How To Analyze Your Portfolio Like a Hedge Fund Manager

So you've got a portfolio of individual stocks, and you're looking at it next to a benchmark like the S&P 500. "Pretty good!" You might be thinking to yourself. 

But is it really that good? 

The risk level of your portfolio might be totally different than that of the S&P 500, so just looking at percentage returns isn't a fair comparison. How can we solve this problem? With math, of course! 

Allow me to introduce you to a very cool risk-adjusted performance metric, the Modigliani Risk-Adjusted Performance measure or M2 (it was invented by Nobel-prize winner Franco Modigliani and his granddaughter, Leah Modigliani -- two Modiglianis, get it? I know, I know, it's actually embarrassing). 

So What Do I Do? 
Mis based on the Sharpe Ratio, which you might have heard of already. The Sharpe Ratio also gives you a risk-adjusted performance measure, but it's dimensionless, meaning it has no units. 

That not only sounds a little weird, it's a bit tough to interpret. If your portfolio has a Sharpe Ratio of 0.8 and your buddy's is 0.6, you know that yours is "better" -- but how much better is it, really? 

M2 solves this problem by putting risk-adjusted performance in terms we can all understand: percentage points. If your M2 is 5.8% and your friend's is 5.2%, you know you did 0.6% better than he or she did. This makes gloating much easier. 

How Do I Do It? 
First, you need a portfolio to analyze and a benchmark. The benchmark can be a real one, like the S&P 500, or it can be subjective, like another portfolio. You'll want to get as much data as you can -- monthly returns over five years is pretty great. 

To make your calculations, you'll need the following: 

Thing You Need

More Details

Excel or a similar program

You probably don't want to crunch these numbers with a calculator

Your portfolio's total returns

You can export the raw data into Excel to calculate a total return for the whole period. Or maybe you have this number already!

Your benchmark's total returns

Again, you can export the raw data. You might just be able to get the number depending on what you use as a benchmark.

Your portfolio's standard deviation

Take your data and use the Excel formula to calculate. 

Your benchmark's standard deviation

Same as above (unless you have this number from another source).

A risk-free asset's total returns

The 10-year Treasury is a popular one -- again, export the data to get an aggregate number if you need to.

A risk-free asset's average total returns

Same as above.

A cup of coffee

This part should be obvious.

One important detail: Make sure all the numbers come from the same period of time! Your fearless and yet humble author has been known to make such blunders. This is where the coffee comes in. 

Step One: Sharpe Ratio 
The first thing you want to do is find your portfolio's total returns and your risk-free asset's total returns. Next, use the appropriate spreadsheet formula to calculate the standard deviation of your total returns (this measures volatility). 

Then, plug those numbers into this formula: 

Step Two: Getting to M2 
To get to M2 you just need two more numbers: the standard deviation of your benchmark and the average risk-free rate for the period. You can calculate them in Excel or find the data online, depending on what you're using as a benchmark. 

Input these numbers into the formula below: 

And... Now What? 
After you compute M2 for your portfolio, the S&P 500, your neighbor's 401(k), and your mom's IRA, you can calm your enthusiasm and see how well you're doing. Is your M2 way higher than the S&P 500? That's pretty great, because it means you're getting a lot of excess return by comparison -- adjusted for the risks in both portfolios. 

Of course, M2 isn't by any means the end-all be-all of analysis, but it does give you another level of insight. It comes with its share of caveats (namely: it's for portfolios, not stocks; don't use bad data; and if your returns are very skewed, as opposed to looking like a bell curve, it might not be so accurate), but it's a nice tool for those days when you want to sit back and really see how things are going, and think about where you might want them to go next. 

Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Read/Post Comments (0) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 3025111, ~/Articles/ArticleHandler.aspx, 9/5/2015 3:49:21 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Anna Wroblewska

Anna began her career in finance as a college intern at a hedge fund, and she hasn’t been able to escape its siren song ever since. She’s done academic research at Harvard Business School and UCLA, was the COO of a wealth management firm, and now writes about finance, economics, behavior, and business.

Today's Market

updated 6 hours ago Sponsored by:
DOW 16,102.38 -272.38 -1.66%
S&P 500 1,921.22 -29.91 -1.53%
NASD 4,683.92 -49.58 -1.05%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes