Practitioner Portfolio Construction and Performance Measurement: Evidence from Europe

Responses to a survey of investment management practitioners in Europe show that most practitioners are aware of key academic concepts in portfolio construction. But they still resort to ad hoc heuristics when they construct portfolios. Consideration of risk–return matters is less common in performance evaluation than in portfolio construction. An economically significant firm-size effect plays a role in the use of sophisticated (versus unsophisticated) portfolio construction but not in performance measurement.We surveyed 229 investment management practitioners in Europe for information on their methods of constructing portfolios and measuring performance. Our purpose was to assess the impact of academic finance research on investment industry practices. The responses show that most practitioners are well aware of key academic concepts in portfolio construction and frequently consider risk–return trade-offs. They often resort to ad hoc heuristics, however, when they construct their portfolios. For example, investment managers are aware of the importance of extreme risks, but the instruments they use to measure them are inadequate. To deal with estimation risk, practitioners use arbitrary weight restrictions rather than portfolio construction methods that explicitly address estimation risk. Responses relating to measurement of ex post performance show that risk–return considerations are less common in this area than in portfolio construction. Extreme risks are hardly taken into account in performance measurement, and adjustments for risk are crude. In general, practitioners use both sophisticated and unsophisticated techniques. When we analyzed the response patterns to determine what drives the differences in sophistication, we found an economically significant firm-size effect for portfolio construction. That is, response patterns from large institutions are markedly different from those from small institutions; small firms tend to use less sophisticated tools than large firms use. For performance measurement, we found a firm-size effect, but it is less pronounced than it is for portfolio construction.In view of the current failure of the industry to adopt sophisticated measures, one is compelled to wonder why investors do not demand better risk assessment in portfolio construction and performance evaluation. Some would argue that greater financial literacy of investors is key in improving matters; others would call for external regulators to mandate the use of appropriate risk measures. Although the evidence reported in this article does not allow us to take a stance on that issue, we believe that ensuring a sufficient transfer of knowledge about portfolio and risk management concepts from research results to practice is a necessary condition for sound investment processes in the industry.