Chapter 17 - Portfolio Monitoring and Performance Evaluation - 6% Flashcards
What is Portfolio Monitoring?
Portfolio monitoring acknowledges that the markets and clients change and that both must be reviewed periodically to ensure that the portfolio remains appropriate for the client’s situation.
What is Portfolio Performance Evaluation?
Portfolio performance evaluation is based on two fundamental concepts -
1. Return is related to risk and thus performance of a portfolio cannot be evaluated on its return alone.
- The view that passive and active management are two mutually exclusive and exhaustive approaches to portfolio management.Active management comes at a price: the portfolio could underperform a passively managed portfolio and transaction costs increase with trading activity.Performance evaluation of a passively managed portfolio is essentially concerned with minimizing tracking error, which is the standard deviation of the difference in returns between the index and the passively managed fund.
What are the two stages in portfolio performance evaluation?
- Performance measurement: involves the calculation of the return by a portfolio over a specific period of time called the evaluation period.
- Performance appraisal: is an assessment of how well a portfolio has done over the evaluation period. Given the costs clients incur to have their portfolios managed, they need to know if the cost justifies the service.
How would you measure portfolio returns?
- If there are no cash flows, then the portfolio’s return is simply the percentage change in its market value from the beginning of the evaluation period to the end of the evaluation period –
Rp = (MVE - MVB)/MVB
where
MVE = market value of the portfolio at the end of the evaluation period
MVB = market value of the portfolio at the beginning of the evaluation period - When there are cash flows, a portion of the change in the value of the portfolio is the result of the cash flows themselves. One way to account for cash flows is to assume that all contributions occur at the beginning of the period and all withdrawals at the end of the period.
Rp = (MVE - MVB - Contributions + Withdrawals) / MVB + Contributions
where
MVB = the value of the portfolio just before any contributions
MVE = the value of the portfolio just after any withdrawals
What is the dollar weighted or money-weighted return?
It measures the performance of the portfolio as experienced by the investor. The first step in finding the dollar weighted return is to determine how long each of the contributions were invested in the portfolio relative to the total length of time for which the rate of return is being measured.
What is time-weighted return?
The time-weighted return eliminates the effect of a portfolio cash flows and measures only the cumulative performance of the portfolio’s investments.
What are the required characteristics of a benchmark?
- Investable: A benchmark is a passive investment alternative.
- Unambiguous in composition: The securities comprising the benchmark and the weighting scheme must be clearly defined.
- Appropriate: The benchmark has the same risk as the portfolio and is consistent with the manager’s investment style or biases.
- Attainable by manager: The manager has current investment knowledge of the securities that make up the benchmark and can invest in all securities.
- Specified in advance: The benchmark is operational before the start of an evaluation period.
- Objectively constructed: The benchmark is not tilted in favour of or against the manager.
- Easily measurable: It is possible to readily observe performance to calculate the benchmark return on a reasonably frequent basis.
What are the four classes of benchmark portfolios?
- Composite market indexes: These published market indexes are designed to measure the movements of specified markets, not benchmark performance.
- Investment style benchmarks: are developed to reflect more closely the behaviour of the kinds of securities in which the manager specializes.
- Normal portfolio: is a specialized benchmark that includes all the securities that a manager normally selects from. In other words, the portfolio manager’s natural habitat is defined, and from that a normal portfolio is constructed.
- Sharpe benchmark: is created statistically using multiple-regression analysis. The average active return over a number of sub-periods can be tested for statistical significance, and the constancy of a portfolio’s style can be examined by rolling estimates.
Describe the steps in Performance Attribution Analysis?
Policy Return: The first step in attribution analysis is to determine the portfolio’s policy return. It is equal to the return on the portfolio based on the strategic asset allocation decision. The benchmark for the equity portion is the return on the S&P/TSX Composite Index, while the benchmarks for the fixed-income and cash portions are the DEX Universe Bond Index and the DEX 91-Day T-bill Index respectively.
Allocation Return: The second step in attribution analysis is to measure the return on the portfolio based on the decision to shift the portfolio’s weights from the strategic asset allocation which is called the portfolio’s allocation return.
