MIP Ch 12: Evaluating Portfolio Performance Flashcards
(38 cards)
Describe how to calculate the time-weighted return (TWR) of an investment portfolio
Assuming n external cash flows occur between time 0 and time t at times t1, t2, . . . , tn,
there will be n 1 subperiod calculations:
rti
pMVti CFti q MVti1
MVti1
for i 1 to n
rti
pMVti q MVti1
MVti1
for i n 1
The TWR is the product of the subperiod growth factors
rTWR p1 rt1qp1 rt2q p1 rtn1q 1
Describe the money-weighted return of an investment portfolio
The growth rate R that solves the following equation:
MVt MV0p1 Rq
t
CFt1p1 Rq
tt1 CFtn p1 Rq
ttn
An IRR calculation can be solved for iteratively with a computer program
Describe a situation for a portfolio when the money-weighted return (MWR) is different
from the time-weighted return (TWR)
MWR and TWR can have material differences if funds are contributed/withdrawn
from an account prior to a period of strong or weak performance
MWR is sensitive to the size and timing of the cash flows, while TWR is not
Example: There will be a positive effect on MWR if funds are invested right before a
strong earnings period
When should an investment portfolio use MWR or TWR for measuring performance?
TWR is more appropriate when evaluating managers who have little or no control
over external investments
MWR is more appropriate if the investment manager has control over external
investments
Example: Private equity fund managers can determine when they receive and
return capital to investors
Compare and contrast the number of times one needs to value the portfolio for
calculating TWR and MWR
TWR requires a valuation of the account each date there is an external cashflow,
which is a drawback
In contrast, the MWR only requires a valuation at the beginning and end of period
This is computationally simpler
Describe how to calculate the linked internal rate of return (LIRR) of a portfolio
LIRR estimates the TWR by calculating the MWR over time intervals (i.e. weekly),
and then chain-linking these returns together
Valid approximation if there are no large external cash flows and volatile swings in
subperiod performance
Example: Suppose over a month, an account’s MWR is calculated each week
MWR’s are 2.1% in week 1, 0.16% in week 2, -1.4% in week 3, and 1.8% in week
4. The LIRR is:
RLIRR p1 0.021q p1 0.0016q p1 0.014q p1 0.018q 1
0.0265, or 2.65%X
Is it acceptable to annualize a return for an investment period that is shorter than one
year?
Returns should not be annualized for periods shorter than a year
Otherwise, we would be extrapolating the account’s returns over a sample period
to the full year
Describe some data quality issues in performance measurement
Accounts invested in illiquid assets may have inaccurate valuations
For many thinly traded fixed-income securities, estimated prices may be derived
on dealer quoted prices for securities with similar attributes (i.e. sector, credit
rating)
This is called matrix pricing
Breakdown of portfolio return into market return, style return, and active return
The portfolio return, P, can be broken down into the following components:
P M pB Mq pP Bq M S A
B = the return of the benchmark
M = the return of the market index
S B M = return that reflects the manager’s investment style
A P B = returns from active management decisions
List properties of a valid benchmark
- Unambiguous (identity and weights of securities are clearly defined)
- Investable (it’s possible to hold the benchmark as a portfolio)
- Measurable (benchmark return can be calculated on a frequent basis)
- Appropriate (consistent with the manager’s style)
- Reflective of current investment opinions
- Specified in advance (before the start of an evaluation period)
- Owned (the investment manager should accept the performance of the
benchmark)
List seven types of benchmarks
- Absolute
- Manager Universes
- Broad Market Indexes
- Style Indexes
- Factor-Model-Based
- Returns-Based
- Custom Security-Based
Describe the issues of an absolute benchmark
An absolute benchmark specifies a minimum return target for the portfolio (i.e.
must return at least 7%)
The main issue with this type of benchmark is it is not investable
Describe the manager universe benchmark
The manager universe benchmark compares the manager’s returns to a universe
of portfolios with similar characteristics
The investment objective may be for the managers’ fund to exceed the median
account return from the manager universe
Describe the problems with a manager universe benchmark
- The median account return from the universe cannot be specified in advance
- It is not investable
- Ambiguous, since the identity of the median manager typically remains unknown
- Unable to verify the benchmark’s appropriateness by examining whether the
investment style it represents adequately corresponds to the account being
evaluated - Survivors bias in the manager universe because poor performing accounts may
be removed
Describe pros and cons from using broad market indices
Pros: Easy to understand, widely available
Cons: Manager’s style may not be reflected in the market index
Describe factor-model based benchmarks
Simplest form is a one-factor model
RP aP PRI P
RP = the return on the account
RI = the return on the market index
P = sensitivity to returns on the market index
P = nonsystematic component of the return (the residual)
Multi-factor models that consider additional factors such as a company’s size,
industry, and growth characteristics
RP aP b1F1 b2F2 bKFK P
Describe the pros and cons from using factor-model based benchmarks
Pros: Help managers and fund sponsors better understand a manager’s
investment style, since they capture the systematic sources of return that affect an
account’s performance
Cons: Not always intuitive and may not be investable
Ambiguous, because one can build multiple benchmarks with the same factor
exposures, but generate different returns
Describe how to construct a Returns-based benchmark
This benchmark is constructed as a weighted average of the investment style
indices that most closely track the account’s returns
The weights can be constructed from a regression using historical data
Describe the pros and cons from using a Returns-based benchmark
Pros: Satisfies most benchmark validity requirements
Cons:
Some of the style indexes may have positions that the manager finds unacceptable
Requires many months of historical observations to establish a statistically reliable
estimate of the weights to each style index
Describe the pros and cons from using custom security benchmarks
A custom security benchmark weights a manager’s universe of investable
securities in a particular fashion
Pros: Can be more suitable than a published index
Cons: Expensive to construct and maintain, and can lack transparency
List the steps for constructing a custom-security benchmark
- Identify important aspects of manager’s investment process
- Select securities consistent with that investment process
- Devise a weighting scheme for the benchmark securities
- Review the preliminary benchmark
- Rebalance the benchmark on a set schedule
List some tests of having good benchmark quality
Low systematic biases
Low tracking error
Similar risk characteristics with the fund
Higher coverage
Low turnover
Positive active positions
What are the three inputs of macro attribution?
- Policy Allocations
The fund sponsor determines target asset allocation weights and weightings to
individual managers within the asset categories - Benchmarks
Broad market indexes (i.e. S&P 500) are normally used as benchmarks for asset
categories
More narrowly focused indexes (i.e. U.S. Large-Cap Growth) are used to represent
the manager styles - Fund Returns, Valuations, and External Cash Flows
Returns must be calculated at the manager level for each asset category
List six decision-making levels in macro attribution
- Net Contributions
- Risk-Free Asset
- Asset Categories
- Benchmarks
- Investment Managers
- Allocation Effects
