SusanneB/E+ via Getty Images
How to Analyze and Monitor Portfolio Health
When analyzing and monitoring portfolio health, investors may use a number of portfolio metrics. While total return is a key metric for performance, it only tells half the story. There are risk measures, such as standard deviation, that are equally important.
Investors often create an Investment Policy Statement, or IPS, to outline their investment strategy. An IPS may be used by individual investors, professional money managers and investment advisors to outline investment goals, objectives, and the measures used to monitor performance. For example, the IPS will clearly state the goal of the portfolio and metrics that monitor whether the portfolio is on the right track.
Some of the basic parameters outlined in the IPS may include the performance benchmark, investment time horizon, and the specific metrics used for monitoring. The IPS may also include investment selection criteria and determining factors for replacing investments that are underperforming or otherwise not meet the IPS standards.
Calculate Total Return
Total return is the best way to measure overall returns of an investment and to compare returns across asset classes. This measurement includes capital gains, dividends, interest, and distributions. Total return of an investment or portfolio are generally compared to a benchmark.
Choose a Monitoring Time Horizon
When choosing a monitoring time horizon, an investor will need to consider their investment goals and investment style. For example, an investor with a long-term goal, such as retirement, may emphasize 5-year and 10-year returns over shorter periods when evaluating performance.
Tip: The most common unit of measurement for monitoring investment performance is one year. For longer periods, returns are “annualized,” which means an annual average. The most commonly published rates of return are 1-year, 3-year, 5-year and 10-year returns. However, investors need to clearly state their performance monitoring metrics and benchmark in their investment policy statement. For example, a long-term investor may choose to focus more on 5- and 10-year returns and less on short-term returns.
Select a Performance Benchmark
The performance benchmark used will depend on the investments held in the portfolio. Investors may use one or multiple benchmarks. For example, the primary benchmark used for stocks is the S&P 500 index and the main performance benchmark for bonds is the Barclays US Aggregate Bond index.
Performance Monitoring Metrics
Investors may use multiple benchmarks for monitoring portfolio performance or for measuring individual investment security performance. The primary portfolio monitoring metric for performance is total return, which is usually measured against a benchmark. Other metrics include statistical risk methods, such as Standard Deviation, Beta, R-Squared, Sharpe Ratio, and Sortino Ratio.
In addition to selecting the appropriate performance monitoring metrics, investors need to choose the monitoring frequency. For example, a common monitoring frequency for an investment or for a portfolio is quarterly (every three months). This frequency is often chosen, in part, because investment data is commonly reported on a quarterly basis. While an investor may not make changes to their portfolio on a consistent basis, it’s important to monitor the metrics periodically.
Investment objectives of a portfolio may include:
- Long-term growth/retirement planning
- Current income
- Capital preservation
- Short-term expense funding
- College savings
Tip: Monitoring metrics are commonly calculated and published on investment websites. Return vs benchmark can be easily found for almost any investment security. However, risk metrics such as standard deviation, Beta, and R-squared are generally used for portfolios, which means they’re more commonly calculated and published on mutual funds and ETFs, not stocks or bonds. For example, Seeking Alpha provides performance, standard deviation, and other risk metrics on ETFs. Morningstar.com is an example of a research site that provides monitoring metrics for investors.
Investment portfolio metrics are:
- Portfolio Return vs Benchmark
- Standard Deviation
- Beta
- R-Squared
- Sharpe Ratio
- Sortino Ratio
Investors may use these metrics to measure performance and risk in a portfolio:
Portfolio Return vs. Benchmark
Performance can be monitored for each investment or for the portfolio as a whole. For example, in addition to using the S&P 500 index for stock holdings and the Barclays Aggregate for bonds, an investor with a moderate allocation of 60% stocks and 40% bonds may choose to use a balanced index fund with a similar allocation, such as Vanguard Balanced Index (VBIAX). Alternatively, the investor can take a weighted average of the returns of the indices, where the weights equal the asset allocation of their portfolio.
Standard Deviation
Standard deviation is a measure of volatility of an investment or a portfolio. For example, a higher standard deviation indicates a greater price variation, or higher volatility, from average performance. To reduce volatility in a portfolio, many investors employ diversification strategies by investing in a variety of assets.
Beta
Beta is a statistical risk metric that measures an investment’s risk compared to a market benchmark. The market will always have a Beta of 1.0. If an investment has a Beta higher than 1.0, it is more volatile than the market and if an investment has a Beta lower than 1.0, it is less volatile than the market.
R-Squared
R-squared is a statistical measure that represents an investment’s price movements that correlate with the movements of its benchmark index. Usually expressed as a percentage, R-squared may range from 0% to 100%. For example, an R-squared of 0.95 means that 95% of the investment’s price movements are correlated to its benchmark.
For example, if an investor were using an S&P 500 index fund as a core holding in their portfolio, they may want to find an investment with a low R-squared compared to the S&P 500 to help diversify the portfolio.
Sharpe Ratio
The Sharpe ratio is a measure of risk-adjusted return that expresses a level of volatility an investor is required to assume to achieve a return higher than a risk-free asset. Put differently, the Sharpe ratio can help an investor decide if additional risk of an asset or portfolio justifies its return. A good Sharpe ratio is one higher than 1.5.
Sortino Ratio
The Sortino ratio is a modification of the Sharpe ratio that measures risk-adjusted return of an investment or portfolio. Where Sortino differs from Sharpe is that Sortino only factors in downside risk. Many investors prefer this because they believe upside volatility (large price increases) are not risk. Thus, the Sortino ratio may be best used for a high volatility portfolio measure of risk and the Sharpe ratio may be best for a lower-volatility portfolio.
Bottom Line
There’s more to measuring portfolio performance than total return. Investors are wise to select appropriate benchmarks, such as the S&P 500 index for a stock portfolio or the Barclays Aggregate Bond Index for a fixed income portfolio. Statistical measures, such as Standard Deviation, Sharpe ratio, and R-squared can be used to measure risk of a portfolio.
Be the first to comment