Chapter 17: Performance measurement (2) Flashcards
Portfolio risk and return analysis
Involves plotting the TWRR from a portfolio over a period against the ‘riskiness’ of the portfolio.
Portfolio then compared against a benchmark or against peer groups or simulated portfolios.
Aim: Help assess the investment manager by ascertaining if superior performance has been obtained by taking more risk or by superior market and/or stock selection/timing.
Implied volatility of a derivative
Black Scholes approach to option pricing prices a European option as a function of:
- current share price
- strike price of the option
- risk-free rate of return
- volatility of the underlying share price
- outstanding term to expiry
- dividend payout rate
All of the above are observable in the marketplace except volatility. Can use Black Scholes formulae and work backwards and derive estimate for the volatility.
In practice, how can control over risk be achieved?
- Guidlines on asset allocations and stock weightings
- Specifying a maximum under-performance over specified periods
- Downside measures of risk may be of use here
Problems with relying on the frequent risk and return analysis approach are:
- Creeping change in portfolio composition (and overall volatility as more risky stocks are included which don’t show up in the std dev immediately)
- A successful investment manager may be treated unfairly by the measurement system
- The manager may disagree with the market view of a stock’s or market’s prospects and/or the uncertainty attached to those prospects
Important that the manager can demonstrate a realistic and convincing rationale for investment decisions
Relative merits of backward looking measures
- How applicable these methods that use historical data might be in future.
- New risks may come into existence which make reliance on backward-looking measures questionable.
- Ease of use of historical measures and relative objectivity = likely to remain a key method of assessing and monitoring risk going forward.
Measuring the performance of equities using market price. Refinements that should be considered
- total return is of interest to the investor so dividends must be allowed for
- equity prices may be influenced by short-term concerns whereas many investors are focused on the long term
What kind of market tends to favour ‘value’ investors and ‘growth’ investors
Markets go through several years in which underperformers and outperformers frequently reverse their their relative performance (‘Value’ investors) and then go through other periods where over- or under-performance can be very persistent (‘Growth’ investors)
Using NPV to measure the performance of equities
The absolute result from an estimate of NPV may be of limited use because it depends on many assumptions which results in a wide variety of results
Differences between market price and an investor’s estimate of NPV can derive from:
- differences in the profile between a particular investor and the average investor
- differences in computation method, information used or assumptions. These are part of the range of value estimates that give rise to the current market price
The trend of NPV estimates and their relationship to market prices may be helpful.
Using NAV to measure the performance of equities
- The NAV of a company or the NAV per share is only one component of overall value.
- All things equal, a share with higher proportion of its share price represented by NAV should be cheaper than a share that has less asset backing.
- This difference is likely to be eliminated in an efficient market where the market value is driven by supply and demand dynamics.
- Share price in an efficient market will reflect factors other than NAV.
- Goodwill must be evaluated for relevance, and removed if inappropriate, to make a valid comparison with the company which has grown organically.
- NAV is a readily available accounting number, which may require adjustments (e.g. to allow for e.g. non-quoted assets).
- NAV may not allow for the extent that some businesses may be more capital intensive than others.
- Intangibles e.g. human capital, may be difficult to value and unlikely to be included in NAV.
- NAV does not reflect risk.
- NAV may not be appropriate to compare companies in different industries / sectors.
- NAV does not currently account for environmental and other less quantifiable socially responsible impacts.
CAPM suggests that if capital assets are priced correctly then:
- returns in excess of the risk-free rate will only be generated from taking risks
- the risk-adjusted return on capital should be equal to the risk-free rate
Risk-adjusted return formula
Main difficulty when using the risk-adjusted return on capital approach to assess company performance
To correctly and accurately identify both the company’s ‘capital’ and the ‘return’ on capital.
Intangible assets are likely a major component of CAPM capital for service-based companies, which may have little in the way of tangible assets.
Generally, what does a high actual return on capital imply?
Using normal accounting measures and a starting measure of the market capitalisation, it implies the successful creation of intangible assets and shareholder value.
The company would therefore be an attractive investment proposition.
Calculating capital for the risk-adjusted return
Include and value:
- Goodwill from mergers/takeovers
- Internally generated goodwill
- Any other intangible assets
- All tangible assets
Ultimately, the best measure of the capital in a company, including all the intangibles, is likely the market capitalisation itself.
Calculating return for the risk-adjusted return
- add back to profits any investment in the creation of new intangible assets and in the expansion and purchase of intangible assets
- continue to deduct any expenses incurred defending and servicing existing tangible and intangibe assets
State the security market line relationship
