Components of Portfolio Evaluation
Performance evaluation consists of three interrelated components that build upon each other: performance measurement, performance attribution, and performance appraisal. On this page, we discuss each of the components of portfolio evaluation in more detail.
Performance evaluation tries to answer three questions regarding a portfolio’s performance:
- What performance did the fund achieve during the period (performance measurement)
- How did the fund manager achieve their performance (performance attribution)?
- Did the fund manager achieve their performance via skill or luck (performance appraisal?)
The first step to portfolio evaluation is performance measurement. It 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 (relative performance) or to a target return percentage that is specified in advance by the portfolio manager (absolute performance).
The second step is performance attribution, which 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 appraisal is the final step. It 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 judgement 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.
We discussed the three questions that portfolio evaluation tries to answer when evaluating a fund’s performance. Each approach builds on the previous step. The ultimate objective is to determine whether outperformance was due to luck or skill.