HOW TO MEASURE
PORTFOLIO PERFORMANCE

Understanding how well your portfolio performs is crucial for making well-informed investment decisions. This guide explores performance metrics other than absolute returns and how you can use the Sharpe Ratio, Treynor Ratio, and Jensen’s Alpha to develop a more nuanced analysis of your performance.

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Whatever strategy you are using, measuring portfolio performance goes beyond simply looking at annualised percentage returns. Learning how to use other performance metrics like the Sharpe Ratio, Treynor Ratio, and Jensen’s Alpha can help you to develop new ways of evaluating your performance.

What Are Portfolio Performance Metrics

Portfolio performance metrics are quantitative measures that help investors evaluate how well their investments are performing relative to the risk taken. They do more than just measure gross returns and also factor in relative performance and volatility of returns.

These metrics provide a standardised way of evaluating different investment strategies, whether you are analysing your holdings or evaluating potential investments. They take your understanding of returns past measuring changes in Net Asset Value (NAV) in absolute terms, and offer greater insight into whether an asset is potentially worthy of investment.

Performance metrics can incorporate risk factors, market conditions, and benchmark comparisons and help answer two critical questions:

• Is your portfolio’s return worth the risk you’re taking?
• Are you outperforming the market after adjusting for volatility?

Why They Matter

Performance metrics matter because they provide additional context and enable meaningful comparisons.

Relying solely on absolute returns can leave you seeing only part of the picture – a portfolio showing a 15% annual increase in value might seem impressive until you realise it came with extreme volatility which could have jeopardised the ability to stay in positions.

Advanced performance measurement tools help investors to:

• Make data-driven decisions and counterbalance the risk of portfolio management being based on emotions
• Quantify the relationship between risk and return
• Develop strategies which factor in a greater number of variables
• Identify weaknesses
• Benchmark performance against market indices such as the S&P 500 Index (SPX500)

Factor	Sharpe Ratio	Treynor Ratio	Jensen’s Alpha
Intent	Expresses returns relative to the amount of risk in a portfolio.	Expresses returns in relation to systematic/market risk rather than portfolio risk.	Expresses returns compared to a benchmark or average market returns.
Process	Divides the portfolio’s excess return (return minus risk-free rate) by its standard deviation	Uses beta (instead of standard deviation) as the risk measure.	Measures the excess return a portfolio generates above what would be predicted by the Capital Asset Pricing Model (CAPM)
Formula	Sharpe = (Rp – Rf ) / σp  Rp = Portfolio return Rf = Risk-free rate  σp = Standard deviation of portfolios excess return	Treynor = (Rp – Rf ) / βp  Rp = Portfolio return Rf = Risk-free rate  βp = Portfolio beta	Alpha = Rp – [Rf + βp × (Rm – Rf)] Rp = Portfolio return Rf = Risk-free rate  βp = Portfolio beta Rm = Market return
Uses	Comparing portfolios with different risk levels or deciding between investment strategies	Evaluating portfolios that are part of a larger, well-diversified investment strategy	Determines to what extent excess returns are due to active management, as opposed to market movements
Good readings	> 1.0  Higher = better	> 0.5  Higher = better	> 0  Higher = better
Poor readings	< 1.0 Lower = worse	< 0.5 Lower = worse	< 0 Lower = worse

Key Performance Ratios

The foundation of portfolio analysis rests on three primary performance ratios: the Sharpe Ratio, the Treynor Ratio, and Jensen’s Alpha.

Each metric offers unique insights into an investment strategy’s effectiveness, and understanding when and how to use each ratio will introduce ways to evaluate and potentially improve your portfolio’s performance.

Case Studies of Performance Metrics

Sharpe Ratio: If a portfolio returns 12% annually with 10% volatility, and the risk-free rate is 2%, the Sharpe Ratio would be (12% – 2%) / 10% = 1.0.

Treynor Ratio: If an alternative portfolio has a 15% return, the risk-free rate is 2%, and the beta measure is 1.2, the Treynor Ratio would be (15% – 2%) / 1.2 = 10.83%.

Jensen’s Alpha: If CAPM predicts a portfolio should return 10% based on its beta, but it actually returns 12%, then its alpha is 2%.

