Investments Ch 5 Flashcards
INTRODUCTION
- Financial analysts begin the portfolio performance evaluation by
computing the various types of returns and measures of variability. - The return and risk measures are used to compute risk-adjusted
measures of performance. These measures assess how a portfolio
has performed. - Attribution analysis provides the reasons behind that performance.
BENCHMARK PORTFOLIO
- A customized portfolio that contains securities similar to those held
by the manager and is weighted comparably. - Sometimes referred to as a normal portfolio, it has identical risk
levels to the actual portfolio. - Indexes are only appropriate if the portfolio contains similar stocks
held with similar weights as those in the index.
BENCHMARK PORTFOLIO: EXAMPLE
Consider a client with a 10% return objective. A financial adviser creates a policy statement for that client, identifies relevant financial securities that fit the risk return profile for this client, and drafts an optimal asset allocation using specialized optimization techniques.
* After one year, the financial adviser’s recommendations produce a
return of 10%.
* Question: Is this client satisfied with the performance of the portfolio?
BENCHMARK PORTFOLIO: EXAMPLE
Consider a client with a 10% return objective. A financial adviser creates a policy statement for that client, identifies relevant financial securities that fit the risk return profile for this client, and drafts an optimal asset allocation using specialized optimization techniques.
- After one year, the financial adviser’s recommendations produce a
return of 10%. - Question: Is this client satisfied with the performance of the portfolio?
FORMING A BENCHMARK PORTFOLIO
- The formation of the benchmark portfolio is critical in determining
relative performance. - It may be appropriate to use an index or combination of indexes as
the benchmark. - A more complex way is to select securities that have high
correlations with the securities in the portfolio.
PERFORMANCE MEASURES
Risk-adjusted performance measures consider risk and return.
- Treynor Ratio - the return is adjusted for systematic risk (beta)
- Sharpe Ratio - the return is adjusted for total risk (standard deviation)
- Jensen’s Alpha uses market data and adjusts for systematic risk
PERFORMANCE MEASURES: EXAMPLE
PERFORMANCE MEASURES: EXAMPLE
THE ASSET ALLOCATION DECISION
THE ASSET ALLOCATION DECISION
Asset allocation is an investment decision in which portfolio weights
are assigned to reflect the investor’s risk profile.
- Typically, optimization software is used to determine the optimum
portfolio and can be adjusted over time.
BUY AND HOLD STRATEGY
BUY AND HOLD STRATEGY
Some investors are comfortable allowing rising and falling markets to
change their original allocations.
- A buy and hold strategy is one in which the investor does nothing
to rebalance the portfolio weights.
–Lower transaction costs are associated with this strategy.
–Over time, the current allocation could potentially be much
different than the original weights in the allocation.
– The major problem: the portfolio can have significantly different
return and risk profiles than when originally constructed
CONSTANT WEIGHTING ALLOCATION
CONSTANT WEIGHTING ALLOCATION
- Investors initially decide on a strategic allocation.
- The target weights for the portfolio are typically allowed to fluctuate
within a narrow tolerance range
CONSTANT WEIGHTING: EXAMPLE
Example: Consider an investor who owns two mutual funds: an equity fund and a fixed income fund
CONSTANT WEIGHTING: EXAMPLE
Example: Consider an investor who owns two mutual funds: an equity fund and a fixed income fund
TACTICAL ASSET ALLOCATION
TACTICAL ASSET ALLOCATION
- Tactical Asset Allocation attempts to profit from short term
mispricing. - Deviations from the long-term allocations are pursued over the short term to increase returns.
DYNAMIC ALLOCATION STRATEGIES
DYNAMIC ALLOCATION STRATEGIES
- Dynamic allocation is a strategy in which the portfolio weights are
constantly being adjusted to reflect changing market conditions and
changing asset values. - Active strategy where macroeconomic variables determine which
asset class should be over-weighted.
ASSET SELECTION
The part of the investments process in which the securities to be
included in the portfolio are selected.
ASSET SELECTION
The part of the investments process in which the securities to be
included in the portfolio are selected.
Four fundamental means of selection:
- Discounted cash flow technique
- Relative valuation with multipliers
- Technical analysis
- Indexing
DISCOUNTED CASH FLOW
DISCOUNTED CASH FLOW
- The value of a firm is based on its ability to generate operating cash flows.
- Intrinsic value of stock or bond = the present value of its expected cash flows.
