Reading 32
Evaluating Portfolio Performance
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Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute. Reproduced
and republished with permission from CFA Institute. All rights reserved.


Contents
1.
2.
3.
4.
5.
6.
7.
8.

Introduction
The Importance of Performance Evaluation
The Three Components of Performance Evaluation
Performance Measurement
Benchmarks
Performance Attribution
Performance Appraisal
The Practice of Performance Evaluation

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1. Introduction
• Performance evaluation is the ex post analysis of investment
performance
 Performance measurement
 Performance attribution
 Performance appraisal

• Fund sponsors and investment managers are concerned with
performance evaluation
 Fund sponsors are owners of large pool of investable assets

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2. The Importance of Performance Evaluation
• Fund sponsor perspective:
 What is the fund’s performance relative to
investment objectives
 What are the investment program’s strengths and
weaknesses
 What are the successful and unsuccessful strategies

Feedback
and Control
Mechanism

• Investment manager perspective:

 Virtually all fund sponsors will insist on
performance evaluation
 Determine effectiveness of various elements of
investment process and examine relative
contributions of those elements
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Feedback
and Control
Mechanism
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3. Three Components of Performance Evaluation
Account: one or more portfolios managed by one or more investment managers

Three questions related to investment performance of an account:
Measurement
Attribution
Appraisal
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4. Performance Measurement
•
•
•
•

•
•
•
•
•

Rate of return with no external cash flows
Rate of return with cash flows at start or end of period
Total rate of return
Time weighted rate of return
Money weighted rate of return
TWR versus MWR
Linked internal rate of return
Annualized return
Data quality issues
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Total Rate of Return
Prior to 1960s performance measurement focused on income
Since then the focus has shifted to total rate of return which measures
increase in wealth due to income and capital gains
Two major methods:
Time-weighted rate of return (TWR) reflects the compound rate of growth of
$1 invested at T = 0

Money-weighted rate of return (MWR) measures compound growth rate of all
funds invested in the account over the evaluation period
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Review of TWR

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Time (Days)

Cash Flow

Starting Balance

1,000,000


T=5

+ 30,000

1,045,000

T = 16

+ 20,000

1,060,000

Final Value (T = 30)

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Account
Value

1,080,000

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Time (Days)

Cash Flow

Starting Balance


Account
Value
1,000,000

T=5

+ 30,000

1,045,000

T = 16

+ 20,000

1,060,000

Final Value (T = 30)

1,080,000

Wealth relative
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Time (Days)

Cash Flow


Starting Balance

+1,000,000

T=5

+ 30,000

T = 16

+ 20,000

Final Value (T = 30)

1,080,000

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TWR versus MWR

TWR
• Represents growth of a single unit of
currency invested
• Unaffected by external cash flows
• Appropriate measure if investment
manager has little or no control over
external cash flows

• Generally required under GIPS®
• Requires valuation on every day that
an external cash flow takes place

MWR
• Represents average growth of all
money invested
• Sensitive to size and timing of external
cash flows
• Appropriate measure if investment
manager has control over timing of
external cash flows (for example with
private equity)
• Requires valuation at start and end of
period

TWR can be approximated by calculating the MWR over reasonably frequent time
intervals and then chain linking those returns  Linked Internal Rate of Return (LIRR)
Example 7
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Under “normal” conditions TWR and MWR
will produce similar results

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Data Quality Issues
• Quality of performance management process depends on quality of input
data
• For accounts invested in liquid and transparently priced securities, reported
rates are likely to be reliable
• For accounts invested in illiquid and infrequently priced assets, the
underlying valuations may be suspect
 Estimated prices may be derived based on dealer-quoted prices for similar assets 
matrix pricing

• Should have appropriate data collection procedure; stated account value
should:
 Reflect impact of unsettled trades
 Reflect income owed to or by the account

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5. Benchmarks
A few different ways to think of a benchmark…
• Collection of securities or risk factors and associated weights

that represent the persistent and prominent investment
characteristics of an asset category or a manager’s investment
process
• Passive representation of manager’s investment style
• Manager’s area of expertise
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P = Portfolio Return
B = Benchmark Return
M = Market Return
P = B + (P – B)
P=

B

+

A

P = M + (B – M) + A

P=M+S+A

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Properties of a Valid Benchmark

(Area of expertise)

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Types of Benchmarks
Benchmark

Advantages

Disadvantages

Absolute. An absolute return is
the return objective.

Simple

Not investable and does not
satisfy benchmark validity criteria


Manager Universes. Median
manager or fund from a broad
universe.

Simple to understand
Measurable

Fails most benchmark validity
criteria

Broad Market Indexes.

Well recognized, easy to
At times manager’s style might
understand, widely available and differ from style reflected in a
satisfies most properties of a valid market index
benchmark

Style Indexes. Represent specific
portions of an asset category.

Well recognized, easy to
understand, widely available

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Might not pass tests of
benchmark validity; certain
weights might be too high; style
might be ambiguous

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Types of Benchmarks
Benchmark

Advantages

Disadvantages

Factor-Model-Based. Use a set of factor
exposures as a benchmark.
Market Model: Example 10
Multi-factor Models
Normal portfolio

Capture systematic
sources of return
Easy to see manager’s
investment style

Not intuitive: very few think in
terms of factor exposures when
designing a portfolio
Not easily investable

Returns-Based. Benchmark constructed
using 1) series of manager’s account returns
and 2) series of returns on several
investment style indexes over the same

period. Then identify combination that most
closely tracks the account’s returns.

Easy to use
Intuitive
Useful when only
information is account
return information

Might hold positions that
manager finds unacceptable
Requires many months of data

Custom Security Based. Represents
manager’s research universe weighted in a
particular fashion.

Satisfies all validity
criteria

Expensive to construct and
maintain
Not published and might lack
transparency

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Market Model

Multi-Factor Model

Normal portfolio is a portfolio with exposures to sources of systematic risk
that are typical for a particular manager
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Building Custom Security-Based Benchmarks

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