Performance Measurement

Performance evaluation includes three components, each relating to a specific question about a portfolio's performance:

1. Performance measurement: Quantifies performance.
2. Performance attribution: Demonstrates performance method.
3. Performance appraisal: Distinguishes skill from luck.

While each factor above stands on its own, there is also an interplay at work. In terms of performance measurement, the portfolio’s performance is often compared to a benchmark. The performance measurement process involves calculating investment returns for both the portfolio and its benchmark. An investment return shows what the portfolio achieved over a specified period, regardless of peer or benchmark performance. This is most commonly called the absolute return. It is also the starting point for understanding the difference between the portfolio return and its benchmark return, the excess return.

In addition to return, performance measurement must take into account the risk incurred to achieve said return. We measure risk using a variety of ex-post (after-the-fact) and ex-ante (before-the-fact) techniques. For ex-post, volatility or standard deviation of past returns may be considered, along with other performance appraisal ratios. Calculating a portfolio’s value at risk (VaR) at a given point in time is an ex-ante measure. These measures of risk allow for quantifying the risk in a portfolio and help to better assess performance.

Performance Attribution

Performance attribution can be used to assess either absolute or relative returns. It can be used to understand what portion of returns was driven by active manager decisions versus what portion was a result of exposures not specifically targeted by the portfolio manager (accidental). This explains how the measured return or risk was achieved/incurred.

Performance attribution can also be used to break down excess returns into their component sources, helping explain why a manager underperformed or overperformed the benchmark. Similarly, risk attribution can be used to do the same for the risk incurred in the portfolio.

Performance Appraisal

Performance appraisal uses the output from both performance attribution and measurement analysis and attempts to assess the quality of the manager's decisions. In other words, was the performance due to skill or luck? Performance appraisal looks at the various forces that play on a portfolio and attempts to distinguish that which is under the manager's control, and that which is not. If the manager is deemed to have made solid decisions and it the reason for the excess return, it is likely that this could also be the case in the future which adds to management credibility.

Question

Calculating a portfolio's VaR is an example of which of the following techniques?

1. Ex-ante performance appraisal.
2. Ex-post-performance attribution.
3. Ex-ante performance measure.

Solution

The correct answer is C.

Value at Risk (VaR) provides a probability-based estimate of potential portfolio losses. It doesn’t delve into the origins of risk (performance attribution) or whether the risk-taking was well-informed (performance appraisal). Therefore, choice C, a performance measure, is the most fitting answer.

A and B are incorrect. In addition to return, performance measurement must consider the risk incurred to achieve that return. Risk is measured using a variety of ex-post and ex-ante techniques. For ex-post, volatility or standard deviation of the past returns may be considered, along with other performance appraisal ratios. The calculation of a portfolio's value at risk (VaR) at a point in time is an example of an ex-ante measure.

Reading 12: Portfolio Performance Evaluation

Los 12 (a) Explain the following components of portfolio evaluation and their interrelationships: performance measurement, performance attribution, and performance appraisal