13. Assessing investment performance Flashcards
“past performance is not necessarily a
guide to future performance” however…
We know that:
* UK equities tend to outperform UK deposits and bonds over the medium
to long term
3 Basic performance measures
- The time value of money
- Compounding & Discounting
- Real & Nominal terms
Time Value of Money - a recap
Definition: Money received today is worth more than the same amount in the future due to its earning potential.
Future Value (FV):The amount a sum of money today will grow to, given a specific interest rate over time.
- Example: £1 today at 5% interest will be worth £1.05 in a year.
Present Value (PV): The current worth of a future sum of money, discounted by the interest rate.
- Example: A promise of £1.05 in 12 months has a present value of £1 today.
Compensation for Delay: Receiving money later must come with compensation, like interest or growth.
Practical Example: Retailers offering “buy now, pay later” allow the buyer to:
- Earn interest or growth on their money before making the payment.
- Benefit from inflation reducing the real value of the debt over time.
Main Implication: A single sum or series of payments can be converted to an equivalent value today or calculated for its future value.
Compound interest and discounting - a recap
Simple Interest: Interest calculated only on the original capital each year.
- Example: £1,000 at 4% simple interest = £40 per year.
- After 3 years: £1,120 total.
Compound Interest: Interest is added to the capital, and future interest is earned on both the capital and the interest.
- Example: £1,000 at 4% compound interest = £1,040 after 1 year, £1,081.60 after 2 years, £1,124.86 after 3 years.
Discounting: The reverse of compounding, used to determine how much to invest now to achieve a future target sum.
- Example: To reach £15,000 in 8 years with a 6% return, you discount the future amount by 6% each year to find the present investment needed.
Application: Both simple and compound interest principles apply to any percentage return, including capital growth.
Real and nominal terms - a recap
Nominal Rate of Return: The stated interest rate or return, without adjusting for inflation.
* Example: 5% nominal return on a deposit account.
Real Rate of Return: The nominal rate adjusted for inflation.
* Example: 5% nominal rate with 3% inflation = 2% real return.
Tax Impact: The real return may be further reduced by taxes.
- Example: A basic-rate taxpayer earning 5% interest with 3% inflation has a net nominal return of 4%, and a net real return of 1%.
- For a higher-rate taxpayer, real return can be nil if inflation equals the post-tax nominal rate.
Holding period return - What is it? When is it used? and how is it calculated?
13.3 Measuring the return
Holding Period Return (HPR):Measures the total investment return (income + capital growth) over a specific period, expressed as a percentage of the original investment.
* Used for comparing returns over the same or different periods.
* Annualisation: HPR can be annualised for investments held over different periods.
Formula:
HPR= (I + (C1 -C0) ÷ C0) x 100
Where
* I = Income received (e.g., dividends).
* C0 = Original investment.
* C1 = Final investment value.
Example:
Bought shares for £100, sold for £110, and received £4 dividends.
= 14%
Annualising the return (holding returns) - Why? How is it useful? How to calculate?
Assumptions?
Annualising Returns: Allows comparison of investments with different holding periods by assuming consistent returns over time.
Why Annualise?: To compare returns on an equal basis, especially when investments are held for different durations.
Key Assumption: Assumes the same rate of return over all periods, which may not always hold true but provides a useful comparison.
Formula:
(1+r)*n =1+R
Where:
* r = Return for the holding period.
* n = Number of holding periods in a year.
* R = Annualised return
Example:
* A 14% return over six months: (1.14 × 1.14) = 1.30 = 30% annualised return.
* A 5% return over three months: 1.05^4 = 1.215 = 21.5% annualised return.
Time‑weighted rate of return - Definition? Why? and calculation?
benefit?
Definition: TWR measures the compound rate of return for a unit of money over a given period, dividing returns into equal sub-periods, allowing for comparison when cash flows occur at different times.
Why Use It?: TWR is ideal for comparing investment fund performance, as it eliminates the impact of money entering or leaving the fund, focusing on how well the money was managed.
