As the year draws to a close, it's crucial for both institutions and individuals to evaluate the historical performance of their investment portfolios. This assessment should not merely be a ritual; it’s a process that lays the foundations for informed decision-making for the following periods.

The purpose of the review is to better understand where current problems may exist and what to then do about them.  To do this, you’ll need to answer three crucial questions:

1.     Are your goals and risk profile still the same?

2.     Did you make the right investments over the prior periods?

3.     Are the asset classes, and their weightings, in your portfolio still appropriate?

With the commonly held view that at least 80% of your portfolio’s return is attributed to which asset classes you have allocated your investment into, it’s important to implement a strategic approach and allocate the right proportion of wealth to each asset class.

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Rebalancing Without Overreaction

So, what determines the right asset allocation?

Firstly, another important question needs to be answered; how big is your portfolio relative to your goals?

For smaller investors, a basic portfolio tends to be constructed with liquid investments of public equities and fixed income in proportions that comply with the investor’s risk appetite. A more complex goal-based approach can also be followed; individuals sets performance targets at the outset, based on their needs and wants. For each type of goal, a specific allocation is set that takes into account the importance and priority of the goal and accordingly, the risk of the related investment.

Financial planners can help individuals with this by providing simulations of probability of meeting such goals, based on models that could take in a wide range of varying assumptions.

Revisiting such goals, assessing the portfolio’s performance and adjusting it to stay within the envisaged allocation (i.e. rebalancing), is a must.

For Shariah conscious investors, the standard portfolios could vary as it is more likely that public equities will form a larger proportion. This is due to the scarcity of quality public fixed income sukuks and the fact that equity is generally subject to lower zakat cost.

For wealthier individuals and family offices who have wealth beyond their quantifiable lifetime goals, maximizing the risk adjusted return on their portfolio is key, hence a systemic performance approach is needed. This starts with identifying the appropriate strategic asset allocation that satisfies their return and risk objectives, followed by an evaluation of how well the portfolio has performed over the prior periods. Measuring the performance of such more complex portfolios is often done relative to a benchmark.

Having measured the performance of your portfolio, how it has been done and an understanding of the quality of the performance follows. Such performance attribution and appraisal complete the steps of portfolio assessment, which we discuss below.

Ultimately, such analysis will lead to making decisions on whether to rebalance the portfolio or to change the way investments are done.

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Stages for Assessing a Diversified Portfolio

1.     Performance measurement

When measuring how well your investments have performed, comparing the portfolio to well-known indices or benchmarks, is a common theme. Of course, all investors wish to achieve returns that beat their benchmark (the difference between the two being the excess return), but it’s also crucial to understand that relying on an individual index is unlikely to be sufficient when evaluating a diversified investment portfolio. Assessing performance against the right mix of indices, with each index’s weight reflecting the components of your specific allocation of assets, would be a better approach.

As such portfolios invest in other assets classes beyond the public markets, benchmarks for these asset classes also need to be identified. 

Real Estate Benchmarking: Choosing an appropriate real estate benchmark requires careful consideration and an understanding of its limitations. Typically, these benchmarks don’t consider transaction costs and may not demonstrate the lower leverage expected in a Shariah-compliant real estate portfolio. It’s important to note that when comparing real estate investment returns, we are not looking at one or two single property investments. Instead, it’s assumed that we hold a well-diversified pool of real estate investments, usually only achievable by investing through funds. Investing in individual properties has extremely high specific/concentration risk, potentially resulting in much lower risk adjusted returns.

Private Equity Benchmarking: In private equity, assessing performance typically involves calculating the internal rate of return (IRR). Common benchmark indices for US and European private equity include those provided by Cambridge Associates, Preqin, and Burgiss. Furthermore, the public market equivalent (PME) method helps compare private equity IRRs with returns from publicly traded equity indices. As in real estate, this comparison assumes investing in a diversified pool of private companies, not just a few.

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2.     Performance attribution and appraisal

Once you have a grasp on the performance of your portfolio, it’s important be aware of how this has been done. Such performance attribution helps to explain how much of the performance is due to manager skill, how much was not as a result of the manager’s decisions and why the portfolio beat or missed the target benchmark.

Such attribution can be done at two levels; ‘Macro Attribution’ is often associated with the strategy behind the asset allocation whereas ‘Micro Attribution’ is to do with determining the impact of selecting specific fund managers and their performance.

By using the information gathered above, you can decipher the quality of your portfolio’s performance. Such analysis may include asking questions such as:

·       Is the performance the result of your or your selected fund manager’s skill or simply down to luck?

·       Were market or economic developments the drivers of performance?

·       Did the manager make astute adjustments during the period that aided performance?

Appraisal of your portfolio in this way could determine whether future performance will continue along the same path.

Various risk-adjusted return ratios, such as Sharpe, Treynor, Information Ratio and others are often used to assess the value of active investment management by providing additional details about the outcome of managerial decisions.

This may be a more meaningful way of measuring portfolio performance, but the investor should still not lose sight of overall market conditions. Expectations may need to be adjusted as a result of other factors, such as economic, political or legal pressures.  

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Making the Right Portfolio Decisions

At the time of portfolio assessment, the opportunity for rebalancing should always incorporate an honest review of your current circumstances and future objectives, as well as the timeframe for achieving them. Your risk tolerance may also have changed during prior periods, and this would need to be addressed.

Regardless of the assets that make up your portfolio, all aspects require due diligence and an understanding from the investor. Venturing into private markets, for instance, provides the potential to benefit from higher returns than can be achieved elsewhere, but only if the most competent managers are selected. At Mnaara, we only select Shariah-compliant funds with strong performing management teams and a top-quartile ranking, but this should still not hinder you from making your own assessment and analysis when assessing and optimizing your portfolio.

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Author

Saad Adada, CFA