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J10 - Discretionary Investment Management > 11. Measuring Portfolio Performance > Flashcards

11. Measuring Portfolio Performance Flashcards

1
Q

A. Indices (page 2)

A

Intended to bring together the movements of an individual security and show which direction a market has moved over a period of time.

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2
Q

A1. What are indices used for? (page 2)

A
  • monitoring market performance
  • comparing shares with sectors or markets
  • comparing fund managers and how they perform
  • constructing index funds
  • measuring systematic risk (Beta)

Moving averages used to see the short and long-term movements of shares:

  • short term moving averages are 20 days or less
  • long term moving averages are 100 days or more
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3
Q

A2. Index construction (page 2)

A
  • some indices are more suited for use as benchmarks

- others are better suited to provide short-term information on the movement of the markets

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4
Q

A2A. Weighting of constituents (pages 2 & 3)

A

MARKET VALUE WEIGHTED INDICES

  • majority of the most widely used indices (FTSE 100) are adjusted for ‘free float’
  • each index is the summation of the market value (or market capitalisation) of all of the companies within the index
  • thus a company with 2x the market capitalisation of a smaller company will have 2x the impact on the index

Issue = companies whose share prices have risen will be a larger part of the index than those that have fallen, so indices will be overweight in those companies whose share prices have risen

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5
Q

A2A. Weighting of constituents (pages 2 & 3)

CONTINUED

A

FREE FLOAT

  • Free Float is the number of shares that are available for trading on the stock market
  • companies whose controlling directors hold the majority of shares will be excluded from the free float as these shares are not available to other investors
  • the same applies to companies that hold each others shares and again are not available to the public, so excluded from the free float (known as cross-holding)
  • founders shares and government holdings are usually excluded too
  • The free float more accurately reflects the available supply of shares
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6
Q

A2A. Weighting of constituents (pages 2 & 3)

CONTINUED

A

PRICE-WEIGHTED INDICES (Dow Jones 30)

  • the prices of the included stocks are added together and divided by a divisor, which reflects the number of stocks in the index
  • the divisor is adjusted downwards if the company has a stock split, which can happen if it is being successfu; and therefore lead to its weighting in the index actually being reduced!
  • price-weighted indices do not make good benchmarks for performance measurement because higher-priced stocks carry more weight than lower-priced stocks
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7
Q

A2A. Weighting of constituents (pages 2 & 3)

CONTINUED

A

UNWEIGHTED INDICES

  • an equal investment in each stock is assumed
  • share price and market capitalisation are irrelevant
  • a percentagr rise in the share price of any company will have an equal impact on the index
  • tend to be used for academic work
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8
Q

A2B. Total return verses capital only (pages 3 & 4)

A
  • Indices can be constructed as total return or capital only
  • FTSE, for example, offer both
  • CAPITAL ONLY indices reflect price-changes only, and are only useful if the income received is then distributed
  • TOTAL RETURN indices should be used in most cases to measure performance
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9
Q

A2C. Limitations of indices (page 4)

A
  • market capitalisation can mean that very large companies can have a big effect on the market and therefore the index they form part of
  • if an index reflects changes in capital values only, it is ignoring reinvested dividend income which can make a substantial difference to long-term performance
  • do not include transaction costs (buying and selling)
  • assume that the investor is fully committed to buying and holds no cash balances
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10
Q

A2D. Benchmark regulation (page 4)

A
  • EU-wide regulation came into effect in 2018 to regulate indices that used as benchmarks

In the eyes of EU Benchmarks Regulation, an index becomes a benchmark if:

  • it is used to determine the amount payable under a financial instrument
  • it is used to measure the performance of an investment fund, for the purpose of:
    1. tracking a return
    2. defining the asset allocation of a portfolio
    3. computing performance fees
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11
Q

A3. Global indices (page 5)

A3A. FTSE UK Index series (page 5)

