THE SACRILEGIOUS DIARIES: MEASURING THE IMPACT OF PORTFOLIO TURNOVER

This is a quick post on how to measure the impact, and it applies as much to an institutional as a retail investor.

The trick is to decompose our portfolio excess returns into three drivers; stock selection, position sizing, and then dynamic allocation of capital (or trading). 

Decomposition can be fun, too!

Here is how you can see which of these drives your returns. Firstly, look back to the actual securities you owned at the end of a period (say, a quarter, or a month) and then create an equal weighted portfolio of these names. You can measure the subsequent performance of these names to determine the “buy-and-hold” performance of the portfolio. You can then compare that to the market’s return to determine the returns to “stock selection”.

Then go back to that same starting portfolio and see what actual size you were in comparison to the total investment and walk that forward. In other words, don’t equal-weight things, look at your actual weights. Then you can compare your weighted returns to your equal-weighted returns. This is called the returns from “position sizing”.

Then, finally, look at the actual returns of your investing (which implicitly is after all commissions). Compare this to your size-weighted portfolio returns to determine any value added from managing (aka trading) your positions in between those measurement periods. This is called the returns to “dynamic capital allocation”.   

You can use your portfolio and choose the right benchmark to do the same kind of analysis.  Aggregating the three drivers of returns noted above, we get the following equation.

You should try something like this to see where your returns are coming from.  You might discover that your trading is terrible and stock selection is great. Or your trading is great but initial position sizing is poor.  You might conclude you should switch entirely to a buy-and-hold approach (aka stop trading) or you might see that initial position sizing gives you a leg up.

No matter the answer, we think it is definitely the kind of information that is worth finding out