Portfolio Performance Measurement

To calculate the performance of a fund manager, first step is to calculate the portfolio return. There are various methods which can be used by the fund managers, two main methods are:-  

• Money Weighted Return – This is also known as internal rate of return. This is the return which will make the net present value of the investment as zero. An assumption is made that the portfolio will generate the same return over the period. Since there are many cash inflow and outflow in a portfolio this method is calculation intensive and various numerical methods are used to calculate the return. This method is preferred when the portfolio manager has the control over the portfolio cash inflow and outflow as it considers the amount of money invested. 
• Time Weighted Return – In this method, the holding period of an investment is divided whenever there is a significant cash inflow or outflow in portfolio. Then geometric mean return of all the periods is calculated, this return is the time weighted return of the portfolio. This is the preferred method when the portfolio manager does not control the portfolio cash inflow and outflow. The best approach for calculation is to calculation the daily holding period return.
  

There are modified approaches to both of the above methods. These are listed below:-

• Simple Dietz method – This method is the first order approximation of the internal rate of return. Here an assumption is made that the cash inflow in the portfolio is done at the middle of the period in consideration
  
• Modified Dietz method – A modification of the simple Dietz method where daily weighting is considered
  
• Linked Modified Dietz – This is a hybrid of money weighted and time weighted return. The return is calculated for a sliced time period using IRR and then the geometric mean return of each periodic return is calculated
  

The next step after the performance measurement is to compare the portfolio or composite return to the benchmark return. There are various measures to find out if the portfolio manager has created value or not, the basis of comparison is the level of risk taken in the portfolio compared to the benchmark. These are also known as risk adjusted performance measures, following are the main measures:-

• Sharpe Ratio: This measure was   developed by Prof. William Sharpe. This is the ratio of portfolio’s excess return with respect to risk free rate to the standard deviation of the portfolio. Here the assumption is that the portfolio returns are normally distributed. The higher the Sharpe ratio, the better is the portfolio performance.
  
• Modified Sharpe Ratio: When the portfolio is composed of assets whose returns are non-normal, Sharpe ratio does not yield good result, to incorporate the skenewss of such cases modified Sharpe ratio is employed. Modified Sharpe ratio is the ratio of excess portfolio return to the modified VaR of the portfolio.
  
• Treynor Ratio:  This ratio measures the excess portfolio return over risk free rate to that of the portfolio Beta. Essentially this ratio is finding the excess return per unit of market risk taken by the portfolio manager. The higher the ratio, the better is the performance.
  
• Sortino Ratio: If a portfolio return is more than the expected return, it is not seen as risk, but when the return is less than the required return we are exposed to the risk. So, the risk can be viewed as one sided risk, or the downside risk. Sortino ratio, measure portfolio performance on this basis, this ratio is the ratio of excess return over the minimum acceptable return to the downside risk of the portfolio. Downside risk is calculated from the semi variance of the returns which are below the minimum acceptable return. Like Sharpe and Treynor ratio, the higher the Sortino ratio, the better it is.
  
• Information Ratio: Information ratio is the ratio of active return (excess portfolio return over the benchmark) to the tracking error (standard deviation of the active return). This ratio helps in identifying how much extra return the portfolio manager has generated in comparison to the relevant benchmark.

Apart from these there are other measures which will be discussed in the next article.

Investment Operations Outsourcing

Most of the asset managers have fixed cost structure of the operations and the revenues are tied up with the asset under management, this exposes the firms to vagaries of the performance of markets. The current fee and cost structure is a survival risk that the firms carry in extreme market corrections. Outsourcing of investment operations not only provides cost benefits but also helps the firms to focus in their core business.

Industry Trends

Considering the non critical nature, most of the firms have already outsourced their back office operations; we can term this as the first wave of outsourcing.  We believe that the current industry turmoil will catalyze the second wave of outsourcing; the outsourcing of investment operations. Investment operations outsourcing can be seen as the outsourcing of the middle office functions.

The middle office operations generally require a higher degree of skills, customization and flexibility than the back office environment as a result firms were reluctant to outsource it. But the firms’ apprehensions regarding outsourcing of the middle office has decreased due to the increased technological capabilities of service providers and the impact on bottom-line due to these initiatives. Outsourcing helps the firms to ramp up their operations swiftly by providing new products, access to new geographies and asset classes.

The operations outsourcing are typically performed in the following two manners:-

Bundled Services - In this service providers take the ownership of a significant portion of the operational process and the provider is considered to be an extension of the investment management division. Typically investment firms go with this option when they have trust in the capability of the service providers and they know that the service providers are able to understand their process.

Component or process based service – Asset managers may not want to outsource all their activities and would like to have control of the activities like client reporting and compliance reporting but would like to outsource some non-core processes. This is a new trend and typically large asset managers are adopting this approach. This approach also provides similar flexibility and cost benefits.

European asset managers have widely adopted operations outsourcing however it has not yet gained significant traction in the United States. The firms in US who have been outsourcing are getting significant benefits and it is expected that it will get significant momentum in the near future.

Operational Areas Amenable For Outsourcing

Firms should outsource operational areas which are non-core to their operations. Typically following are the processes which the firms should outsource.

·         Account opening and setup

·         Fund accounting

·         Performance Reporting

·         Management Reporting

·         Trade processing and settlements

·         Corporate actions

·         Reconciliations

·         Collateral management

·         Client reporting

·         Portfolio accounting

·         Data warehouse

·         Compliance and regulatory reporting

·         Custodian aggregation

Many investment fund firms outsource a substantial amount of their fund admin and accounting operations. Some firm may consider compliance and client reporting outsourcing as risky but given the maturity of the service providers and advent of ASP model and Service level agreements, the risk has reduced.

Benefits Of Operations Outsourcing

• Investment managers are not looking for just outsourcing, but an extension of their overall operating environment. Operations outsourcing provide significant benefits to the asset management firms. Some of these are highlighted below
  
• Asset managers can shift their operational risk to the service provider. Since service providers are specialized in these processes they are better equipped to manage operational risks and hence the asset managers are able to reduce their risk. The service level agreements (SLAs) provide the investment firms to resolve their critical issues within the tolerable time period.
  
• Reduction in the cost of operations as the specialized vendors owing to their scale and process are able to provide the operation services at a reduced cost.
  
• The risk of technology obsolescence lies with the service provider. Service providers are able to upgrade and implement new software products and hence the investment management firms have access to latest technology which they may not able to afford on a standalone basis.
  
• By outsourcing their operations firms can focus on their core business. Outsourcing provides scalability which is a critical factor for growth.
  
• The investment managers have better cost predictability
  
• Asset managers can minimize capital expenditure as most of the investment is done by the service providers and most of their expenditures are operating in nature.
  
• Firms can gain access to service provider expertise and are able to implement industry standards and processes.
  
• Improved front office support is one of the most important benefits as outsourcing brings operational excellence closer to the business and the front office personnel are able to realize the improved efficiency.
  

Drawbacks Of Operations Outsourcing

• Often requirements and service level agreements are overlooked which may lead to challenges in the outsourcing engagement
  
• Service providers must invest in technology to support complex activities like investment strategies, high throughput etc.
  
• Lack of controls may lead to delivery of in-accurate information to investment managers 

References

1. Middle Office Survey Results – Beacon Consulting Group
2. Opportunities In The Evolving Middle Office – Beacon Consulting Group
3. Is operations OUTSOURCING the only solution? - Jonathan Dolby, UBS
4. Asset management in the UK 2008 – The IMA’s seventh annual survey
5. Financial Insights Asia/Pacific Executive Survey 2009