Ch 15 - Performance Measurement (1)

Question 1

When calculating rates of return, take extra care with:

Answer 1

The timing and size of all cashflows

Differentiating between investment income and new money

Tax and expenses

Question 2

Merits of the money-weighted rate of return

Answer 2

Useful as an absolute measure of the achieved return (positive)

Affected by the timing and size of cashflows (negative) - Thus, not a good basis for comparing two different fund managers

Question 3

Money-weighted rate of return - may be alright to compare two different fund managers if either of the following conditions hold:

Answer 3

No large cashflows (relative to the funds involved) in the valuation period

No great fluctuations in market values during the period (or rate of return is stable over the period)

Question 4

TWRR and MWRR are similar when:

Answer 4

No large cashflows (relative to the funds involved) in the valuation period

No great fluctuations in market values during the period (or rate of return is stable over the period)

Question 5

Merits of time-weighted rate of return

Answer 5

Not affected by the size or timing of cashflows - Therefore, can use as a basis for comparing different investment managers

Does not give the rate actually achieved

Impractical (think why for short answers like this)

Question 6

Practical solution is to use the linked internal rate of return as an approximation for the TWRR. Conditions needed for the approximation to be good:

Answer 6

Rate of return is stable over each inter-valuation period

Small cashflows between periods relative to the size of the fund

Note:
LIRR and TWRR will be exact if the valuations occur on the same date as the cashflows!

Question 7

Merits of the Linked Internal Rate of Return

Answer 7

Practical approximation for the TWRR

Does not give the rate of return actually earned on the assets over the period

Question 8

Linked Internal Rate of Return

Answer 8

Determine the value of the fund at various dates throughout the year (e.g. monthly or quarterly intervals)

For each inter-valuation period, calculate the MWRR

Link the inter-valuation MWRRs together to get the LIRR for the year

Question 9

Two basic ways in which to compare the performance of a portfolio with an index:

Answer 9

Compare the actual value of the portfolio with what would have been achieved had the money been invested in the same way in an index (gives us the notional value of the fund)

Comparing the TWRR from each (or the LIRR) OR EVEN IRR

Question 10

Time-weighted rate of return formula

Answer 10

(1+i)^T = V(t1)/V(0) * V(t2)/[V(t1)+C(t1)] …V(T)/[Vtn)+C(tn)]

Question 11

Money-weighted rate of return formula

Answer 11

V(0)(1+i)^T + sum(C(t)(1+i)^(T-t)) = V(T)

Question 12

Treynor measure

Answer 12

[R(p) - r]/ beta(p)

Question 13

Sharpe measure

Answer 13

[R(p) - r] / sigma(p)

Question 14

Jensen measure

Answer 14

R(p) - R(b)

Where R(b) = r + beta(p)[R(m) - r] (the expected return on the benchmark)

Question 15

Pre-specified standard deviation

Answer 15

R(p) - R(b)

Where R(b) = r + [R(m)-r]/(sigma(m) * sigma(p))

Question 16

Beta formula

Answer 16

B = COV(Return on stock, Return on market) / Variance(Market return)

Where covariance = correlation coefficient * sigma(x) * sigma (market)

Question 17

The main uses of performance measurement are to:

Answer 17

Improve future performance

Compare actual performance against target rates

Compare actual performance against a benchmark portfolio, index or other portfolios

Appraise and remunerate investment managers

Question 18

The limitations of performance measurement include:

Answer 18

The past may be a poor guide for the future

Difficulty of allowing for risk

Possibility of spurious and/or misleading results if invalid comparisons are made or time periods that are too short are considered

Different funds may have differing objectives and constraints

Measurement may influence the actions of fund managers in ways that are inconsistent with the fund’s long-term objectives

It adds to the cost of investment

Question 19

Merits of assessing a portfolio against an index

Answer 19

Easy to do

Data is readily available and is accurate

Published index may not be appropriate - Index is not consistent with the objectives (and constraints) of the investor

Question 20

Merits of assessing a portfolio against other portfolios

Answer 20

Is appropriate if the funds being considered have the same objectives and the same factors influencing investment strategy

In practice there may be very few other funds that can be used for a valid comparison

Data from other funds may not be easily available

Overall, performance measurement relative to other portfolios is not ideal

Question 21

Merits of assessing a portfolio against a benchmark portfolio

Answer 21

Can be constructed to reflect the objectives of the fund

Should also be constructed in such a way that the data necessary for comparisons is easily obtainable

By having a benchmark portfolio that reflects the liabilities of the fund, the danger of giving the fund manager conflicting objectives is also avoided

e.g. assessment encourages the fund manager to adopt a strategy that is not consistent with the objectives of the fund