warranting a return of 12.00 + 32.95 = 44.95% marginally higher than the market’s
41.40. but the actual return earned by P of 70.60 is far higher than this. The real problem
is in the third component – the compensation required for P’s poor diversification is a
whopping 29.52%; this is what turns the tables on P making his performance somewhat
mediocre. The portfolio manager should now know what to do with such a portfolio: the
unsystematic risk of the portfolio needs to be brought down. Throughout this book,
particularly in the chapter on portfolio design, we have talked of the dangers of seeking
excess returns at the cost of diversification and the steps required to avoid it. The Fama
decomposition pinpoints the source of the problem and now it is up to Mr. P to correct it.
In other cases, the Fama decomposition may indicate that the problem is one of excessive
beta. The portfolio manager would then have to examine whether he has been allowing
his beta to exceed the target value decided by him on the basis of his attitude towards
risk.
In yet other cases, the analysis may show that the problem is not due to risk but to the
return itself being inadequate. Further investigation may reveal that the poor return may
have been caused by high operating costs. For example, the portfolio may have been
turned around too often leading to very high brokerage and other transaction costs. This
may indicate the need for a less active portfolio management strategy. Alternatively, the
return may have been low because of poor stock selection. This may mean that the
portfolio manager needs to revise his knowledge of fundamental and technical analysis,
firm and industry analysis, etc.
In short, with performance evaluation, the wheel has turned a full circle and we are back
to the essentials of portfolio management with which we started this book. As we
approach the end of this book at this point, we would like to remind our readers that the
wheel never stops. The path to superior performance lies in a continual refinement of
skills with regular evaluation of performance to tell us how far we have come and how
far we need to go.