INTRINSIC VALUE FOR BONDS AND STOCKS
For a bond with no embedded options:
INTRINSIC VALUE FOR BONDS AND STOCKS
For a bond with NO embedded options:
* Simply discount the coupon and principal payments to determine
present (intrinsic) value.
For bonds with embedded options:
* Payments are contingent on interest rate or price
movements, but the intrinsic value can still be computed using
sophisticated mathematics.
For equity securities:
* Intrinsic value is the present value of the expected dividend
payments and capital gains
RELATIVE VALUATION WITH MULTIPLIERS
RELATIVE VALUATION WITH MULTIPLIERS
- Valuing a company can also be done by comparing it to the value of
its competition. - Relative valuation can be completed with far fewer assumptions
than the discounted cash flow method.
ASSET SELECTION DECISION
The big challenge in using multiples is to find acceptable peer groups.
ASSET SELECTION DECISION
The big challenge in using multiples is to find acceptable peer groups.
- Advisers must select from among firms in various industries across
sizes, capital structures, and even countries. - Relative value analysis is as much an art as it is a science.
Relative measures: - Price to earnings ratio (PE)
- Price to book ratio (PB)
- Price to sales ratio (PS)
- Price to cash flow (PCF)
- Enterprise to earnings (EE)
RELATIVE VALUATION: EXAMPLE
Bernice is a financial adviser searching for one stock to add to one of
her institutional client’s portfolios. Bernice has narrowed her choices to three firms in the same industry, each with acceptable risk levels for the client.
Bernice uses relative valuation to estimate the following multiples for each firm
RELATIVE VALUATION: EXAMPLE
Bernice is a financial adviser searching for one stock to add to one of
her institutional client’s portfolios. Bernice has narrowed her choices to three firms in the same industry, each with acceptable risk levels for the client.
Bernice uses relative valuation to estimate the following multiples for each firm
TECHNICAL ANALYSIS
TECHNICAL ANALYSIS
- Technical analysis is the use of historical pricing and volume data
to make asset selection decisions. - Technicians believe that patterns exist, and that history does repeat
itself. - Users of technical analysis believe that market sentiment and
pricing patterns are appropriate to value a company
INDEXING
INDEXING
- Indexing results in performance that closely matches general stock
market returns. - Many passive investors choose a portfolio of different index funds
ATTRIBUTION ANALYSIS AND FAMA DECOMPOSITION
ATTRIBUTION ANALYSIS & FAMA DECOMPOSITION
- Eugene Fama wondered if manager performance was due to luck
or unique skill sets developed by the managers. - Fama decomposition model begins with four component pieces:
- Risk-free rate of return
- Expected return demanded by the client
- Extra return provided by the manager due to market timing skills
- Extra return provided by the manager due to security selection kills
FAMA DECOMPOSITION: EXAMPLE (1 OF 5)
- An endowment fund hires Edward York, CFA, to manage its portfolio.
The endowment fund has a target beta of 1.11 but allows York to
deviate from that level as part of a tactical strategy. York identifies a
diversified portfolio that has an actual beta of 1.23. Additional critical
data is shown in the table below:
FAMA DECOMPOSITION: EXAMPLE (1 OF 5)
- An endowment fund hires Edward York, CFA, to manage its portfolio.
The endowment fund has a target beta of 1.11 but allows York to
deviate from that level as part of a tactical strategy. York identifies a
diversified portfolio that has an actual beta of 1.23. Additional critical
data is shown in the table below:
Risk Free rate of return 3.4 %
Market risk premium 7.1 %
Market portfolio volatility 10 %
- After one year, the portfolio has generated a return of 15.1% with a
standard deviation of 23%
__________________________________________ - In this example, York’s target beta is 1.11 but he tactically chose to
invest in a portfolio with a beta of 1.23. With a market risk premium
of 7.1%, the two returns can be calculated as follows:
Clients return 1.11 x 7.1 = 7.881%
York’s return 1.23 x 7.1 = 8.733%
- York exceeded the client’s return by 0.852% (8.733 – 7.881)
____________________________________________
Fama suggests that York’s return could reasonably be expected to
be 12.133%:
Risk Free Rate 3.4 %
Clients Return 7.881 %
Yorks extra return for Higher beta portfolio .852%
Total expected Return for York’s portfolio 12.133% - The actual return on York’s portfolio is 15.1%.
