Investment Performance Measurement
Many investors are happy about investment managers until the stock market is growing, but when the decline starts investment managers gets only the worst words about their job. However, this is wrong attitude. Even if the value of the portfolio is growing very fast it does not necessary mean that investment manager did a good job and otherwise. Investment performance basically depends on few factors:
- Chosen risk level.
- Performance of financial markets.
- Value created (or destroyed) by investment manager.
- Costs incurred during investment process (investment fees etc.)
Only the last two factors depend solely on investment manager. Because the risk level must be characteristic of a client and financial markets are not predictable.
Ratios used for measurement:
Sharpe ratio = (Return of the portfolio – Risk free rate) / Standard deviation of the portfolio
As being the most popular ratio for investment performance measurement Sharpe ratio has some advantages. The main one is simplicity compared to other ratios. It is easier to define standard deviation of the portfolio than to find beta.
Sharpe ratio measures return of the portfolio over risk free investment return compared to standard deviation, which shows the riskiness of the portfolio (the higher volatility means higher risk).
Treynor ratio = (Return of the portfolio – Risk free rate) / Beta of the portfolio
Maybe Traynor ratio is more exact than Sharpe ratio, but not so often used in practice like Sharpe ratio is used. The main reason for that is more subjectivity in Treynor ratio calculation. To measure beta you have to compare the volatility of the portfolio to market volatility, but if portfolio is allocated in many markets and sectors it is hard to find the really exact benchmark for the portfolio.
The best way to measure performance
All ratios are good tools compared to nothing. But still may be troubled like every statistical calculation does. Such ratios as Sharpe and Traynor might be real help for investment management only when they are calculated correctly and long term data are used. They can’t be used until economical cycle is not complete. Economical cycle may last over a decade or more, and any data used for shorter period might show faulty results.
If you want to asses result in shorter period, the only way is to find a good benchmark index. Sometimes it can be harder than calculate few ratios. The problem is that you might not know whether the benchmark is correct until cycle will turnaround. The benchmark index for the portfolio should exactly meet the risk level of the investment portfolio. If during the cycle increase portfolio beats the benchmark, but during decrease looses to it, it means the benchmark is not proper and has lower risk level.
In practice composite benchmark indices are used. They are made up from several different indices that represent investment portfolio in the best way.