procedure, prepare, execute, and control, that repeats itself in a feedback loop. This process leads, in particular, to what Bailey, Richards, and Tierney (2007) call “performance evaluation.” From the most general perspective, we can represent it with the chart shown in Figure 1-1, inspired from the process depicted by Maginn, Tuttle, McLeavey, and Pinto (2007).

The sequence presented in Figure 1-1 clearly shows that the preparation phase (left part of the chart) features two complementary exercises. The first one, on the upper side, consists of understanding the investor and translating this knowledge into usable parameters. The outcome of the process is to determine a portfolio policy (very long term) and associated strategy (medium long term).1 This is also where the benchmark portfolio, if applicable, will be determined.2 The second module relates to the financial market. It involves the economic intelligence that leads to the calibration of the market parameters that are necessary to parametrize the risk and return properties of financial assets.

FIGURE 1-1 Steps in the portfolio management process.

Source: Adapted from Maginn et al. (2007), Exhibit 1-1.

The meeting point of the market and investor dimensions is the inception of the actual execution process. It first involves creating a “real” portfolio, made up of stocks, bonds, and other instruments, with the aim of being the best possible allocation corresponding to the inputs. This is the construction phase. This is also where the optimization process is implemented. Then, the portfolio manager starts showing their skills through their decisions. The portfolio composition is regularly updated through the buy and sell trades. This can be performed from the upper level of global asset classes down to the most granular securities selection decisions, with a continuum of decision levels in between. If the portfolio is managed passively, the rebalancing decisions are driven by a mechanical rule. If, however, the manager has an active strategy, then this is the stage where they can show the quality of their decisions.

The last stage occurs a posteriori from the execution decisions. It is about monitoring and control. The monitoring process can be viewed as a continuous attempt to challenge and improve the way the portfolio is managed. To do so, the manager will seek information from the market and the investor's sides, which generates a feedback loop both at the execution level (by generating trades) and even going back to the preparation level by possibly changing the assumptions underlying the whole portfolio management cycle. The control level occurs at the end of the process. It consists of providing an answer to two types of questions: “How has the portfolio management process performed?” and “To what extent has the outcome achieved its stated objectives?”. If the answers are satisfactory, then the feedback is positive. If not, it may certainly impact the way the mandate is executed but probably some of the assumptions used in the preparatory phase as well. Our scope is related to the first of these two questions.3

1.1.2 Performance as an efficiency indicator

1.1.2.1 Efficiency versus effectiveness

The two dimensions of control mentioned in Figure 1-1 are termed “performance” and “achievement.” The former concept aims at evaluating to what extent the whole process has delivered an output that makes the best possible use of all the inputs that were put at the disposal of the management unit. It is a measure of the efficiency of the portfolio management process and indicates how productive it has been. By contrast, the concept of achievement reflects how successful the portfolio has been: It is a measure of effectiveness. There is necessarily an objective that is associated with it.

Consider that we are interested in a specific portfolio that has been managed according to the principles of Figure 1-1. Adapting the concepts of efficiency (performance) and effectiveness (achievement) to the particular case of the management of a financial portfolio, we can simultaneously translate them under the form of a summary equation:

where is the set of inputs in the portfolio management process, is the observed output (that, for simplicity, we consider to be unique at a single point in time), and is the objective set by the target user, who in our case is the investor. The right arrow “” symbolizes the whole transformation process that uses the inputs in order to produce the output, whose quality reflects its efficiency level. The double arrow “” symbolizes the gap between the observed and the desired output. The magnitude of this gap reflects the effectiveness of the process.

It is not the purpose of this section to discuss at length the notion of an efficient production frontier, but we can simply posit that the process aims at consuming the least possible inputs. Thus, the smaller the quantity of each input producing the same level of output , the higher efficiency is. A well-performing portfolio management process will thus seek to be as parsimonious as possible for the same result or, equivalently, to produce the largest...