A
  • FTSE is now wholly owned by the LSE
  • Eight main FTSE indices

FTSE ALL SHARE

  • consist of 630 companies
  • 98% of UK market capitalisation
  • aggregation of FTSE 100, FTSE 250 and FTSE SmallCap indices
  • updated in real time
  • companies reviewed quarterly
  • designed to behave like an actual portfolio and indicator of the London market’s long-term performance

FTSE 100

  • 100 largest companies by market capitalisation
  • represents 80% of UK market capitalisation
  • updated in real time
  • companies reviewed quarterly
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12
Q

A3A. FTSE UK Index series (page 5)

CONTINUED

A

FTSE 250

  • next 250 larges companies by market capitalisation after the FTSE 100
  • represents 15% of UK market capitalisation
  • updated in real time
  • companies reviewed quarterly
  • has two formats, one that includes and one that excludes investment companies

FTSE 350

  • combination of the FTSE 100 and FTSE 250
  • covers 95% of UK market capitalisation
  • has two formats, one that includes and one that excludes investment companies
  • also calculated according to the dividend yield of the constituent companies ranked in descending order
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13
Q

A3A. FTSE UK Index series (page 6)

CONTINUED

A

FTSE AIM Index Series

  • tracks the performance of shares listed on the AIM
  • free float
  • reviewed quarterly
  • there are three main indices:
    1. FTSE AIM All-Share Index
    2. FTSE AIM 50 (tracks top 50 AIM by market-cap)
    3. FTSE AIM 100 (top 100 AIM by market-cap)

FTSE Fledgling

  • comprises of companies too small for the FTSE All-Share
  • together they represent less than 1% of UK market capitalisation

Other main FTSE Indices

  • FTSE UK Gilts Indices
  • FTSE Sterling Corporate Bond Index
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14
Q

A3A. FTSE UK Index series (page 6)

CONTINUED

A

Widely used UK indices

  • FTSE All share - for UK Equities
  • FTSE Index-Linked (all stocks) - for Index-Linked securities
  • FTSE Gilts (all stocks) - for Government securities
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15
Q

A3B. Overseas indices (pages 6 & 7)

A

DOW JONES INDUSTRIAL AVERAGE (USA)

  • takes the share prices of 30 blue-chip companies and measures their movements
  • price weighted index (using a divisor)

STAND & POOR’S (S&P) COMPOSITE (USA)

  • consists of 500 companies listed on the NY stock exchange
  • represents 75% of US market capitalisation
  • weighted according to the free float

THE NASDAQ COMPOSITE (USA)

  • an index of small young companies
  • these companies are usually in technology or biotech
  • used as a reference for tech stocks
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16
Q

A3B. Overseas indices (pages 6 & 7)

CONTINUED

A

NIKKEI 225 (JAPAN)

  • based on 225 large, publicly owned Japanese companies
  • price-weighted index

TOKYO STOCK PRICE INDEX (TOPIX) (JAPAN)

  • provides a better guide to the overall market
  • tracks all domestic companies of the exchange’s first section

DAX 30 (GERMANY)

  • consists of the 30 larges quoted German companies
  • updated in real time
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17
Q

A3B. Overseas indices (pages 6 & 7)

CONTINUED

A

HANG SENG INDEX (HONG KONG)

  • composed of a representative sample of Hong Kong stocks
  • is market weighted

CAC GENERAL INDEX (FRANCE)
- records the opening prices of the Paris cash market

CAC 49 (FRANCE)

  • updated in real time
  • market-value-weighted index of the largest stocks

MSCI WORLD INDEX / FTSE ALL-WORLD INDEX
- are global indices covering global equity markets

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18
Q

B. Measurement of return (pages 7 & 8)

A

Covering the various measures used by investment managers.

