Investments, tenth edition

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4

  MOST FINANCIAL ASSETS 

are managed 

by professional investors, who thus at least 

indirectly allocate the lion’s share of capital 

across firms. Efficient allocation therefore 

depends on the quality of these profes-

sionals and the propensity of financial mar-

kets to direct capital to the best stewards. 

Therefore, if capital markets are to be rea-

sonably efficient, investors must be able 

to measure the performance of their asset 

managers. And such measurement must be 

sufficiently accurate to allow a proper rank 

ordering of their ability. At a minimum, effi-

ciency demands that performance evaluation 

be accurate enough to distinguish managers 

who (net of fees) are inferior to a randomly 

chosen, diversified portfolio. Thus, the social 

benefit of a reasonably reliable performance 

evaluation method is as large as that of mar-

ket efficiency. 

  How can we  evaluate the performance of 

a portfolio manager? It turns out that even 

an average portfolio return is not as straight-

forward to measure as it might seem. In 

addition, adjusting average returns for risk 

presents a host of other problems. In the end, 

performance evaluation is far from trivial. 

 We begin with the measurement of port-

folio returns. From there we move on to con-

ventional approaches to risk adjustment. We 

identify the problems with these approaches 

when applied in various real-life situations. 

We then turn to some practical procedures 

for performance evaluation in the field such 

as style analysis, the Morningstar Star Ratings, 

and in-house performance attribution.  

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T VII