12.3 Performance Measures & Reporting

Accurate performance measurement is essential for evaluating investment results and comparing managers. Understanding various performance metrics and reporting standards is critical for investment advisers.

Return Calculations

Total Return

Total return captures all sources of investment gain:

Total Return = (Ending Value - Beginning Value + Income) / Beginning Value

Example: An investment of $10,000 grows to $11,000 and pays $200 in dividends:

- Total Return = ($11,000 - $10,000 + $200) / $10,000 = 12%

Annualized Return

Converts returns to an annual equivalent for comparison:

Annualized Return = (1 + Total Return)^(1/Years) - 1

Example: A 33.1% return over 3 years:

- Annualized = (1.331)^(1/3) - 1 = 10% per year

Time-Weighted Return (TWR)

TWR eliminates the impact of cash flows to measure pure investment performance:

Purpose: Measure manager skill

Cash Flows: Eliminates their effect

GIPS Required: Yes

Best For: Comparing managers

How It Works: Links sub-period returns before and after each cash flow

Money-Weighted Return (MWR / IRR)

MWR reflects the investor's actual experience, including the timing of cash flows:

Purpose: Measure investor's actual return

Cash Flows: Reflects their timing

Best For: Personal performance assessment

Calculation: Internal rate of return (IRR)

On the Exam: TWR is for comparing managers (GIPS requirement). MWR shows the investor's actual experience and is affected by the timing of their contributions and withdrawals.

Risk-Adjusted Performance Measures

Sharpe Ratio

Measures excess return per unit of total risk (standard deviation):

Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation

Risk Measure: Standard deviation (total risk)

Interpretation: Higher is better

Best For: Undiversified portfolios or sole investments

Limitation: Penalizes both upside and downside volatility

Treynor Ratio

Measures excess return per unit of systematic risk (beta):

Treynor Ratio = (Portfolio Return - Risk-Free Rate) / Beta

Risk Measure: Beta (systematic risk only)

Interpretation: Higher is better

Best For: Well-diversified portfolios

Assumption: Unsystematic risk has been diversified away

Jensen's Alpha

Measures the excess return above what CAPM predicts:

Alpha = Actual Return - [Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)]

Positive: Outperformed risk-adjusted expectation

Zero: Performed as expected

Negative: Underperformed risk-adjusted expectation

Example: If CAPM predicts a 10% return but the portfolio earned 12%, alpha = 2%

Information Ratio

Measures the consistency of outperformance relative to a benchmark:

Information Ratio = Active Return / Tracking Error

Where:

- Active Return = Portfolio Return - Benchmark Return

- Tracking Error = Standard deviation of active returns

0.5+: Good

0.75+: Very Good

1.0+: Excellent

Comparison of Measures

Sharpe Ratio: Risk Basis - Total risk (std dev). Best Use: Single portfolio evaluation

Treynor Ratio: Risk Basis - Systematic risk (beta). Best Use: Diversified portfolios

Jensen's Alpha: Risk Basis - Systematic risk (beta). Best Use: Manager skill assessment

Information Ratio: Risk Basis - Tracking error. Best Use: Active manager consistency

Benchmarking

Benchmark Selection Criteria

An appropriate benchmark should be:

Investable: Could actually be purchased

Measurable: Returns can be calculated

Appropriate: Reflects strategy and style

Unambiguous: Clearly defined constituents

Specified in Advance: Known before the period

Owned: Manager accepts it as valid comparison

Common Benchmarks

U.S. Large Cap: S&P 500

U.S. Small Cap: Russell 2000

U.S. Aggregate Bonds: Bloomberg U.S. Aggregate

International Developed: MSCI EAFE

Emerging Markets: MSCI Emerging Markets

Real Estate: NCREIF, FTSE NAREIT

Global Investment Performance Standards (GIPS)

GIPS are voluntary ethical standards for investment performance presentation, created by CFA Institute.

Objectives of GIPS

1. Promote investor confidence

2. Ensure accurate and consistent performance data

3. Establish a global standard for comparison

4. Promote fair competition among firms

5. Encourage industry self-regulation

Who Can Claim GIPS Compliance

Can Claim: Investment management firms; Asset owners managing discretionary assets; Firms competing for business

Cannot Claim: Individual advisers; Brokers without discretion; Non-investment firms

Key GIPS Requirements

Minimum Performance History: At least 5 years (building to 10)

Return Calculation: Time-weighted returns required

Composite Construction: All discretionary, fee-paying accounts

Fee Disclosure: Both gross and net-of-fee returns

Verification: Voluntary but recommended

GIPS Composite Requirements

All fee-paying discretionary portfolios must be included in at least one composite based on:

- Similar investment strategy

- Similar risk/return objectives

- Comparable mandates

On the Exam: GIPS is voluntary, requires time-weighted returns, and all discretionary fee-paying accounts must be in composites. No "cherry-picking" of best performers.

Key Takeaways

1. TWR measures manager performance (GIPS required); MWR measures investor experience

2. Sharpe uses total risk (std dev); Treynor uses systematic risk (beta)

3. Positive Jensen's alpha means outperformance vs. CAPM prediction

4. GIPS are voluntary standards requiring TWR and composite presentation

5. Benchmarks must be investable, measurable, appropriate, and specified in advance