19
Q

B1. Holding period return (page 8)

DESCRIPTION

A

HOLDING PERIOD RETURN

  • compares returns on different investment
  • encompasses the total return, including income and capital gains, over a period
  • expressed as a percentage (%) of the original cost
  • it equals all income received plus capital gains during the period as a % of the original investment

DISADVANTAGES:

  • period looked at must be the same when comparing two investments
  • does not take into consideration timing of cash flows or compounding of returns
20
Q

B1. Holding period return (page 8)

CALCULATION

A

HOLDING PERIOD RETURN CALCULATION:

     D + V1 - V0 R =  -------------------    x 100 to get a %
            V0
R = holding period return
D = income received during the period
V0 = price/value at acquisition
V1 = price on selling

EXAMPLE:
Investment costs £100, pays a dividend of £10 and is sold for £110 after six months

   £10 + £110 - £100 R =  -------------------          = 0.20 x 100 = 20%
            £100
21
Q

B2. Relative return (pages 8 & 9)

DESCRIPTION

A

RELATIVE RETURN

  • is the return from an investment/portfolio measured against the return from a benchmark index
  • shows how well the investment/portfolio has performed relative to a benchmark
  • measures whether a fund manager had added value above the index return
22
Q

B2. Relative return (pages 8 & 9)

CALCULATION

A

RELATIVE RETURN CALCULATION:

rREL = r - rB

r = the total holding period return
rB = the benchmark return

EXAMPLE:

Portfolio has a total return of 12% and the benchmark rose by 10%

rREL = 12% - 10% = 2%

23
Q

B3. Money verses time weighted rates of return (pages 9 & 10)

A

MWR and TWR - incorporate cash inflows/outflows and useful for when cashflows are used

24
Q

B3A. Money-weighted rate of return (pages 9 & 10)

DESCRIPTION

A

MONEY WEIGHTED RATE OF RETURN

  • a modified form of the holding period return
  • adjusts for cash inflows into the portfolio

ISSUES

  • not considered appropriate when trying to compare different portfolios
  • strongly influenced by the timing of cash flows
  • does not identify whether the overall return for the investor is due to the ability of the fund manager or as a result of when additional funds were invested
25
Q

B3A. Money-weighted rate of return (pages 9 & 10)

CALCULATION

A

MONEY WEIGHTED RATE OF RETURN CALCULATION

           D + V1 - V0 - C MWR =  -----------------------
           V0 + (C x n / 12)
n = number of months remaining in the year
C = the new money introduced during the year
V0 = the price or value at acquisition
V1 = the price on selling

EXAMPLE

V0 = £20,000
V1 = £24,000
D = nothing as no income paid out
Money In = £3,000 in March
Money Out = £2,000 in September (withdrawal)
                       D + V1 - V0 - C MWR =  -------------------------------------------
           V0 + (C x n / 12) + (C x n /12)

             0 + 24,000 - 20,000 - 1,000 MWR =  ---------------------------------------------------
            [20,000 + (3,000x9/12) + (-2,000x3/12)]

                        3,000 MWR =  --------------------------------- = 0.1379 x 100 = 13.79%
           20,000 + 2,250 - 500
26
Q

B3B. Time-weighted rate of return (pages 10 & 11)

DESCRIPTION

A

TIME WEIGHTED RATE OF RETURN

  • can compare the performance of one fund manager to another by eliminating distortions caused by the timing of new money
  • does this by breaking down the return for a particular period into sub-periods
27
Q

B3B. Time-weighted rate of return (pages 10 & 11)

CALCULATION

A

TIME WEIGHTED RATE OF RETURN CALCULATION

1 + R = (1 + r1) (1 + r2) (1 + r3) (1 + r4) … (1 + rn)

R = TWR
ri = holding period return in each sub-period

EXAMPLE

  • Portfolio starting value of £100m
  • Value after 6 months is £110m
  • £2m cash dividend paid out
  • Value at end of 12 moths is £130m
  1. HOLDING PERIOD
      D + V1 - V0 R =  -------------------    x 100 to get a %
         V0
R = holding period return
D = income received during the period
V0 = price/value at acquisition
V1 = price on selling
    2 + 110 - 100 r1 = --------------------- = 0.12 x 100 = 12%
           100

