Chapter 17: Performance measurement (2) Flashcards
l) performance of an investment and limitations of the measurement techn
State the aim of pf risk and return analysis.
List the steps in pf risk and return analysis.
Portfolio risk and return analysis
Aim
- To assesss whether superior perforamance has been obtained by simply taking more risk or by superior stock and sector selection and timing and conversely for inferior performance
- This can be done by using:
-risk-adjusted performance measures
-information ratios
-the method below
Steps
- Plot the TWRR from pf over period against ‘riskiness’ of the pf
- compare portfolio to benchmark/peer group/simulated portfolios.
- Riskiness measured by looking at s.d of returns over historical sub-period or implied volatilities.
l) performance of an investment and limitations of the measurement techn
How can hirers of investment managers ensure although difficult to enfore that excessive risk is not taken to achieve E[higher returns]
- guide lines on asset allocation and stock weightings
-limits for departures can be expressed as a % of benchmark allocation (or total fund size) —> this is referred to as load differences and load ratios - Specifying max under-performance over specified periods. return cannot be:
- less than a specified absolute figure
- fall below that of the average peer group by more than a specified.
Downside measures of risk:
- semi-standard deviation
- expected shortfall
- shortfall probability
might be useful here.
l) performance of an investment and limitations of the measurement techn
List the three potential problems with pf risk and return analysis.
Portfolio risk and return analysis
if results and return analysis are discussed with investment managers at six monthly intervals, the problems with that approach are:
- Creeping change in pf composition - A pf may change every six months by an amount which is not of concern each time but which is significant in total. More risky stocks may have been included which do not not immediately show up in the standard deviation of returns.
- successful managers may be treated unfairly by a measurement system. e.g., the manager might be skilled at selecting good stocks that viewed risky by the market, as measured by implied volatilities in prices of derivative contracts. Alternative the manager might be good at selecting stocks and markets that are volatile but grow over the period.
- the manager may disagree with the market view of a stock’s or prospects and/or the uncertainty of those attached to prospects. Market prices are a result of a pricing process which is likely to result in 50% of investors viewing a price as too low and 50% viewing it as too high. Perhaps only a few professional investors will see a particular market price as roughly fair.
l) performance of an investment and limitations of the measurement techn
Valuation and performance of equity investments
l) performance of an investment and limitations of the measurement techn
List three advantages and four disadvantages of asssessing the performance of a share using its market price.
Valuation and performance of equity investments
Advantages:
1. Objective
2. generally easy, quick and cheap to obtain
3. easy to understand/justify
Disadvantages:
1. More than quoted figure, e.g., bid price and offer price
2. subject to short-term fluctuations, so volatile
3. need to allow for income
4. unavailable for unquoted shares
l) performance of an investment and limitations of the measurement techn
List three advantages and disadvantages of assessing the peformance of a share using its net present valye (NPV).
Valuation and performance of equity investments
advantages:
- Can be made consistent with the basis used to value liabilities
- Useful for unquoted shares
- yields stable results (if assumptions do not change)
Disadvantages:
- Depends on (many) subjective assumptions which may result in a wide variety of results
- absolute result from an estimate of NPV may be of limited use (scenario testing?)
- results will reflect any changes in assumptions (sensitive to changes in assumptions)
- may differ from actual market price, at which shares are traded.
l) performance of an investment and limitations of the measurement techn
Outline where the differences between the market price and an investor’s estimate of net present value cn be derived from:
Valuation and performance of equity investments
- differences in the profile (objectives, environment, constraints, etc) between investor and average investor
or:
2. differences in computation method, information or assumptions.
it would be justifible to allow for 1, if the differences could be identified reliably. Allowing fro 2 involves the investor in active investment management.
l) performance of an investment and limitations of the measurement techn
outline the limitations of NAV that should considered when it is used.
Valuation and performance of equity investments
- if other things equal, a share with a higher proportion of its share price represented by NAV will be cheaper than one that does not.
- however, other things are unlikely to be equal, as the market will, in both cases, be attaching the full value of future cashflow, resulting from holding all exisinting assets and liabilities.
