Evaluating Portfolio Performance
The success of a portfolio manager is determined by comparing the total rate of return of the portfolio being evaluated to the average total return of comparable portfolios. In this way the portfolio manager and the client can compare their returns to industry norms and estimate their approximate ranking in relation to other portfolio managers.
For most individual investors, the ranking can be estimated most easily by comparing their performance to the averages shown in one of the Survey of Funds appearing regularly in financial publications. Not only is it convenient, but many different funds are measured in the surveys and the portfolio manager can compare both the total return and the component returns of the portfolio. For example, balanced portfolios can be compared to the balanced portfolios in the survey and the equity component of the balanced portfolio can be compared to the equity funds shown.
The most common method of computing total return is to divide the portfolio's total earnings (income plus capital gains or losses), or the increase in the market value of the portfolio, by the average amount invested in the portfolio. The average amount invested is equal to the opening market value of the portfolio plus one half of the net contributions made during the measurement period. Net contributions are calculated by subtracting funds withdrawn from the portfolio from funds deposited.
For example, assume that in the course of a particular year a portfolio had a market value of $1 06,000 on January 1, that the investor deposited $3,000 on March 5 and withdrew $5,000 on July 10. Assume also that the market value of the portfolio on December 31 was $110,000. On this basis, the return for the portfolio for the year would be 5.71%. If the total return of a portfolio is required for a shorter period, or if a return for only a component of the portfolio is needed, the same method is used.
Although this formula provides a total return percentage, it is subject to certain distortions. For example, if large withdrawals of funds occur towards the end of the measurement period, the average amount invested will be understated and the total return overstated. Conversely, if large contributions are made late in the period, the average amount invested will be overstated and the total return understated. When deposits or withdrawals distort the total return percentages, performance comparisons are inappropriate and should not be used.
In addition to return distortions, dissimilarities in portfolios also make accurate performance comparisons difficult. For example, portfolios may have different risk characteristics, special investor constraints or objectives and the method used to calculate the returns may differ. When such factors affect returns, the conclusions drawn from the performance comparisons should be adjusted to reflect the impact of the variable.
Rates of return can also be calculated on an after-tax and after-inflation basis. To calculate the total return after tax or the "net return", the income taxes payable on the portfolio would also be subtracted from the closing value when computing the increase in value. The after inflation, or "real rate of return", is calculated by subtracting the inflation rate for the period from the net return.
Because of the large number of variables in the management and measurement of portfolios, assessing investment performance is difficult. Regardless, when performance comparisons are made, investors should be concerned primarily with longer term results since they best measure a manager's ability in all phases of the business cycle. Also of importance are consistency of results and the trend of performance as indicated by the results over the last few measurement periods.
For most individual investors, the ranking can be estimated most easily by comparing their performance to the averages shown in one of the Survey of Funds appearing regularly in financial publications. Not only is it convenient, but many different funds are measured in the surveys and the portfolio manager can compare both the total return and the component returns of the portfolio. For example, balanced portfolios can be compared to the balanced portfolios in the survey and the equity component of the balanced portfolio can be compared to the equity funds shown.
The most common method of computing total return is to divide the portfolio's total earnings (income plus capital gains or losses), or the increase in the market value of the portfolio, by the average amount invested in the portfolio. The average amount invested is equal to the opening market value of the portfolio plus one half of the net contributions made during the measurement period. Net contributions are calculated by subtracting funds withdrawn from the portfolio from funds deposited.
For example, assume that in the course of a particular year a portfolio had a market value of $1 06,000 on January 1, that the investor deposited $3,000 on March 5 and withdrew $5,000 on July 10. Assume also that the market value of the portfolio on December 31 was $110,000. On this basis, the return for the portfolio for the year would be 5.71%. If the total return of a portfolio is required for a shorter period, or if a return for only a component of the portfolio is needed, the same method is used.
Although this formula provides a total return percentage, it is subject to certain distortions. For example, if large withdrawals of funds occur towards the end of the measurement period, the average amount invested will be understated and the total return overstated. Conversely, if large contributions are made late in the period, the average amount invested will be overstated and the total return understated. When deposits or withdrawals distort the total return percentages, performance comparisons are inappropriate and should not be used.
In addition to return distortions, dissimilarities in portfolios also make accurate performance comparisons difficult. For example, portfolios may have different risk characteristics, special investor constraints or objectives and the method used to calculate the returns may differ. When such factors affect returns, the conclusions drawn from the performance comparisons should be adjusted to reflect the impact of the variable.
Rates of return can also be calculated on an after-tax and after-inflation basis. To calculate the total return after tax or the "net return", the income taxes payable on the portfolio would also be subtracted from the closing value when computing the increase in value. The after inflation, or "real rate of return", is calculated by subtracting the inflation rate for the period from the net return.
Because of the large number of variables in the management and measurement of portfolios, assessing investment performance is difficult. Regardless, when performance comparisons are made, investors should be concerned primarily with longer term results since they best measure a manager's ability in all phases of the business cycle. Also of importance are consistency of results and the trend of performance as indicated by the results over the last few measurement periods.
Source...