        130 - 110 r2 = --------------------- = 0.1818 x 100 = 18.18%
           110
  1. LINK THE RETURNS TO CALCULATE THE TWR
    1 + R = (1 + r1) (1 + r2)
    1 + R = (1.12) (1.1818)

1 + R = 1.3236

R = 1.3236 - 1
R = 0.3236 or 32.36% (0.3236 x 100)
28
Q

B4. Bond yields (page 11)

B4A. Interest Yield (page 12)

DESCRIPTION

A

BOND INTEREST YIELD
- expresses the annual income from a bond as a percentage of the price an investor would pay for the bond

ISSUES

  • can be misleading as bonds may create a capital gain or loss if held until redemption, depending upon the price at which they were purchased
  • bonds may trade above or below their par or nominal value because their prices are not fixed
  • if the coupon is above current interest rates and the issuer has a strong credit rating, the bond will trade above par
29
Q

B4A. Interest Yield (page 12)

CALCULATION

A

BOND INTEREST YIELD CALCULATION:

                              Coupon Interest Yield =    -------------------   x 100
                           Clean price

Example:

Coupon = 8%
Clean price (purchase price) = £124.27
                      8 6.44% =    -------------------   x 100
                 £124.27
30
Q

B4B. Redemption yield (pages 12 & 13)

DESCRIPTION

(CALCULATION IN FORMULA SECTION)

A

BOND REDEMPTION YIELD

  • is a more accurate calculation of the yield on a bond
  • takes into account the income payments from a bond and the capital gain or loss from holding the bond until maturity
  • adjusts the value of each payment according to when it is received
  • assumes the bond is held to maturity and that coupons can be reinvested at the redemption yield
  • assumes that the investor reinvests each interest payment
31
Q

B4C. Semi-annual and annual yields (pages 13 & 14)

A
  • semi-annual yields can be doubled to get an annual yield
32
Q

B4D. Index-linked bonds (page 14)

A
  • calculating a yield for an index-linked bond requires an assumption of the future inflation rate, since the fact value of the bond will increase with inflation
33
Q

B5. Measuring returns from different asset classes (page 14)

A

VALUING INVESTMENTS WHERE THERE ARE NO RELIABLE MARKET PRICES AVAILABLE

  • broker quotes can be used for OTC derivatives
  • models can be used to value derivatives

WHEN AN INVESTMENT IS GEARED, AS IS OFTEN THE CASE WITH PROPERTY, THE GEARED AND UNGEARED RETURN MAY BE QUOTED

  • unleveraged return only shows the return of the original investment
  • leveraged return includes the effect of the leverage and typically gives a larger rise or fall

IN SOME ASSET CLASSES, IRR RATHER THAN TWR IS COMMONLY USED TO ASSESS PERFORMANCE
- for private equity, the fund manager, rather than the client, often commits to making additional investments in a company and therefore a TWR is not appropriate

NO SUITABLE BENCHMARK
- for alternative investments, there may be no suitable benchmark against which to measure performance

34
Q

C. Risk-adjusted returns (pages 14 & 15)

A

There are various ways to measure risk-adjusted returns

35
Q

C1. Sharpe Ratio (pages 14, 15 & 16)

DESCRIPTION

A

SHARPE RATIO

  • is a measure of the risk-adjusted return of a stock
  • measures the excess return for every unit of risk that is taken in order to achieve the return

WHAT IT MEASURES

  • the higher the sharpe ratio the better the return on an investment compensates an investor for the risk taken
    i. e. the better it’s risk-adjusted performance has been
  • a negative sharpe ratio indicates that a risk-free asset would have performed better
36
Q

C1. Sharpe Ratio (pages 14, 15 & 16)

CALCULATION

A

SHARPE RATIO CALCULATION:

standard deviation of the return on the investment

EXAMPLE:

Return = 10%
Risk-free return = 4%
Standard Deviation = 8%

                             10 - 4 Sharpe Ratio =     ------------ = 0.75 (or 0.75%)
                                8

Portfolio earned a 0.75% return above the risk-free investment.

