Chapter 16: Performance measurement (1) Flashcards
Money-weighted rate of return relative merits
Advantage:
- Useful as an absolute measure of the achieved return
Disadvantage:
- Affected by the timing and size of cashflows thus, not a good basis for comparing two different fund managers
Under what circumstances is the MWRR appropriate for comparison purposes?
- There are no large cashflows in the valuation period
- The rates of return during the period remain stable (i.e. no great fluctuations in market values during the period)
Time-weighted rate of return relative merits
Advantages:
- Not affected by the size or timing of cashflows therefore, can be used as a basis for comparing different investment managers
Disadvantages:
- Impractical - amount of data required - fund values are needed for every occasion on which there is a cashflow
Under what circumstances with TWRR and MWRR be very similar?
- When cashflows during the valuation period are small relative to the funds involved or
- the rate of return is stable over the period
Linked internal rate of return (LIRR)
A practical compromise solution to the TWRR.
Conditions needed for the approximation to be good:
- 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
LIRR process
- Determine the value of the fund at various dates throughout the year (e.g. monthly, quarterly intervals)
- For each intervaluation period, calculate the MWRR
- Link the intervaluation MWRRs together to get the linked internal rate of return for one year
Ways in which to compare the performance of a portfolio with an index
- By comparing the actual value of the portfolio at the end of a defined period with the value that would have been achieved had the initial value of the portfolio and subsequent net new money been invested in the same way as the index
- By comparing the TWRR from each
In practice, the method chosen and type of return calculated depends partly on the data available
What information is typically needed to assess the performance of an investor’s portfolio compared to an index?
- timing and size of cashflows
- level of the index at dates the cashflows occur
- amount of the investment income that would’ve been earned by investing in the index
- taxation basis of the investor and hence the tax that would’ve been incurred by investing to track the index including any change in outstanding tax liability over the year
- the expenses the investor would’ve incurred by investing to track the index
- riskiness of the investments held by the investor
- appropriateness of the index for the investor
- value of the portfolio over regular intervals over the year
Comparing portfolio performance with benchmark portfolio (notional fund)
Similar to assessing against a published index.
Difference is that rather than devloping a notional fund based on a particular market index, the notional fund is defined in some other predetermined manner.
What is it necessary to set out when specifying the benchmark portfolio?
- how new money and investment income are to be invested
- how often the benchmark is to be rebalanced
Issues that make the assessment of portfolio performance complex when comparing it to a benchmark portfolio
- cashlfows
- investment income
- tax
- expenses
Must make appropriate allowance for these factors in the notional/benchmark portfolio
Overall investment performance of a fund can be divided into
- sector selection - choosing the right investment sectors
- stock selection - having chosen the sector, choosing the right stocks
Performance attribution/Attribution analysis
The process of attributing performance to stock and sector selection to understand the relative strengths and weaknesses of each investment manager
Sector selection profits
Arises from difference between fund’s choice of proportions in various sectors and proportions in benchmark portfolio
Stock selection profits
Arise when selected stocks within sector perform better than the sector
Formula for overall relative performance
Formula for stock selection performance
Problem with risk-adjusted performance measures
Only allow for risk defined in terms of variance and do not allow for actuarial or downside risk
How to know what the appropriate measure of risk for an investor to use is?
- Portfolio being considered represents whole of the investor’s wealth - standard deviation
- If porfolio being considered is a subset of their assets - portfolio beta
Why is portfolio beta appropriate to use where the portfolio being considered is a subset of the investor’s assets?
Beta of a portfolio is a measure of its risk relative to a well diversified portfolio and adjusting the returns using beta tells us how good the manager is at picking out-performing securities, given the systematic risk assumed.
Why is standard deviation appropriate to use where the portfolio being considered is all the investor’s assets?
Using the standard deviation to adjust return allows us to measure how well-diversified the whole portfolio is as well as how good the manager is at individual stocks that produce an excess return relative to their betas.
The Treynor measure
The Sharpe measure
The Jenson measure
Pre-specified standard deviation
What is the beta of a stock?
Beta is a measure of the stocks volatility relative to movements in the whole market. It’s usually calculated as the covariance of the return on the stock with the return on the market, divided by the variance of the market return
Reasons why the performance of an investment portfolio will be measured
- to improve future performance
- comparison of the rate achieved against the target rate
- comparison against the performance of other portfolios, an index and/or a benchmark portfolio
- to appraise and remunerate investment managers
Limitations of performance measurement
- the past may be a poor guide to the future
- the difficulty of allowing for risk
- the possibility of spurious/misleading results if invalid comparisons are made or time periods that are too short are considered
- different funds may have different objectives
- measurement may influence the actions of the fund managers in ways that are inconsistent with the fund’s long term objectives
- it adds to the cost of investment
Relative merits of assessing performance relative to published indices
Advantages:
- Relatively easy to do
- Data for published indices is readily available and is reliably accurate
Disadvantages:
- The published index may not be appropriate
- May be no single index that’s consistent with objectives of investor
Relative merits of assessing performance relative to other portfolios
Advantages:
- Appropriate if funds being compared have same objectives and same factors influencing investment strategy
- Gives indication of cost or benefit of following particular strategy, relative to that adopted by other funds
Disadvantages:
- Inappropriate to compare performance of funds that have very different investment objectives
- In general, an investor won’t have knowledge of the objectives, restrictions and mandates of other investors
Performance measurement relative to other portfolios is not ideal
Relative merits of assessing performance relative to a benchmark portfolio
Advantages:
- Benchmark portfolios can be constructed to reflect the objectives of the fund
- Can be constructed in such a way that the data necessary for comparison is easily obtained
- By having a benchmark portfolio that reflects the liabilities of the fund, the danger of giving the fund manager conflicting objectives is also avoided (would occur if basis for assessment encourages fund manager to adopt strategy not consistent with objective of fund).
Money weighted rate or return formula
Time weighted rate of return formula