- NAV is an accounting number, it is important to understand how it has arisen to make appropriate adjustments. e.g., goodwill (remove it)
- Some companies require more assets than do others. So,
- comparisons of NAV in different sector may inform predominatly about the differences in the two sectors
-so comparison should be made for companies in the same sector - Net assets surplus required to run the business may not attract full value because of potential operational inefficiencies and cash is not used to fund growth.
l) performance of an investment and limitations of the measurement techn
List the three advantages and disadvantages of assessing performance of a share using NAVV per share.
Valuation and performance of equity investments
advantages:
1. useful for investment and property companies
2. Useful for unquoted shares
3. yields stable result
Disadvantages:
1. based on accounting values, not true, economic values.
2. depends on subjective accounting standards
3. results reflect any changes in accounting standards
4. Intangibles e.g. human capital, may be difficult to value and unlikely to be included in NAV
- Goodwill must be evaluated for relevance, and removed if inappropriate
5. difficult to compare companies in different sectors.
(6.) is a readily available accounting number, which may require adjustments (e.g. to allow for e.g. non-quoted assets).
(7.) Does not reflect risk.
(8.) Does not currently account for environmental and other less quantifiable socially responsible impacts.
l) performance of an investment and limitations of the measurement techn
State:
- the formula used to calculate the risk-adjusted return on capital (RAROC) for a company.
- how the return is estimated in the RAROC formula and explain what the formula tells you.
Risk-adjusted return on capital
- Risk adjusted return on capital calculated as:
RAROC = R - beta (R_m - r_f)
where R is the return achieved by the company, beta reflects the systematic risk of its projects, R_m is the market return and r_f is the risk-free rate of return.
- Returns estimated as profits divided by capital employed to generate those profits.
- RAROC > r_f, the company has outperformed after allowing for cost and risk involved in using its capital to generate profits.
l) performance of an investment and limitations of the measurement techn
A company boasts a high projected return on capital (ROCE) using traditional accounting methods, and its market capitalization has been consistently increasing. How can the Capital Asset Pricing Model (CAPM) help interpret these findings in terms of risk-adjusted return?
Risk-adjusted return on capital
For a company, a high projected return on capital (ROCE) using traditional accounting and a growing market capitalization can be positive signs within the CAPM framework. Here’s why:
- ROCE and Efficiency: High ROCE indicates efficient capital use, potentially generating strong future profits.
- Market Cap Growth and Intangibles: A growing market cap suggests investor belief in the company’s value, which might be driven by the creation of intangible assets like brand reputation or skilled workforce (not fully captured in accounting).
- CAPM and Risk-Adjusted Return: CAPM emphasizes risk-adjusted return. A high projected ROCE might involve calculated risks, but the market rewards them with a higher valuation (growing market cap).
l) performance of an investment and limitations of the measurement techn
State how capital and return might be calculated for use in RAROC.
Risk-adjusted return on capital
Capital include:
- goodwill from mergers( and event if when normal accounting would not recognise it, e.g., internally generated goodwill)
- successful acquisition of a customers (such that the increment of future CF makes RAROC going forward equal to risk-free rate)
- all tangibles
However, best measure including intangibles as required by CAPM, is market cap.
Return:
- to profits add back any investment expenditure to acquire expand additional tangible and intagible assets
- continue to to deduct any expenses incurred in defending and servicing existing tangible and intangible assets.
l) methods for monitoring and controlling exposure to risks
Give three reasons why the risk-adjusted return on capital (RAROC) is very difficult to estimate in practice.
Risk-adjusted return on capital
- Difficult to accurately estimate beta of the company (but need forward looking estimate which is subjective)
- Difficult to estimate company profits as some accouting costs (e.g., deprerciation) need to be sujectively adjusted to reflect true cost of using the company’s assets.
Also, costs not associated with using or maintaining existing capital should be exlcuded from the profit calculation.
- Difficult to accurately estimate the capital employed in the company to generate profits - in particular, values of any intangibles.
