The constant development of financial markets results in a considerable rise in interest concerning wealth multiplication by way of financial investments. On the other hand, the ever so rapid pace of life means we have no time to acquire the necessary knowledge to invest by ourselves. Therefore, more and more of us choose to entrust our savings to asset management institutions where assets are managed in line with a specific investment strategy. Full access to the results achieved through the implementation of investment strategies is a key element required for verifying the effectiveness of investments as well as for maintaining an open information policy towards us – customers.
One of the most popular methods of analyzing the results of portfolio management is Performance Attribution. This analysis allows to identify the sources of the achieved rates of return as well as determining the contribution of each source to the final investment results.
Conducting such an analysis is impossible without a system performing all the complex and intricate calculations. It would seem that it should be enough to have a thorough knowledge of a spreadsheet program; however, the complexity of the issue requires more sophisticated financial tools. This article will name key features of a world class performance measurement system in the form of a list of requirements.
First Requirement: The system must be flexible and effective. Despite the development of performance measurement standards there are considerable differences in terminology, methodology and attitude to performance measurement throughout the world. System flexibility allows for solutions tailored to the needs of different asset managers. Flexible systems are the ones that provide a number of ways to access as well as report the data. Even the most knowledgeable asset manager would not be able to achieve good results if, instead of focusing on trading, he had to spend his time collecting, analyzing and processing data from many different sources. Consequently, the system must provide quick and reliable access to the market information. Flexibility has been listed first because it is guided [‘followed’?] by further requirements.
Second Requirement: The system must provide user-definable methods for portfolio valuation.
In every investment portfolio there are different types of instruments, so the system should calculate their values by using algorithms dedicated to the various types. In accordance with the flexibility requirement, the system should allow its user to build own valuation methods. Furthermore, a key component in long-term investment performance is the fee charged by the asset manager. When evaluating and comparing the performance of portfolio managers it is essential to properly assess the impact of fees. System should be capable of calculating the portfolio valuation before and after fees are charged. It is important that in the age of direct access to financial markets from around the globe the system calculates value of investment portfolio in any currency the user may choose.
Third Requirement: The system must possess a powerful module for probability determination.
The primary measure of portfolio profitability is the rate of return. Rate of return reflects changes in the value of investment portfolio resulting from changes in market prices of the instruments included in a portfolio as well as cashflows related to concluded transactions. Therefore, system user should be provided with different methods for calculating portfolio return. A functionality allowing calculation of returns over various time periods – monthly, daily, year to date, or point to point – should feature within the system. Another important feature of such a system is its ability to calculate return at different sub-portfolio levels, such as sector, asset class, security, or a user-defined classification. Similarly to the portfolio valuation module, system should perform returns calculation at base and local level. Moreover, provision of a flexible way to calculate and report the currency effect should be ensured.
Fourth Requirement: The system must provide vast choice of benchmarks.
Determination of a benchmark is one of the most important decisions in the portfolio management process, because parameters of its currency structure, the shares of individual securities, and individual sectors determine the preferred ratio of expected return. Relationship between return on investment and actual yield of a benchmark determines the relative rate of return defined as the excess return. Analysis of the impact of an investment decision on the achieved profitability requires decomposition of the excess return using performance attribution models. Therefore, the system should feature a functionality enabling definition of market indices, peer groups, absolute indexes and custom indexes as benchmarks. For market indices, there should be a host of indices available. Definition of one or more indexes for the portfolio and user reporting using dynamically chosen indexes should feature, too.
Fifth Requirement: The system must provide choice of multiple attribution models.
So far there is no uniform methodology for performance attribution, and various financial institutions use their own models adapted to the characteristics of their investment process, differing in the degree of detail analysis and applied calculation methods. Again, there is a need for system flexible enough to match our investment style and preferences. Portfolio managers should have a choice of one attribution model from among several implemented models. Performance attribution can be calculated on different levels of asset portfolio aggregation, so the user could calculate attribution for each of major assets classes. Moreover, system should provide multiple ways to calculate multi-currency attribution.
Sixth Requirement: The system must present the results of analysis in a clear and intelligible way.
Performance presentation is the final step in the process of evaluating the results of asset portfolio management. The point is that any theoretical findings within portfolio measurement and calculation are properly presented to customers. In this regard, the undisputed standard has been developed by the CFA Institute – the Global Investment Performance Standards (GIPS®). The described system should therefore be compliant with this particular standard. The existence of a single world standard regarding presentation of investment performance is important in the era of globalization of financial markets and the asset management sector. It ensures investors have a clear comparison of results from different financial institutions.
To sum up, performance attribution is an issue gaining prominence due to the need for providing reliable information about the quality of asset portfolio management to customers. The task is impossible without having an up-to-date financial tool performing all calculations. The list of functionalities mentioned above is certainly not a complete list, but represents a set of functions satisfying even the most demanding portfolio and asset managers.