Source: DhakaTribune June 22, 2022 6:46 PM

If you truly want an idea of how well your portfolio is doing, you need something to compare the return with your invested capital.

It took you several months to save up and now you are finally determined to invest.

Perhaps it is for a near term personal goal or you just want to reap the benefits of greater wealth during retirement.

Whatever those goals may be, you are on the hunt for an asset manager.

However, how do you choose which firm or person to approach and how do you evaluate their performance?

Also, why is it so important you do so?

When searching for a suitable manager, there are a plethora of qualities to look for, such as integrity, talent, dedication and so on.

All of these can be grouped into three simple evaluation criteria which makes it easier to assess your manager. They are:

·         Reputation

·         Investment style

·         Performance

This guide will only focus on the third criteria, the manager’s performance which looks at the returns generated by the manager and the risks undertaken to do so.

We will briefly show you how to calculate and compare the metrics to benchmarks so you can get a solid picture of how well your manager is performing.

Keep in mind that the framework mentioned below can not only be used to judge mutual fund managers but also corporate fund managers (i.e., at banks, insurance companies or even individual portfolio performance).

Step 1: Calculate time-weighted returns

To understand time weighted returns, let us look at return calculation first.

Here, we introduce the concept of time-weighted return with an example.

1.      On December 31, 2021, an investor invested Tk1,000.

2.      As of June 2022, the portfolio grew to Tk1,200

3.      On July 1, 2022, the person invests Tk1,000 further, taking the total portfolio value to Tk2,200

4.      As of December 31, 2022, the portfolio value stood at Tk2,100.

A person who is unfamiliar with return calculation may decide to use the following equation to calculate their returns –

Return = (Ending value – money deposited) / (money deposited)

This would give us,

= (2100 – 2000)/ 2000= 5%

However, this return is inaccurate since it completely ignores the timing of fund injection and what particular returns are being generated using which particular amount.

Hence, any deposit or withdrawal can affect the calculated return of the portfolio, during the time period when those transactions took place.

Time weighted return (TWR) addresses this issue by separating the return on a portfolio into distinct intervals depending on whether cash was injected or withdrawn from the fund.

Consider the situation above, the return calculation can be broken down into two parts based on the cash flows:

·         From December 31 to June end,

Return = (1200 – 1000)/1000 = 20.00% (Holding period return)

·         From July to December 31,

Return = (2100 – 2200)/2200= -4.55% (Holding period return)

Now that we have holding period returns for both timelines, we can calculate the portfolio’s real return by finding out the geometric mean of the aforementioned returns.

Time-weighted return (geometric mean) = [(1 + 20.00%) x (1 + (-4.55%))] – 1 = 14.5%

The TWR equation would be the same if money had been withdrawn from the fund.

This method adjusts for the distorting effect of cash flows on returns.

Moreover, this method makes the returns comparable with other benchmark annual returns (since it can be annualized)

Step 2: Use appropriate benchmarks

The return of your portfolio is not very helpful by itself.

If you truly want an idea of how well your portfolio is doing, you need something to compare the return with.

This is where benchmarks come in.

Imagine a completely unmanaged portfolio with a similar investment structure to your portfolio (yours is being actively managed by a manager).

Here, the unmanaged portfolio is your benchmark, and your asset manager’s goal is to generate returns exceeding those generated by the former.

Usually, a country specific market index is considered the benchmark portfolio.

This index is a theoretical portfolio of all equity securities that are being traded within that region.

Its value is calculated based on the prices of the stocks within the index. In the case of Bangladesh, the Dhaka Stock Exchange Broad Index (DSEX) represents the market index.

However, this is not always the case.

The most important factor when considering which portfolio to use as a benchmark for comparison is its similarity to your portfolio.

Investors should look at the investment objective, asset allocation, and risk and return characteristics of the benchmark under consideration. 

For example, a portfolio consisting of exclusively fixed income securities such as bonds is likely to underperform than one consisting of exclusively stocks.

This is because bonds provide guaranteed interest payments which means they are relatively lower risk than stocks.

This makes the two incomparable (or unfair to compare).

Note: Managers mislabeling their funds and its relation to style drift

If an investor’s goal is to preserve the value of their wealth (capital preservation), their portfolio would contain low risk securities such as bonds, and fewer stocks.

Style drift occurs if the portfolio manager of this portfolio decides to change their investing style by investing in more stocks in hopes of reaping a larger return.

However, it can also occur naturally if the value of the stocks in the portfolio appreciates considerably more than the bonds.

To avoid the possibility of investing in a mutual fund which has strayed away from its objectives, always go through the fund’s portfolio statements for multiple years to understand trends and investment styles.

These list the types of securities the fund invests in.

For balanced funds and income funds, asset allocation should not consistently be equity heavy.

For growth funds, investments should heavily favor equity.

However, study the portfolio keeping the context of the economy at larger (fewer stock investments during periods of recession or slowdowns).

Step 3: Check risk level of the strategy

So far, we have successfully looked at the return aspects of investing (both calculation and comparison).

Now, we turn toward the risks. Two very common risk measures are discussed below.

Sharpe Ratio

The Sharpe ratio is calculated as:

Where,

Rp = Portfolio Return

RFR = Risk Free Return

σp = Standard Deviation of Excess Portfolio Returns

Here, the RFR is the return generated when no risk is involved.

Removing this component from the portfolio return isolates the excess return generated by taking risk.

You can refer to treasury bond rates for RFR.

The σp shows how much risk was undertaken to generate the excess returns.

Hence, this ratio illustrates the excess return generated per unit of risk.

Higher diversification in a portfolio tends to lower the standard deviation (again, depending on the asset classes), causing the Sharpe ratio to rise.

Investors can compare the Sharpe ratio of multiple portfolios to identify portfolios that only have high returns because they take on more risk.

The ideal portfolio is one which has a comparatively higher Sharpe ratio than its peers.

This means that the portfolio generates higher return per unit of risk.

Maximum Drawdown (MDD)

Imagine a graph where the returns of a portfolio are plotted on the y-axis against time on the x-axis.

Returns fluctuate immensely over time so you should have a graph with numerous peaks and troughs.

The concept of maximum drawdown calculates the percentage difference from the highest peak to the lowest trough before another new peak begins.

It quantifies the downside risk of a portfolio over a specified time frame.

The lower the maximum drawdown value the lower the losses experienced by the portfolio.

A 0% maximum drawdown means that the portfolio never lost money in that time frame and a hundred percent maximum drawdown means that the portfolio lost all its money in that time frame.

Note that the downside risk of your portfolio must be compared to that of a benchmark.

When the benchmark is down, a superior asset manager will keep losses at a minimum.

Therefore, you would prefer a portfolio with a maximum drawdown that is lower than that of the benchmark for the same time period.

Conclusion

There is a huge body of knowledge globally on evaluating investment performance.

CFA Institute for example has published a set of standards known as Global Investment Performance Standards (GIPS) to ensure fair disclosure and fair performance.

There is also a massive consulting industry that has grown to help asset deployers select the best asset managers.

Our article focuses on the very basic steps in return performance measurement.

However, for Bangladesh where the concept of investment return performance measurement is very new, this will be a good start.

Over time we can hope to catch up to international standards.

Rahma Mirza is an investment analyst at EDGE Research & Consulting Limited. Humayra Afroz is a former intern at EDGE AMC Limited