Chapter 11 - The Performance Of Investments

Question 1

Investment performance - important to know past performance for what (4) and essential for - markets, competence, reward and fees

Limitations to using historical performance as a predictor;
- equities and performance, specific predictions and identifying attractive investments

Answer 1

Important to know how individuals, portfolios, sectors and markets have performed in the past and essential for;

• understanding investment markets in general
• assessing competence of fund managers and investment portfolio managers
• rewarding investment managers
• charging performance related fees

Limitations to using historical performance as a predictor;

• equities tend to out perform FIS but have had periods of underperformance
• when predictions become more specific, past performance value diminishes (e.g. comparing fund managers track records).
• most systems of identifying attractive investments rely on past performance and rely on volatility and correlation to be the same as past but may be diff.

Question 2

Performance measurement - performance of who split into two categories - measurement - how measured and evaluation - added value and how

Holding period return - measured as (value or income), formula and breakdown of what each letter means

E.g. start £25k, end £28k and income of £1k

Holding Period Return - example - value at start £25k, value at end. - £28k and income £1k

Answer 2

When looking at performance of investment manager, must be split between performance measurement and evaluation;

• measurement - calculation of investment return over stated period.
• evaluation - whether manager added value by meeting or outperforming benchmark and how they achieved that return (asset strategy or risk eg)

Holding Period Return can be measured as;

• can be either the difference in portfolio value at end of period from the start or
• income or distributions made from portfolio during that period
• R=D+V1-Vo/Vo
• R= return, D = income received, Vo - value at start and V1 - value at the end

E.g.
(1k+28K-25k)/25k = 16%

Question 3

Money weighted rate of return - used to calculate what, formula and breakdown of formula, how money added or withdrawn affects formula (top and bottom line), money reinvested, if no cash flows, rate of return produced can be considered what that portfolio +NM must earn where to equal what

Drawbacks of MWRR - comparisons and why and overall return

Example;

• start of the year - £20k
• end of year - £24k
• £3k invested in march
• £2k withdrawn in September

Answer 3

MWR - Used to calculate return over a year, adjusting for cash inflows.

• MWR = D+V1-Vo-C/Vo+(C*n/12)
• C= new money added throughout year and n = number of months left in year
• If new money added to portfolio then C is subtracted from top line but if it is withdrawal, added instead.
• on the bottom line, the above is reversed (if money added, then added to start value)
• if money received throughout year is immediately reinvested, it can be ignored in calculation.
• if no cash flows, D & C go to 0 and effectively doing a HPR formula.
• rate of return produced by this method can be considered the rate of interest that initial portfolio + new money must earn in a deposit account to equal portfolio value at end of year.

Drawbacks;

• not appropriate when evaluating or comparing portfolios as influenced by cashflow which is out of fund managers control.
• does not identify if overall return due to fund manager or timing of additional funds.

E.g. (24k-20k-(3k-2k))/(20k+(3k9/12)+(-2k3/12) = 3k/20k+2,250-500 = 13.79%

Question 4

Time Weighted rate of return - attempts to eliminate what and how, compare, takes into account (3), sub period and link, formula for this and breakdown of r and how two period calc’d

Investment 1 - start 100 end £110
Investment 2 - Start £210 end £248

Answer 4

• Attempts to eliminate distortion caused by timing of new money by breaking down period of return for particular period between each addition or withdrawal of capital.
• can therefore compare managers
• takes into account investment income, new money and realised and unrealised capital profits or losses.
• Holding period return calculated for each sub period and then link together to calculate TWR.
• 1+R = (1+r1)(1+r2)(1+r3) etc
• R = TWR, r holding period return for each sub period
• two periods = TWR = R= (V1/Vo)*(V2/(V1+C)) - 1

E.g. - Manager A;
- HPR = (260-200))/200 =30%

Manager B
- HPR = (110-100)/100 = 10%
Second investment
- HPR = (248 - 210)/210 = 18.10%
TWR = 1+R=1.1*1.1810 = 1.2991
R = 1.2991-1 = 30%
TWR is the same for both funds.

