5 Critical KPIs for your investment portfolio in 2022

The first and most urgent question for management is always can we measure the characteristics of the process? This is why every time new COVID strain arises the first question is whether the current tests can diagnose it, are our tools good enough to detect the issue? It is the same with portfolio and asset management! You need to have good tools to measure the investment, before you can apply any kind of management.

Coming into 2022 markets are changing at even faster pace. In order to keep up with all the changes you need to have the right KPIs (Key Performance Indicators) to your investment portfolio. Tracking the right KPIs will enable both asset managers and individual investor to keep on top of any potential issues with their portfolios. Usually asset managers will provide some common KPIs to their clients and individual investors will track whatever the platform gives them. While these metrics will cover most of the information they have to be augmented with some new KPIs to shed light on current market risk and economic trends. For example one year ago inflation was not a problem, but coming into 2022 it is the main topic:

US inflation reached 7% in December as prices rise at rates unseen in decades

Even FED in their statement finally started to take inflation into account. This means that you need measure your portfolio against that inflation, because in reality even if the market gives you 10%, if inflation has eaten 15% of your savings then you have pretty big problem.

Answering this need to stay on top of economic trends here are the 5 most important KPIs to measure the performance of your investment portfolio/strategy:

1. Alpha, it is always alpha

Alpha will remain the most dominant measure of performance. In the last few years the entire stock market has been up and therefore the fact that you made positive return can’t tell you whether you have good investments or it simply because of the general market movement. So we expect this trend to continue.

How it is estimated?

Alpha is estimated by subtracting the benchmark from your portfolio’s return to get the pure return that is over the market. The formula uses is:

Everything you need is easily accessible. You know your return for the month (if not please stop investing immediately!!!) and value of S&P 500 can be obtain by public websites like Yahoo Finance.

How to read it?

Alpha tells you whether your portfolio has outperformed the market portfolio. You want it to be higher as possible, but it is especially important to be positive. If alpha is positive then you are beating the market, but if it is negative then you better think about another asset manager, different investors or just buy ETF on S&P 500 from Vanguard, because its cheaper and you obviously can’t achieve market returns on your own.

2. Cost per dollar of alpha

Rising inflation means increasing prices of everything including brokerage. In this new reality investors need to have tight control on their cost of trading. It doesn’t matter if you have achieved 10% return if you paid half in transaction cost for trades. One great estimator of this trade cost is tracking the trade cost of achieving $1 of alpha. In this way you know how expensive is your additional return. It is important to note that this indicator is more advanced and useful for people who are managing large portfolio and have relatively frequent trading. For “buy and hold” investors is not very useful, because cost incurs only when entering the position and cashing out, there is no rebalancing that can eat the achieved alpha.

How it is estimated?

To estimate such indicator you need data on all of the transactions from your investment platform/broker. Keep in mind in some cases this could be a lot of data, but with the right approach and tools it doesn’t really matter. So to estimate it you need to go through several steps:

  • Estimate what would be the dollar value of your portfolio if you have invested only in S&P 500;

  • Subtract this “potential value of passive portfolio” from the current dollar value of your portfolio and this is your alpha in dollar amount;

  • Divide the total costs (all transactions both buy & sell) to the dollar alpha and you have it!

How to read it?

As this is more advanced indicator first thing is to know from what it depends. Current business models of most of the brokers means that essentially when you have more trades you will have higher costs. Therefore this indicator will be higher to those investors who trade more often. It is really a KPI for efficiency, if one investor can achieve their alpha with X trades and another with X+10 trades then the first one is much more efficient. In more simple terms when you make mistakes you need to make new trades to amend them and this means more trading cost per dollar of alpha achieved. If in the end it turns out that you are paying more than $1 for every $1 of alpha then my friend you need to stop trading and just buy ETF of S&P 500, because you are destroying your wealth.

3. Return vs. Inflation

Entering in 2022 the hot topic of financial markets is inflation. Due to a lot of reasons now we are living in a world with high inflation and it is for the first time in 2 decades. All prices are rising and your money are worth less and less, therefore your investment portfolio need to make up the difference. You need to put your savings to work and outperform inflation, so you need to track that performance against current inflation rates.

How it is estimated?

Estimating the premium of your portfolio on inflation is very easy – you only need to subtract it from the return of the portfolio. However key moment is to use smoothed inflation or get the YoY inflation rate (basically the change in price for last 12 months) then divide it on 12 to get the inflation for 1 month:

The data is again publicly available, there are number of sources that provide inflation data. We usually use CPI from Bureau of Inflation Statistics or OECD data for the global portfolios.

How to read it?

Well it is easy – you need to have this KPI positive at any cost! If you are not achieving more than the inflation then you are destroying your wealth. So inflation can get extreme and it will be very difficult to stock portfolios to keep up and in this case you are seeking max return to close this gap as much as possible.

4. Top 3 exposures to risk factors

More complex KPI is estimating the top 3 risk factors that are impacting your portfolio. Currently we are at all time high of the stock market and the amount of risk involved is also incredibly high. So it is good idea to have a stricter risk management. One way to do that is find out the top 3 risk expositions of your portfolio. For the uninitiated risk factors are general economic measures like price of oil, inflation, interest rates, moves of crypto etc. and if you are too exposed to certain factors then any changes in its price affect greatly the value of your portfolio. That’s why it is a good idea to keep an eye of the biggest 3-5 exposures.

How it is estimated?

The simplest way to estimate is with linear regression. In this case the returns of each stock in your portfolio is regressed against all relevant risk factors and betas are estimated, then by weighting these betas with individual portfolio weights we get the portfolio beta for each risk factor which is it exposure. Applying this model sounds complex but in reality there are readily available tools to help you. However it is very important that you know what you are doing otherwise there could be mistakes.

How to read it?

Once exposures/betas for each factors are estimated then it is very easy to interpret. High betas mean more dependency of this risk factor, and you don’t want that. In ideal case all betas are in similar range and there is not one clear leader, in this case the portfolio is well balanced against those risks and it is safer.

If you are using any kind of risk model is great. Find below quick 11min training on how to measure the accuracy of your risk model:

5. HHI index

Another simple KPI for risk management is the level of concentration in your portfolio. Ideally to be less risky you want more diversified portfolio i.e. wealth is distributed almost equally among stocks and there is no clear leader that concentrates the money. If there are such leader then if something happens to this stock it will greatly impact the entire portfolio. The most common tool to track the level of concentration is Hirsh-Herfindahl Index (HHI).

How it is estimated?

HHI is estimated at each point of time and tracks the level of concentration. The formula for HHI is:

To estimate it you want the portfolio weight of each security in your portfolio i.e. what percentage of total wealth is invested in the particular stock (when summed those weights have to give 1). Then you need to find the sum of the squares of these weights.

How to read it?

HHI is basic estimator to level of concentration. Higher value of HHI means that your portfolio is more concentrated into few stocks. If you want to reduce the risk level and increase diversification you need to look how to lower the HHI. Also it is good idea to track the difference in HHI at different points of time (each month) so not to overlook if your portfolio gets overconcentrated because of one successful stock.

Now you have them all 5 most important KPIs for you investment portfolios in 2022.

I am considering making a free video lesson in which I will show you how to estimate them with some free BI tools. Tell me in the comments if you would like such a video lecture?