37
Q

C2. Alpha (pages 16 & 17)

DESCRIPTION

A

ALPHA (JENSEN’S ALPHA)

  • the difference between the return that would be expected from a security, given its beta, and the return it actually produced
  • is the part of a return that cannot be explained by movements in the overall market
  • sometimes referred to as ‘value added’

WHAT IT SHOWS

  • positive alpha shows that the investment has performed better than expected given its beta
  • negative alpha indicates that it has performed worse than expected given its beta
    i. e. for a portfolio it allows us to quantify the value added or taken away by a manager through active management
38
Q

C2. Alpha (pages 16 & 17)

CALCULATION

A

ALPHA CALCULATION

a = actual portfolio return - [Rf + Bi (Rm - Rf)]

BODMAS: 1. Rm - Rf 2. Bi x (Rm - Rf) etc
Rf = risk-free rate of return
Rm = market return
Bi = beta of the fund or portfolio

EXAMPLE

Portfolio return = 12%
Beta of fund = 1.5
Market return = 8%
Risk-free rate = 2%

39
Q

C3. Information ratio (pages 17 & 18)

DESCRIPTION

A

INFORMATION RATIO

  • used to assess the risk-adjusted performance of active portfolio managers
  • shows the consistency to which they beat the benchmark index
  • measures the relative return achieved by an investment manager divided by the amount of risk the manager has taken relative to a benchmark

NEGATIVE INFORMATION RATIO
- investor would have received a better return by matching the benchmark using tracker fund

40
Q

C3. Information ratio (pages 17 & 18)

CALCULATION

A

INFORMATION RATIO CALCULATION

                                       Rp - Rb Information Ratio =  -------------------------
                                 tracking error
Rp = portfolio return
Rb = benchmark return

EXAMPLE

Fund return = 13%
Benchmark return = 10%
Fund tracking error = 6%

                                     13 - 10 Information Ratio =  ------------------------- = 0.5
                                          6
41
Q

Chapter 11 Key Points (pages 19 & 20)

A

INDICES

  • can be used to monitor market performance
  • can be used to compare the performance of a particular stock with its sector or a market
  • can be used to construct index funds
  • can be constructed in different ways:
    1. price-weighted
    2. equal-weighted
    3. market capitalisation-weighted (most common)
  • most indices are capital-only, but some are total-return
  • bond indices are usully weighted by the market value of the bond issue
  • FTSE 100 is 80% of UK market-capitalisation
  • FTSE All Share is 97% of UK market-capitalisation
42
Q

Chapter 11 Key Points (pages 19 & 20)

CONTINUED

A

MEASUREMENT OF RETURN

  • total return measures the capital and income return from an investment
  • relative return compares a return to a benchmark
  • two methods used to measure portfolio performance:
    1. MWR
    2. TWR (eliminates time created distortions)
  • the interest yield measures the income derived from a bond as a percentage of the clean price but does not take account of any capital gain or loss if the bond is held until redemption
  • measuring returns from assets sometimes needs to take into account the lack of reliable market prices
43
Q

Chapter 11 Key Points (pages 19 & 20)

CONTINUED

A

RISK-ADJUSTED RETURNS

  • sharpe ratio compares different risk-reward options
    1. the higher the sharpe ratio, the better an investment compensates an investor for the risk taken
  • alpha measures the return that would be expected from a security, given its beta, compared to what it acheived
    1. is a measure of the manager’s stock-picking skill
  • information ratio assesses the risk-adjusted performance of active portfolio managers
    1. used to gauge the skill of a fund manager and shows the consistency at which they beat the benchmark

J10 - Discretionary Investment Management (15 decks)

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