Chapter 17: Performance Measurement 2

Question 1

State the aim of portfolio risk and return analysis

List the steps in portfolio risk and return

Answer 1

Aim

To assess whether superior performance has been obtained simply by taking more risk or by superior stock and sector selection and timing

Steps

Plot overall TWRR from portfolio over period against riskiness of portfolio

Compare portfolio to benchmark/peer group/simulated portfolios

Riskiness measured by looking at standard deviation of returns over historical sub periods or implied volatilities

Question 2

List three potential problems with portfolio risk and return analysis

Answer 2

Creeping change portfolio composition - riskiness of portfolio may change gradually, but significantly, over time

Successful investment manager may be treated unfairly by measurement system eg if skilled at selecting high risk stocks

manager may disagree with market view of stock’s or market’s prospects and/or uncertainty attached to those prospects

Question 3

List three advantages and four disadvantages of assess the performance of a share using its market price

Answer 3

Advantages

+Objective
+Generally quick, cheap and easy to obtain
+Easy to understand/justify

Disadvantages

• Subject to short term fluctuations, so volatile
• need to allow for income
• unavailable for unquoted shares
• may be more than one quoted figure, eg bid price and offer price

Question 4

List three advantages and four disadvantages of assessing the performance of a share using its net present value

Answer 4

Advantages

+Can be made consistent with basis used to value liabilities
+useful for unquoted shares
+yields stable results

Disadvantages

+Depends on subjective assumptions
+results will reflect any changes in assumptions
+differs from actual market price, at which shares actually trade
+difficult to understand

Question 5

List three advantages and five disadvantages of assessing the performance of a share using its NAV per share

Answer 5

Advantages

+Yields stable results
+available for unquoted shares
+useful for investment and property companies

Disadvantages

+Based on accounting values, not true, economic values
+depends on subjective accounting standards
results will reflect any changes in accounting standards
+may exclude intangibles/goodwill
+difficult to compare companies in different sectors

Question 6

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

Answer 6

The risk adjusted return on capital calculated as

RAROC = R - ß(Rm - rf)

Where R is return achieved by compnay, ß reflects systemic risk of its projects, Rm is market return and rf the risk free return of return

Return as profits divided by capital employed to generate those profits

If RAROC > rf company has out performed after allowing for cost and risk involved in using its capital to generate its profits

Question 7

Give three reasons why the risk adjusted return on capital (RAROC) in practice

Answer 7

+Difficult to accurately estimate beta of the company
+Difficult to estimate company profits, as some accounting costs (eg depreciation) need to be subjectively adjusted to reflect cost using the company’s assets

Also, costs not associated with using or maintaining existing capital should be excluded from profit calculation

+Difficult to accurately estimate capital employed within business to generate profits - in particular, values of any intangibles