Calculation Example:
* Investment over 4 quarters with returns of 4%, 7%, 6%, and 8%.
* To find the TWR: 1.04 x 1.07 x 1.06 x 1.08 = 1.274 or 27.4% compounded return over the period.
GIPS Requirement: Funds must use TWR to comply with Global Investment Performance Standards (GIPS), ensuring standardized performance reporting.
Benefit: TWR isolates the manager’s investment performance, unaffected by timing of cash flows into or out of the fund.
Three ways that the risk-adjusted return can be shown?
- The Alpha
- The Sharpe ratio
- The information ratio
The alpha - recap: Definition, purpose, application, limitation?
What does a positive and negative alpha show?
13.4 Risk‑adjusted returns
Definition: Alpha measures the risk-adjusted return of a share or collective fund compared to a benchmark (typically an index).
Purpose: It shows the difference between the actual return and the expected return, based on the security’s beta (volatility measure).
Interpretation:
- A positive alpha (e.g., 3%) indicates that the investment outperformed the benchmark by 3%, suggesting the additional risk was worth taking.
- A negative alpha means the investment underperformed the benchmark, implying the risk was not justified.
Contrast with Beta: While beta measures how much a security moves with the market, alpha shows how much it moves independently of market fluctuations.
Application: Often seen as a measure of a manager’s stock selection skills, though it may also reflect luck.
Limitation: Both alpha and beta are based on past performance, so they are not always reliable for predicting future outcomes.
The sharpe ratio? - Definition, formula, advantages, interpretation, etc.
13.4 Risk‑adjusted returns
Definition: The Sharpe ratio measures how well an investment’s return compensates for the risk taken, comparing it to a risk-free investment (e.g., Treasury bills).
Formula:
- (Return - Risk free return) ÷ Standard deviation
Example: If a unit trust has a return of 7%, a standard deviation of 5%, and the risk-free return is 3%, the Sharpe ratio is:
- (7-3) ÷ 5 = 0.8
This means the investment provided 0.8% return per unit of risk above the risk-free rate.
Advantages:
* Does not rely on beta, making it more reliable as standard deviation is considered more accurate.
* Allows comparison between different types of securities using the same calculation.
Interpretation:
* A higher Sharpe ratio indicates better returns for the same level of risk.
* Good returns and low standard deviation result in a high Sharpe ratio, while high standard deviation needs higher returns to maintain a strong Sharpe ratio.
Comparison Use: The Sharpe ratio is only meaningful when compared with other investments.
The information ratio? - Definition, formula, advantages, interpretation, etc.
13.4 Risk‑adjusted returns
Definition: The Information Ratio (IR) measures risk-rated return, comparing a fund’s return to a chosen benchmark (not a risk-free rate, unlike the Sharpe ratio).
Formula:
* (Fund return - Benchmark return) ÷ tracking error
Tracking error: Measures how closely a fund follows its benchmark.
Performance Scale:
* 0.5 = Good performance
* 0.75 = Very good
* 1.0 = Excellent
Usage:
- Useful for evaluating funds with similar asset allocation.
- Positive IR indicates a manager’s ability to outperform the benchmark and suggests better stock-picking skills.
Interpretation:
* Higher IR implies better fund performance relative to its benchmark, often outperforming average fund managers.
Stock market indicies - What is it? What are they useful for?
Definition: Stock market indices measure the combined price movements of a range of shares to show the performance of a market or sector over time.
Uses for Investors:
- Compare performance of shares or investments with the overall market or specific sectors.
- Identify market trends and potential future movements.
- Compare fund performance against a benchmark index.
- Help analysts observe economic activity.
Types of Indices: Not limited to shares—include property, gilts, bonds, and other assets like art.
Limitations:
- Weighted indices can be distorted by large companies.
- Most indices focus on capital returns, excluding dividends (underestimating total returns).
- No consideration of transaction costs or tax.
- Global companies listed on multiple exchanges can distort the index’s reflection of a country’s economy.
