EVALUATING PORTFOLIO PERFORMANCE Flashcards
LOS 32.a: Demonstrate the importance of performance evaluation from the perspective of fund sponsors and the perspective of investment managers.
LOS 32.b: Explain the following components of portfolio evaluation: performance measurement, performance attribution, and performance appraisal.
- Performance measurement to calculate rates of return based on changes in the
account’s value over specified time periods. - Performance attribution to determine the sources of the account’s performance.
- Performance appraisal to draw conclusions regarding whether the performance was
affected primarily by investment decisions, by the overall market, or by chance
32.c: Calculate, interpret, and contrast time-weighted and moneyweighted rates of return and discuss how each is affected by cash contributions and withdrawals.
The time-weighted rate of return (TWRR) calculates the compounded rate of growth over a stated evaluation period of one unit of money initially invested in the account.
The money-weighted rate of return (MWRR) is an internal rate of return (IRR) on all funds invested during the evaluation period, including the beginning value of the
portfolio.
In contrast, TWRR is only a linking of
subperiod returns and is not affected by external cash flows.
LOS 32.d: Identify and explain potential data quality issues as they relate to calculating rates of return.
For many thinly-traded fixed-income securities, current market prices may not be available. Estimated prices may be derived from dealer quoted prices on securities
with similar attributes. This is known as matrix pricing.
LOS 32.e: Demonstrate the decomposition of portfolio returns into components attributable to the market, to style, and to active management.
A portfolio return can be broken up into three components: market, style, and active management.
P=M+S+A
where:
P = investment manager’s portfolio return
M = return on the market index
S = B - M = excess return to style; difference between the manager’s style index (benchmark) return and the market return. S can be positive or negative.
A = P - B = active return; difference between the manager’s overall portfolio return and the style benchmark return.
LOS 32.f: Discuss the properties of a valid performance benchmark and explain advantages and disadvantages of alternative types of benchmarks.
- Specified in advance. The benchmark is known to both the investment manager and
the fund sponsor. It is specified at the start of an evaluation period. - Appropriate. The benchmark is consistent with the manager’s investment approach
and style. - Measurable. Its value and return can be determined on a reasonably frequent basis.
- Unambiguous. Clearly defined identities and weights of securities constituting the
benchmark. - Reflective of the manager’s current investment opinions. The manager has current
knowledge and expertise of the securities within the benchmark. - Accountable. The manager(s) should accept the applicability of the benchmark and
agree to accept differences in performance between the portfolio and benchmark as
caused only by his active management. - Investable. It is possible to replicate the benchmark and forgo active management.
Absolute. An absolute benchmark is a return objective (i.e., aims to exceed a minimum target return).
Advantage:
Simple and straightforward benchmark.
Disadvantage:
An absolute return objective is not an investable alternative.
Manager universes. The median manager or fund from a broad universe of managers or funds is used as the benchmark. The median manager is the fund that
falls at the middle when funds are ranked from highest to lowest by performance.
Advantage:
It is measurable.
Disadvantages:
Manager universes are subject to “survivor bias,” as underperforming managers often go out of business and their performance results are then removed from
the universe history.
Fund sponsors who choose to employ manager universes have to rely on the compiler’s representations that the universe has been accurately compiled.
Cannot be identified or specified in advance so it is not investable.
LOS 32.g: Explain the steps involved in constructing a custom security-based benchmark.
Step 1: Identify the important elements of the manager’s investment process.
Step 2: Select securities that are consistent with that process.
Step 3: Weight the securities (including cash) to reflect the manager’s process.
Step 4: Review and adjust as needed to replicate the manager’s process and results.
Step 5: Rebalance the custom benchmark on a predetermined schedule.
(Doubt —-)
32.h: Discuss the validity of using manager universes as benchmarks.
Apart from being measurable, it fails the other properties of a valid benchmark:
It is not possible to identify the median manager in advance.
Because the median manager cannot be determined ahead of time, the measure also fails the unambiguous property.
The benchmark is not investable, as the median account will differ from one evaluation period to another.
It is impossible to verify the benchmark’s appropriateness due to the ambiguity of the median manager.
LOS 32.i: Evaluate benchmark quality by applying tests of quality to a variety of possible benchmarks.
Systematic Bias- There should be minimal systematic bias in the benchmark relative to the account.
Returns to the manager’s active decision making (A) should be uncorrelated with the manager’s investment style (S). That is, whether the style benchmark performs well should have no effect on the manager’s ability to generate active return, A.
Tracking error
Risk characteristics.
Coverage., Turnover
Positive active positions. An active position is the difference between the weight of a security or sector in the managed portfolio versus the benchmark.
LOS 32.j: Discuss issues that arise when assigning benchmarks to hedge funds.
The difficulty of defining benchmarks has led others to use the Sharpe ratio as the basis of comparing hedge fund managers.
LOS 32.k: Distinguish between macro and micro performance attribution and discuss the inputs typically required for each.
LOS 32.l: Demonstrate and contrast the use of macro and micro performance attribution methodologies to identify the sources of investment performance
Macro performance attribution is done at the fund sponsor
level. The approach can be carried out in percentage terms (i.e., rate-of-return) and/or in monetary terms (i.e., dollar values).
Micro performance attribution is done at the investment manager level.
There are three main inputs into the macro attribution approach: (1) policy allocations;
(2) benchmark portfolio returns; and (3) fund returns, valuations, and external cash
flows.
Macro attribution starts with the fund’s beginning market value and ends with its ending
market value. In between are six levels of analysis that attribute the change in market
value to sources of increase or decrease in market value. The levels are:
1. Net contributions.
2. Risk-free asset.
3. Asset categories.
4. Benchmarks.
5. Investment managers.
6. Allocation effects
Micro performance attribution analyzes individual portfolios relative to designated benchmarks. The value-added return (portfolio return minus benchmark return) can be broken into three components: (1) pure sector allocation, (2) allocation/selection interaction, and (3) within-sector selection
Pure sector allocation assumes the manager holds the same sectors as in the benchmark and that within each sector the same securities are held in the same proportion as in the benchmark.
LOS 32.m: Discuss the use of fundamental factor models in micro performance attribution
