Evaluating portfolio performance

Most of us have little time to do our own investing and thus use a mutual fund or a wealth manager to manage our money. But how do you evaluate if they are doing a good job?

Suppose you invested in Great Retail Mutual Fund, an equity fund that focuses on blue-chip stocks. This fund earned a total return of 20 per cent for its unit holders for 2009.

It advertises as the “No.1 performer” in its category. Well, before you pat yourself on the back on having picked a winner, you need to consider several other aspects. Whenever you evaluate a manager or a fund's performance, do ask the following questions:

At what risk?

Investing is a two-dimensional process based on return and risk.

Both must be evaluated to make an intelligent decision. So, if we know nothing about the risk taken by Great Retail Mutual Fund, little can be said about its performance. It is possible that Great Retail's fund managers have taken twice the risk of comparable portfolios to achieve this twenty per cent return.

A fund that invests in small, little-known ,does not assume the same risk as one that invests in well-known index stocks.

That is why, it is totally inadequate to consider only the returns from a portfolio without reckoning for risk.

One must determine whether the returns are large enough given the risk involved. So, to assess portfolio performance, one must evaluate the performance on a risk-adjusted basis.

Over what time?

Funds or managers may use different time periods over which they measure performance.

The longer the period for which the fund managed good returns, the better. For instance, one fund could use the ten years period ending December 31, 2009 whereas another fund may use the five years ending June 30, 2009.

In our case, Great Retail fund could be using a one-year period, which may not be very representative of how the fund will perform in the long haul.

Returns can also vary widely based on whether it was a bull market or a bear phase. Comparison between funds or managers also must be done over similar time frames.

What's the benchmark?

Another reason why one can say little about the performance of Great Retail fund is that its 20-per cent return is meaningful only when compared to a legitimate alternative. Obviously, if the market returned twenty five per cent in 2009, and Great Retail is an average-risk fund, its performance isn't great.

Therefore, one must take relative comparisons for measuring performance. The benchmark to be used is an important issue.

It is critical in evaluating portfolio performance to compare returns obtained on the fund with the returns that could have been obtained from an index or a benchmark.

The benchmark's portfolio must also be a legitimate alternative that accurately reflects the objectives of the fund or portfolio being evaluated.

What were the objectives?

While evaluating a portfolio, an investor should also consider the objectives set by the manager and any constraints under which he or she must operate.

For instance, if a mutual fund's objective is to invest in small, speculative stocks, investors must expect the risk to be larger that of a fund invested in Nifty, with a substantial swing in the annual returns.

It is imperative to take note of the investment policy statement pursued by a portfolio manager in determining the portfolio's results. In many cases, the investment policy determines the return and risk of the portfolio.

More than 90 per cent of the movement in a fund's returns, relative to the market returns, is attributable to a fund's asset allocation policy.

Therefore, a portfolio that invests in both stocks and debt instruments can't be compared to one which invests only in stocks.

What other factors influence returns?

There are other important issues involved in measuring portfolio performance.

One important factor is how well-diversified the portfolio was during the evaluation period, as diversification can reduce portfolio risk.

A large number of investors, while selecting mutual funds, evaluate them on the basis of their published performance statistics.

If the published ‘track record' looks impressive, that is typically enough to convince them to invest in that fund. However, these returns often have to be seen in light of risk, time frame, the benchmark and portfolio structure to arrive at the true picture of performance.

All investors must understand that even in today's world of computers and databases, there is a lot of subjectivity in evaluating portfolio returns.

(The authors teach accounting and finance at Indian Institute of Management, Shillong)

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