Understanding the sources of a portfolio's return can help in monitoring the effectiveness of the management process and in identifying its strengths and weakness. Managers can more effectively evaluate the consequences of their decisions. A framework that analyzes sources of return may also serve as a communication tool for marketing purposes, provide insight for the portfolio sponsor, and aid in the selection of managers by desired skill and style.

The goal is to enlarge the capabilities of bond performance analysis, and to provide a precise and comprehensive structure both for the measurement of the total realized return and for attribution of that return to its sources.

HedgeOne's performance analysis system includes all portfolio activity over the evaluation period. Rather than simply reviewing the performance of a static portfolio at the beginning of a period, we include in the analysis all transactions, cash flows, contributions and withdrawals, cash account activity and any other changes in the portfolio structure. The components of return performance also reflect timing of managerial decisions.

To review all activity over the evaluation period, a time-weighted return is used. HedgeOne uses the modified Dietz’ method ("Performance Presentation Standards," 1993, AIMR).

First, we divide the return into components of trading, and withdrawal or other portfolio activities. Denoting the total realized portfolio return as R, we write

R = T + B, where

T is the return due to portfolio activities;

B is the return from holding the portfolio.

B = I + P + M

where

I is the return of the coupon payment;

P is the return of the principal payment (prepayment or sinking fund);

M is the return due to the market condition changes.

M may be broken down in different ways. If the manager is interested in sector selection, M can be subdivided as follows:

M= B + O + S

where

B is the return due to changes in the base term structure;

O is the return due to changes of the option;

S is the return due to sector changes.

If the manager is interested in speculating on the shape of the interest rate curve, M can be subdivided as follows:

M = R + S + H

where

R is the return due to a parallel change in the term structure;

S is the return due to a twist in the term structure;

H is the return due to a hump in the term structure.

The parallel, twist and hump perturbations are modelled by the functions k1, k2, k3 in the following figure.