Oran Hall | Measuring investment portfolio performance
QUESTION: How do you estimate the rate of return on your entire portfolio given the different asset classes? While bonds, rental real estate, cumulative preference shares are easy to estimate, what about stocks where the rate of return is based on...
QUESTION: How do you estimate the rate of return on your entire portfolio given the different asset classes? While bonds, rental real estate, cumulative preference shares are easy to estimate, what about stocks where the rate of return is based on dividends and capital gains (if sold)? I hope you see the challenge I am having.
How will I know when my entire portfolio is performing optimally when some rates of return are fixed, while others, the majority of my portfolio, have variable return rates? How does one even plan for this uncertainty if one seeks to achieve financial independence without over investing in lower performing instruments?
FINANCIAL ADVISER: You are taking a very positive approach to the management of your portfolio. It is critical to know how it is performing overall and how individual portions of it are doing.
For the sake of simplicity, let us focus on the performance in a single year and assume that you invested at the beginning of the year and did not make any purchases or sales during the course of the year.
Let us also look at some useful concepts. Yield is the income from an investment expressed as a percentage of the sum invested. Some forms of income are interest from bonds, dividends from ordinary and preference shares and rent from real estate.
Sometimes income is fixed for the life of the instrument, as in the case of a fixed-rate bond or preference share. Sometimes, it is variable, as in the case of variable rate bonds and preference shares.
In the case of equities and unit trusts, it is hardly possible to determine total returns given the variation in the market prices of the instruments. In many cases, history may give an indication of the level of dividend to expect, but there is no certainty.
Total returns, which expresses income, other distributions and capital gains as a percentage of the sum invested over an evaluation period, is a more comprehensive measure of investment performance.
Although capital gains and losses tend to be associated with ordinary stocks and real estate, it is also possible to derive capital gains, or losses, from bonds, preference shares and unit trusts and mutual funds depending or whether market prices increase or decrease.
Capital gains and losses refer to the increase and decrease respectively in the value of an asset due to changes in its price.
In determining the performance of your portfolio, it is first necessary to determine the performance of each asset and then the performance of each asset class. It is also possible to determine the contribution of each asset and each asset class to the overall performance of the portfolio.
Let us say that your portfolio is made up of unit trusts, bonds, preference shares and equities. Very few unit trust funds distribute income, so the returns on unit trusts – and mutual funds – are generally determined by expressing the change in the value of that element of the portfolio as a percentage of the sum invested in such securities.
Even if the income on preference shares and bonds is variable – generally determined by adding a pre-determined amount of percentage points to the market-determined yield of a specific instrument like a treasury bill – the yield, does not remain a secret.
To determine the total return of each instrument, subtract the value at the beginning of the period from the value at the end of the period and express the result as a percentage of the sum invested. The value at the end of the period should be the sum of any income received and any capital gain or loss.
In the case of unit trusts and mutual funds, there is often just one price at which transactions are done. There are cases, however, in which there are two prices – the bid and the offer price. Investors buy units at the offer price and sell at the bid price in such cases. It is more accurate then, to use the bid price to determine the value of the investment at the time of the evaluation.
You need not wait until you sell an investment asset to calculate its return at any point. You may consider its unrealised gains, often called the paper gain of paper loss. Of course, that changes as prices change.
To determine the total return of the portfolio, subtract the total sum invested from the value – including capital gains or loss and all income earned – at the evaluation date and calculate the difference as a percentage of the sum initially invested.
To determine the contribution of each element of the portfolio to the overall portfolio return, express each element of the portfolio as a percentage of the total portfolio and multiply it by its return.
For illustration, let us say you have three classes of assets – unit trusts, bonds and equities – in your portfolio. They make up 20 per cent, 50 per cent and 30 per cent respectively of the portfolio and generate returns of 25 per cent, 20 per cent and 33.33 per cent respectively. The return of the full portfolio is 25 per cent.
If you multiply the proportion of each asset class in relation to the total portfolio by its return – 0.20 x 25; 0.50 x 20; 0.30 x 33.33 – and sum the answers, you should get 25 per cent. Of this amount, unit trusts would account for 5 per cent, bonds 10 per cent and equities 10 per cent. You can also use the same method to determine how much each instrument contributes to the total return of the portfolio.
- Oran A. Hall, author of ‘Understanding Investments’ and principal author of ‘The Handbook of Personal Financial Planning’, offers personal financial planning advice and firstname.lastname@example.org