Richard Newell talks to John Fu, Senior Product Manager at J.P. Morgan Worldwide Securities Services, about the specific approaches institutional clients are adopting with regards to performance measurement.
There are a variety of measures that investors can to derive a rate of return for a given level of risk. Treynor, Sharpe or Jensen, to name but three. But which one is best?
John Fu - In our opinion, there is no single measure of risk-adjusted returns that can be considered ‘best’ for every investor. It will depend on the investment objectives and constraints. Sharpe Ratio and Information Ratio are the most widely used measures of risk-adjusted returns. Many institutional investors also consider the Treynor Ratio, Sortino Ratio and Jensen’s Alpha. Most recently, academics and investors have been considering the usefulness of ‘Omega’, which attempts to provide a measure of performance that takes into account the non-normality of investment returns. In practice, most investors will monitor several different statistics in order to gain a robust picture of risk-adjusted returns.
What are the lessons that can be learned about the investment performance and measurement process from the experience of pension funds and major global investors?
Fu - Today, pension funds often monitor portfolios down to the security level. In many cases, pension funds demand custom and tailored benchmarks in order to better understand their risk exposures. Also, large global pensions seek information on a daily basis.
Large pension funds often receive performance and risk information from several different sources, including directly from their investment managers. It is often difficult to reconcile between different sources. Pensions are searching for a holistic and integrated approach to their performance and risk measurement, and custodians in particular have developed the capabilities to respond to this need for consolidated, independent reporting.
At the end of the day, simply measuring the return of a plan or fund will have limitations. As a result, evaluating the sources of investment returns, through the use of attribution analysis, is vital to understand how returns have been generated.
What are the future prospects for performance measurement and future directions for the measurement of investment performance?
Fu - Clearly, pension funds and other institutional investors will strive to find the most accurate and robust measures of investment performance. Many investors are increasingly interested in their exposure to economic factors such as interest rates, inflation, and foreign exchange rates. Also, there is considerable interest surrounding the idea that investment returns are non-normal. On the performance side, Omega may provide insights that consider the entire return distribution of portfolios. On the risk side, many investors are considering the merits of Conditional Value-at-Risk (a.k.a. “Expected Shortfall”).
Challenges on the horizon include higher quality data on all instruments, including derivatives, and the ability to provide timely and accurate performance, analytics, and risk measurement across all asset classes, including private equity, hedge funds, and real estate. It is vital for performance measurement providers to offer holistic analysis and insight into the risks and rewards of the entire plan or fund.