The difference between the policy return and the allocation return is referred to as the allocation effect.
The final decision is to measure the portfolio manager’s ability to select individual securities, which is known as the selection effect. The manager’s contribution is equal to the difference between the actual portfolio return and the allocation return.
What is risk-adjusted returns? What are the different types?
Risk-adjusted return measures compare the returns generated by a fund to the level of risk taken to earn those returns.
a) Jensen’s alpha: quantifies the degree to which a manager has added value to the market given the portfolio’s systematic risk
Jp = Rp - Rf - [Bp X (Rm - Rf)]
Jp = Jensen's alpha Rp = the average return on the portfolio over a specified evaluation period Rf = the average risk-free return over a specified evaluation period Rm = the average return on the market index over a specified evaluation period Bp = the portfolio's beta over a specified evaluation period
b) Treynor Ratio: It is also called Treynor’s reqard-to-volatility ratio, is a measure of the average excess return per unit of risk.
Tp = (Rp - Rf) / Bp
c) Sharpe Ratio: It is also known as the reward-to-variability ratio, differs from the Treynor ratio only in its choice of risk measure. Like Treynor’s quantity, the Sharpe ratio is a measure of the reward/risk ratio and the numerator is the same as Treynor’s. However, the Sharpe ratio of a portfolio uses total risk, in the form of the portfolio’s standard deviation of returns, as the risk measure.
Sp = (Rp - Rf) / Tp
Sp = Sharpe ratio Rp = the average return on the portfolio over a specified period of time Rf = the average risk-free return over a specified evaluation period Tp = the standard deviation of returns over a specified evaluation period
What measure of portfolio performance eliminates the effects of portfolio cash flows and measures only the cumulative performance of the portfolio’s investments?
a) Money-weighted return
b) Dollar-weighted return
c) Time-weighted return
d) Internal rate of return
A. Unlike the dollar-weighted return, the time-weighted return eliminates the effect of portfolio cash flows and measures only the cumulative performance of the portfolio’s investments. If an IA has recommended all the securities in a client’s portfolio, the the time-weighted return measures the performance of the IA’s recommendations. Since the IA cannot control when a client deposits or withdraws money, it is not appropriate to use the dollar-weighted return to measure the performance of the IA’s recommendations.
Which of the following types of return is an internal rate of return?
a) Mean return
b) Real rate of return
c) Time-weighted return
d) Dollar-weighted return
The dollar weighted return is an internal rate of return that equates the ending value of the portfolio to the beginning value of the portfolio and all portfolio cash flows. In essence, it is a time value of money problem that solves for the discount rate, which in this case is the portfolio return.
Over a number of years, David has recommended all twenty stocks that his client Scarlet now has in her portfolio. What type of return would be the most appropriate measure of the return based on David’s stock picks?
a) Cash-on-cash return
b) Time-weighted return
c) Dollar-weighted return
d) Load-adjusted return
B. The Time-weighted return. It measures only the cumulative performance of the portfolio’s investments. If an advisor has recommended all of the securities in a client’s portfolio, then the time-weighted return measures the performance of the advisor’s recommendations.
William holds his portfolio in a wrap account, which charges a fixed management fee. When Williams sits down with his advisor to evaluate the performance of his portfolio, which of the following guidelines should they follow?
a) The performance evaluation should be based on post-fee returns
b) The performance evaluation should be based on the beta of the portfolio multiplied by the risk-free rate of return
c) The performance evaluation should be based on pre-fee returns
d) The performance evaluation should be based on the risk-free rate of return plus a risk premium
A. Performance evaluation for individual investors should be based on post-fee returns. Fees in this case refer to management fees, not commissions. If fees are not factored into the calculation, the client’s return will be overstated.
What is the Treynor ratio?
a) The portfolio’s risk premium
b) The portfolio’s risk premium per unit of systematic risk
c) The portfolio’s risk premium per unit of unsystematic risk
d) The portfolio’s risk premium per unit of total risk
B. The Treynor ratio, also called Treynor’s reward-to-volatility ratio is a measure of the average excess return per unit of systematic risk. The average excess return is defined as the average portfolio return minus the average risk-free return.
