Performance evaluation includes three primary components, each corresponding to a specific question we need to answer to evaluate a portfolio’s performance:
- Performance measurement—what was the portfolio’s performance?
- Performance attribution—how was the performance achieved?
- Performance appraisal—was the performance achieved through manager skill or luck?
Performance evaluation consists of three interrelated components that build upon each other:
Performance measurement serves as the initial foundation phase and calculates both the return and the risk of the fund over specified time periods. It is imperative to determine, before any performance evaluation analysis, if the portfolio will be compared to a benchmark or to a target return percentage that is specified in advance by the portfolio manager.
In its simplest form, performance measurement is the calculation of investment returns for both the portfolio and its benchmark. This return calculation is a critical first step in the performance evaluation process, building the foundation on which performance evaluation is based.
The investment return tells us what the portfolio achieved over a specific period, irrespective of peer or benchmark performance, called the absolute return. But it also provides the basis to understand the difference between the portfolio return and its benchmark return, the excess return.
Performance attribution determines the key drivers that generated the account’s performance. Performance attribution expands upon the risk and return that was quantified through performance measurement and explains how the return was achieved given the risk taken by the portfolio manager. Also, performance attribution can explain both relative and absolute returns.
Performance attribution can also be used to decompose the excess return into its component sources, where it is used to help explain why a manager over- or underperformed the target benchmark. Similarly, risk attribution can be used to decompose the risk incurred in the portfolio.
Performance appraisal determines whether the performance was affected primarily by investment decisions, by the overall market, or by chance. Performance appraisal combines output from both performance measurement and performance attribution to render a professional judgment on the quality of the performance. If a fund’s performance is attributed to luck, we cannot expect the portfolio manager to exhibit similar returns in the future.
Performance appraisal, makes use of risk, return, and attribution analyses to draw conclusions regarding the quality of a portfolio’s performance. The analysis may affirm the management process or may contain insights for improving the process. This is a key feedback loop in the investment management process.