Summary of the main stick indicies - FSTE 100, FTSE All-share
FTSE 100
* Composition: 100 largest UK companies by share capitalisation.
* Real-Time Index: Updates during the day with price changes.
* Market Capitalisation Weighting: Companies’ influence on the index is based on their market cap (e.g., AstraZeneca at 8.64%).
* Significance: Represents around 81% of UK total market capitalisation.
* Impact of Changes: Significant share price movements (e.g., AstraZeneca) can greatly influence the index, while smaller companies (e.g., BT) have less impact.
* Relegation/Promotion Effects: Losing/gaining FTSE 100 status affects market confidence and share price due to tracker fund adjustments.
FTSE All-Share
Composition: Includes all companies in FTSE 100, FTSE 250, and FTSE Small Cap.
Coverage: Represents around 99% of UK market capitalisation across 38 sectors.
Indicator: Good indicator of the London market’s long-term performance.
Calculation: Not a real-time index; value calculated at the end of each business day.
Summary of the main stick indicies - Dow-Jones, NASDAQ, NIKKEI 225
Dow Jones Industrial Average (DJIA)
* Composition: 30 of the largest and widely held blue-chip companies on the New York Stock Exchange.
* Purpose: Represents major segments of the U.S. economy.
NASDAQ Composite Index
* Composition: Approximately 3,000 companies listed on the NASDAQ stock exchange.
* Technology Focus: More than 50% weighting in technology stocks, making it a key indicator for the tech sector.
* Global Scope: Includes companies outside the USA.
Nikkei 225
* Composition: Index for the Tokyo Stock Exchange, comprising 225 Japanese stocks.
* Unweighted Index: Based on the average price of the constituent stocks, rather than market capitalisation.
Using Rankings for evaluating fund performance - key definitions
13.6 Evaluating managers’ returns
Median
* Definition: The middle value in a list of funds ranked by performance.
* Example: In a list of 11 funds, the 6th fund is the median; in a list of 10 funds, the median is between the 5th and 6th funds.
Quartile
* Definition: Division of ranked funds into four equal groups (25% each).
* Example: In a list of 60 funds, each quartile contains 15 funds.
* Expectation: Many funds aim to be consistently in the first and second quartiles, though no fund can be top-ranked all the time.
Sector Average
* Definition:The mean return of all funds in a sector.
* Calculation: Total returns from all funds divided by the number of funds.
* Limitations: The mean can be skewed by one or two funds with extreme performance (very high or very low).
Evaluating managers’ returns
Using peer group comparisons for evaluating fund performance
Definition: Comparing a fund’s performance with similar funds (peer group) to assess effectiveness.
1.Fund Similarity: Ensure peer groups consist of funds with comparable market sectors, objectives, and styles.
2.Cash Flow Impact:
- Regular cash inflows allow funds to seize new investment opportunities without selling assets.
- Large withdrawals may force a fund to sell assets, impacting performance.
3.Fund Size:
- Smaller funds are more flexible and can trade without affecting market prices.
- Larger funds may struggle with liquidity and market impact when selling.
4.Volatility and Risk:
- Ratings organizations provide volatility metrics.
- Less volatile funds are generally more reliable; consider risk-adjusted returns in assessments.
5.Performance Measurement:
- Analyze performance over longer periods (minimum of three years recommended).
- Assess yearly performance to identify consistent returns versus temporary spikes.
6.Management Techniques:
- Funds in the same sector often use similar investment techniques.
- Contrarian strategies can carry risks; understanding their implications is essential.
Information Sources
* Data Availability: A wealth of comparative data is available through:
Internet sources (up-to-date and flexible filtering).
Investment magazines (less flexible, may be outdated).
* Performance Presentation:
Data typically organized by product types (unit trusts, investment trusts, etc.) and sorted into specific fund sectors.
Conclusion
* Informed Decisions: Investors have access to extensive performance information, aiding in better investment decisions through careful analysis of funds and their peer groups.
How to calculate the weighted return of an investment?
Multiply the benchmark return by the percentage of the portfolio