It is important to note that these multiples and ratios use historical data and so are not predictive. They also assume normalised return distributions which means that a reading taken soon after a once-in-a-decade market crash would give additional statistical weight to data from an event which occurs infrequently.

Implementing Performance Measurement in Your Trading Strategy

Integrating performance metrics into your trading routine can be done by developing a step-by-step approach.

1. Establish a baseline: Calculate your current portfolio’s Sharpe Ratio, Treynor Ratio, and Alpha using historical data from the past 12–24 months.
2. Measure future developments: Create a monthly review process where you recalculate these metrics and compare them to appropriate benchmarks.
3. Select a benchmark: When using an index as a benchmark, take care which one you choose. For example, UK investors might consider using the FTSE 100 or FTSE All-Share whereas those with global portfolios might benefit from comparing against instruments which track the MSCI World Index.
4. Document your findings: Use a trading journal, noting any significant changes in metrics and the market conditions that may have influenced them.

Backtesting and Validating Your Portfolio Performance

Further insight into performance can be gained by incorporating the Sharpe and Treynor Ratios and Jensen’s Alpha metrics into any backtesting you perform on your investment strategy.

Applying more advanced metrics to historical scenarios makes it possible to understand how your strategy would have performed during different market conditions, including the 2008 financial crisis or the COVID-19 market volatility. There are some guidelines to follow to ensure the integrity of your stress-testing remains high:

• Focus on out-of-sample testing to avoid overfitting.
• Apply conservative assumptions and consider using walk-forward analysis to continuously validate your strategy as new data becomes available.
• Split your historical data into training and testing periods, developing your strategy on one set and validating it on another.
• Pay particular attention to how your Sharpe Ratio behaves during market downturns – a strategy that maintains a positive Sharpe Ratio during bear markets demonstrates true robustness.
• Remember that backtesting has limitations. Transaction costs, slippage, and changing market dynamics can affect real-world performance.

Applying Performance Metrics to Your Portfolio

Putting theory into practice requires adapting the three metrics to your specific investment approach. The methods of application and usefulness of any data readings may be influenced by the types of assets you invest in and the nature of the strategy you adopt.

Systematic Strategies

Traders adopting a systematic approach have the option of integrating performance metrics directly into their algorithm’s decision-making process.

That enables being able to set, for example, minimum Sharpe Ratio thresholds for entering new positions, or using rolling Alpha calculations to identify when strategies begin underperforming.

Discretionary Strategies

Discretionary traders can use these metrics as part of periodic portfolio reviews and strategy adjustments. That includes comparing key metrics against those of professional fund managers or exchange-traded funds (ETFs) with similar objectives.

Final thoughts

Developing a more nuanced view of performance returns introduces another way to adapt your portfolio to be better able to navigate risk events and achieve your investment aims.

While some of the analysis is data-heavy, the good news is that once you have a firm grasp of the basic principles, you can use tools such as Portfolio Risk Insights found on eToro to make the experience more user-friendly.

Visit the eToro Academy to learn more about advanced investment strategies.

FAQs

How often should I calculate my portfolio’s performance metrics?

Calculate performance metrics at least monthly for active portfolios and quarterly for long-term investments. More frequent monitoring helps identify trends early, but avoid over-analysing daily fluctuations.

Do retail and institutional investors use the same metrics?

Yes. Advanced performance metrics are used by both retail and institutional investors. The interpretation of the data may be different, for example, a Sharpe Ratio above 1.0 is considered good for retail investors whereas professional fund managers often target ratios above 1.5.

Should I use different benchmarks for different parts of my portfolio?

Yes, use appropriate benchmarks for each asset class. Compare UK equities to FTSE indices, global stocks to MSCI World, and bonds to relevant fixed-income benchmarks for accurate performance assessment.

Can the Jensen Alpha on my portfolio be negative?

Yes. Unfortunately this means your investment has underperformed the market or its benchmark on a risk-adjusted basis. Your returns were lower than what was expected given the level of risk taken. Factors which could play a part in this happening include poor decision-making, market conditions, or management fees being too high.

How often should I rebalance my investment portfolio?

Many investors rebalance their portfolio on an annual basis. This strikes a balance between rebalancing too frequently or not frequently enough. The exact time frame will be influenced by the nature of the strategy you are applying, market conditions, and any changes to your personal circumstances which might shift your investment aims.