Chapter 16: Performance measurement (1)

Question 1

Money-weighted rate of return relative merits

Answer 1

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

Question 2

Under what circumstances is the MWRR appropriate for comparison purposes?

Answer 2

• 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)

Question 3

Time-weighted rate of return relative merits

Answer 3

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

Question 4

Under what circumstances with TWRR and MWRR be very similar?

Answer 4

• When cashflows during the valuation period are small relative to the funds involved or
• the rate of return is stable over the period

Question 5

Linked internal rate of return (LIRR)

Answer 5

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

Question 6

LIRR process

Answer 6

1. Determine the value of the fund at various dates throughout the year (e.g. monthly, quarterly intervals)
2. For each intervaluation period, calculate the MWRR
3. Link the intervaluation MWRRs together to get the linked internal rate of return for one year

Question 7

Ways in which to compare the performance of a portfolio with an index

Answer 7

1. 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
2. By comparing the TWRR from each

In practice, the method chosen and type of return calculated depends partly on the data available

Question 8

What information is typically needed to assess the performance of an investor’s portfolio compared to an index?

Answer 8

• 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

Question 9

Comparing portfolio performance with benchmark portfolio (notional fund)

Answer 9

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.

Question 10

What is it necessary to set out when specifying the benchmark portfolio?

Answer 10

• how new money and investment income are to be invested
• how often the benchmark is to be rebalanced

Question 11

Issues that make the assessment of portfolio performance complex when comparing it to a benchmark portfolio

Answer 11

• cashlfows
• investment income
• tax
• expenses

Must make appropriate allowance for these factors in the notional/benchmark portfolio

Question 12

Overall investment performance of a fund can be divided into

Answer 12

1. sector selection - choosing the right investment sectors
2. stock selection - having chosen the sector, choosing the right stocks

Question 13

Performance attribution/Attribution analysis

Answer 13

The process of attributing performance to stock and sector selection to understand the relative strengths and weaknesses of each investment manager

Question 14

Sector selection profits

Answer 14

Arises from difference between fund’s choice of proportions in various sectors and proportions in benchmark portfolio

Question 15

Stock selection profits

Answer 15

Arise when selected stocks within sector perform better than the sector

Question 16

Answer 16

Question 17

Formula for overall relative performance

Answer 17

Question 18

Formula for stock selection performance

Answer 18

Question 19

Problem with risk-adjusted performance measures

Answer 19

Only allow for risk defined in terms of variance and do not allow for actuarial or downside risk

Question 20

How to know what the appropriate measure of risk for an investor to use is?

Answer 20

• Portfolio being considered represents whole of the investor’s wealth - standard deviation
• If porfolio being considered is a subset of their assets - portfolio beta

Question 21

Why is portfolio beta appropriate to use where the portfolio being considered is a subset of the investor’s assets?

Answer 21

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.

Question 22

Why is standard deviation appropriate to use where the portfolio being considered is all the investor’s assets?

Answer 22

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.

Question 23

The Treynor measure

Answer 23

Question 24

The Sharpe measure

Answer 24

Question 25

The Jenson measure

Answer 25

Question 26

Pre-specified standard deviation

Answer 26

Question 27

What is the beta of a stock?

Answer 27

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

Question 28

Reasons why the performance of an investment portfolio will be measured

Answer 28

• 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

Question 29

Limitations of performance measurement

Answer 29

• 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

Question 30

Relative merits of assessing performance relative to published indices

Answer 30

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

Question 31

Relative merits of assessing performance relative to other portfolios

Answer 31

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

Question 32

Relative merits of assessing performance relative to a benchmark portfolio

Answer 32

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).

Question 33

Money weighted rate or return formula

Answer 33

Question 34

Time weighted rate of return formula

Answer 34