Question 5

Risk adjusted returns - simple analysis consists of - returns and vol over what period and comparing against what (3), cumulative returns shown in tabular form are what and why and discrete performance reveals what

Sophisticated analysis - monthly what and analysis how and managers decisions

Answer 5

Simple performance analysis consists of;

• looking at actual returns and volatility over a cumulative and discrete periods and comparing fund with benchmark index, sector index or funds sharing common strategies or aims.
• cumulative returns show in tabular form can be a poor guide because they conceal periods of good and bad performance therefore discrete periods can show an reveal consistency.

Sophisticated analysis;

• takes monthly returns and volatility and subjects them to analysis using ratios
• helps reveal whether managers decisions are adding value.

Important to consider level of risk - higher risk should expect higher returns.

Question 6

Sharpe Ratio - measures what (return, risk and compare), ratio formula, annualised, negative return indicates and skill or risk

E.g. - annualised return 10%, annualised return on risk fee 4% and SD of 8%

Answer 6

• Measures excess return for every unit of risk that is taken to achieve return and frequently used to compare investments (diff risk/reward options).
• Ratio = (return on investment - risk free return)/standard deviation of returns = return above risk free rate for each unit of risk taken.
• risk and returns usually annualised
• negative return indicates risk free asset would’ve provided better returns.
• useful in identifying if returns due to skilful investment or excessive risk

E.g. - 10-4/8 = 0.75%

Question 7

Alpha - difference between (returns), part of return that, mean performance, positive alpha meaning, negative and expenses, allows us to do what and how, CAPM, actual returns, formula and description of formula

e.g. - fund return 12%, risk free rate 4%, market return 10% and beta 1.2

Answer 7

• difference between return expected given its beta and the return that it has actually produced.
• part of return that cant be explained by markets
• can be used to mean the under or outperformance of investment related to benchmark.
• positive alpha indicates security performed better than predicted by its beta and negative vice versa.
• negative can sometimes result in expenses that are present in fund performance figures but not in benchmark.
• allows us to quantify value added or taken by a manager through active management, since it is independent of underlying market and therefore measure managers stock picking abilities.
• not explained by capital asset pricing model.
• uses actual returns rather than expected
• actual portfolio return - (Rf+(Bi(Rm-Rf))
• Rf- risk free return, Rm - market return and Bi is beta

E.g. - 12- (4+(1.2*(10-4)) = 0.8%

Question 8

Information Ratio - used to assess what, skill and consistency, formula and explanation of each and negative returns mean

E.g. - fund return 8%, benchmark return 10% and TE 8%

Answer 8

• used to assess risk adjusted performance of active portfolio managers
• gauge skill of fund manager and shows consistency of beating index
• info ratio = Rp-Rb/tracking error
• Rp is portfolio or fund return, Rb benchmark and tracking error is SD of returns
• negative return means investor would have got a better return if invested in a tracker or index fund.

E.g.
- (12-10)/8 = 0.25

Question 9

Performance attribution - results achieved depending on (4, straightforward) and benchmark

First steps in performance attribution are;
- identify what (benchmark x2) and calculation performance how, shows what and manager could have achieved this return how.

• then compare what to what, comparison made assuming what is the same as what and performance of what is the what, contribution of return formula, can then work out what from this

Answer 9

Portfolio managers achieve good or bad results by the exercise of the following;

• Asset allocation, stock selection, market timing and risk
• portfolio compared to benchmark and if positive, have performed well.

First steps in performance attribution are to;

• identify appropriate benchmark, find out asset allocation of benchmark and calculate performance of each asset class in benchmarkasset performance in benchmark portfolio (e.g. 55%20%=11%).
• this is done for each asset class and show model rate of return and manager could have achieved this return if copied distribution in benchmark and tracked appropriate index for each class of asset.
• then compare benchmark performance to actual portfolio performance.
• comparison made assuming that asset allocation is the same as managers portfolio and performance of asset class is the index performance.
• contribution of return = manager asset allocation*index performance
• can then work out where underweights against benchmark caused performance to be higher or lower and if benchmark performed better or not

Question 10

Performance attribution - stock/sector selection - compares what (index and manager) and therefore removes?

Out/under performance can be as a result of - (2), formula for this and can then judge what

Answer 10

• compares index performance of each asset class with managers actual performance, thereby removing the effects of asset allocation

Out or underperformance can be as a result of;

• Sector choice or stock selection - weightings can affect performance
• formula - (actual performance - index performance)*benchmark asset allocation
• can then judge where under and outperformance has come from and its affect on overall portfolio.