Calculating performance returns for an investment portfolio of mutual funds is just the starting point for the performance evaluation process. While a portfolio's absolute returns may satisfy most investors, a more thorough evaluation should be performed in order to determine the success of each asset class versus its benchmarks and peers. So how is your portfolio really doing? Read on to find out.

Equity Peer Comparisons
The comparative equity peer groups have evolved as fast as the styles of management have evolved. Any equity manager or equity mutual fund can be compared to an overall universe of other managers. This peer comparison is particularly helpful to gauge the effectiveness of the fund's management team in times when absolute returns fall in the outer range of historical norms.

Equity manager universes come in all shapes and sizes, from all equity, small-cap, international and style peer groups. Two of the most common style peer groups of large capitalization equity managers are growth and value. If your money is invested with a value style manager or mutual fund, then it should be compared to other value style funds along with an overall equity universe. Value managers tend to invest in companies that appear to be trading below their intrinsic values, so their fund performance will most likely not be similar to that of a growth style manager during any given time period. A growth manager conversely, avoids value stocks and steers toward companies he or she believes will grow faster than the overall market. Growth managers typically have return patterns similar to other growth managers.

There are a variety of databases for both the institutional and the mutual fund market; Callan and Lipper are two commonly quoted purveyors of comparative universes. They gather investment performance from managers or from posted mutual fund returns as they are reported. The universe of managers (usually more than 1,000) is broken down into quartiles and sometimes deciles. For example, a mutual fund ranking in the top quartile has performed in the top 25% of an equity fund universe. The goal of each manager is to rank as high as possible in the universe.

Within the general equity universe there are also peer universe cut outs. For example, of the 1,000 managers or funds in a general universe, maybe 350 would be growth managers. It would be important for a growth manager to rank highly among his or her peers at all times. This would matter even more if the growth style had underperformed and had been out of favor over the period to which the ranking applies. (For more insight, read Has Your Fund Manager Been Through a Bear Market?)

Bond Fund Evaluations
Bond managers and bond mutual funds can also be ranked against their peers. There are general bond universes, which are broken down into segments of the bond market. Because the spreads between the highest and lowest bond returns tend to be smaller compared to equity fund spreads, peer rankings can be very similar across many managers. In order to distinguish the success of a bond fund or manager, other tools can be used to evaluate performance. (To learn more, read Evaluating Bond Funds: Keeping It Simple.)

Various effects are considered non-systematic and can be somewhat controlled by the bond manager. Sector success would be when the manager has made sector bets into areas that may have been undervalued and have therefore outperformed the general market. The best way to evaluate a portfolio using the sector differential tool is to use "before" and "after" portfolio reviews. Because this is a form of interest rate betting, choosing the sweet spot on the yield curve will make all the difference in a before-and-after review. The interest rate effect is successful when the bond manager picks the right place to invest on the yield curve in an interest rate anticipation strategy. Because interest rate anticipation is one of the riskiest active strategies, you could almost assume its success if the manager performed well above or below the rest of the pack.

It is also important to rule out both residual and yield-to-maturity effects as they are considered systematic and cannot be controlled by the manager's decisions. Yield refers to the passive nature of bond investing, in which part of the return is earned just through the interest from the residual effects refer to random events that affect bond returns. Pulling these two effects out of the equation should reveal how effectively the manager produced returns through active management. (For more information on mutual fund evaluation, see Morningstar's Stewardship Grade Scores Big.)

Performance Attribution
Attribution analysis is a relatively new tool and not widely used by individual investors. The method breaks down the components of a fund's returns versus a benchmark to determine where the manager earned his or her fees. By examining the manager's portfolio construction choices, the user can determine which decisions were most profitable or costly. The flexibility of attribution analysis allows the user to cross-evaluate any type of manager against any type of benchmark. One key element of all attribution models for both stock and a bond comparison is that the results will trace the impact of three major decisions through a top-down approach. While they are called various names by various industry groups, generally they are overall investment policy decisions, asset allocation decisions and security selection decisions.

Overall policy decisions trace any impact not associated with asset allocation or security selection. The asset allocation decision refers to how the manager distributes portfolio dollars across cash, fixed-income and equity securities. An example of an asset allocation decision would be to hold a 10% cash weighting when the market is falling. If the manager beats the market during this time period, he or she will most likely have a positive allocation effect. Security selection can have some effects on performance, but these are usually not as significant as asset allocation effects. Empirical evidence has shown that security selection accounts for a relatively small effect on overall portfolio performance. The attribution analysis draws out the effects of superior security selection on total performance.

Tips of Using Evaluation
While it is very important to evaluate performance beyond just calculating returns, it is necessary to keep it all in perspective. This includes a thorough evaluation of a manager before hiring or firing. Start with the most general tool and move to the most specific tools so as not to draw inaccurate conclusions about a manager's style or strategy. Most importantly, use the longest time intervals available. As economic cycles get shorter and shorter, so do investment cycles. For example, if one is evaluating a growth manager for selection, it would behoove the investor to see how the manager performed over time periods when growth was in and out of style. It would also be helpful to make sure the manager did not style drift, meaning slowly slip away from his or her discipline as styles changed. While a move like that may help a manager's overall performance, it will not improve his or her success as a growth manager. (For more on style drift, read Focus Pocus May Not Lead To Magical Returns.)

As the investment world becomes more complex, so does the process of performance evaluation. Merely calculating total investment performance on an absolute basis is not enough to evaluate the overall success of a fund or manager. Equity and bond managers need to be evaluated based on their rankings against their peers and against managers of similar styles. Beyond that, attribution analysis quantifies the success of strategic decisions, asset allocation and security selection. It is important to keep in perspective the ebb and flow of investment cycles and, most importantly, to always evaluate performance on the longest time frame available.