- York outperformed by 2.967% (15.1 – 12.133)
____________________________________________
The equation for the return that should have been earned based on
total risk is:
Return = Risk-Free Rate + Market Risk Premium × (SDp/SDm)
Return = 3.4 + 7.1 × (0.23/0.18) = 12.472%
Net selectivity is: 15.1 – 12.472 = 2.628%
___________________________________________
Summary of decomposition of return:
Risk Free Rate 3.40%
Strategic Return of Portfolio 7.881%
Tactical Out performance ( market Timing) .852%
Net selectivity 2.628%
Return for lack of diversification .339%
total portfolio Return 15.100 %
BRINSON, HOOD AND BEEBOWER (BHB)
BRINSON, HOOD AND BEEBOWER (BHB)
- The Brinson, Hood, and Beebower (BHB) model found that the
asset allocation decisions were the most significant driver of
portfolio variability. - Found that over 90 percent of return variability is explained by asset allocation.
FIXED INCOME ATTRIBUTION ANALYSIS
FIXED INCOME ATTRIBUTION ANALYSIS
- Fixed income investors and issuers have become more complex in
their needs as have the characteristics of bonds being issued. - Fixed rate bonds are the most commonly issued bonds today.
- More complex securities are also available.
COMPONENTS OF FIXED INCOME ATTRIBUTION ANALYSIS
The components of fixed-income attribution analysis are:
COMPONENTS OF FIXED INCOME ATTRIBUTION ANALYSIS
The components of fixed-income attribution analysis are:
* Policy Effect
* Rate Anticipation Effect
* Analysis Effect
* Trading Effect
POLICY EFFECT
POLICY EFFECT
- The policy effect measures the return impact of the difference
between the duration of the benchmark and the duration of the
portfolio. - Basic policy decision that reflects the general difference in interest
rate risk between the two. - Higher portfolio duration suggests higher portfolio return in periods of falling rates
RATE ANTICIPATION EFFECT
RATE ANTICIPATION EFFECT
- The rate anticipation effect measures the return impact of the
difference between the strategic duration of the portfolio and tactical
deviations from it. - Managers can add value by shortening duration when rates rise
and lengthening duration when they fall.
The Nacho Equity Fund has a beta of 1.44 and a standard deviation of 20.8%. It has returned 12.9% during the past year when the return on one-year Treasury bills has been 3.2%. The Sharpe Ratio of the Nacho Equity Fund is closest to:
.466.
Rationale
Sharpe = (Portfolio Return-Risk Free Rate)/(Standard Deviation)
Rp - Rf Sp = ------------------
SD
Rp = Portfolio Return
Rf = Risk Free Rate
SD = Standard Deviation
Sharpe = 12.9 - 3.2
——————- = 0.466
20.8
A fixed income manager identifies the ten bonds in the portfolio with the highest duration. The manager increased allocation to those bonds because of expectations that yields will fall over the next three months. The results of this decision will most likely be revealed in the:
Rate anticipation effect.
Rationale
The rate anticipation effect will show any tactical decisions made by the portfolio manager by altering duration over the short term. When rates fall, the price of those longer duration bonds will rise dramatically and improve total bond return
A financial analyst computes the price-to-sales ratio as a comparison to determine which company is most expensive. The analyst is most likely using:
Relative valuation methodology.
Rationale
Relative valuation method uses price multiples to determine the relative value of each individual stock. The price-to-sales ratio is commonly used for firms that do not have a long history of positive earnings.
A financial analyst computes present value of a firm’s operating cash flows to calculate an intrinsic value of the shares. The analyst is most likely using:
A discounted cash flow technique.
Rationale
Discounted cash flow analysis includes estimating future cash flows and then discounting them at an appropriate interest rate. The present value is often times referred to as the intrinsic value of the company.
Technical analysis most likely relies on the belief that:
Stock price patterns exist and can be predicted.
Rationale
Technical analysis is almost the opposite of fundamental analysis. Technicians do not believe that capital markets are efficient, that prices are reflective of relevant information, and that behavioral investors can be ignored. Rather, they believe that historical price and volume data can be used to predict future stock price through the analysis of patterns
Digger’s portfolio generates a return of 14% when the risk-free rate of interest is 3% and the return due to the risk of the portfolio is 10%. The Fama decomposition would assign a selectivity value that is closest to:
1%.
Rationale
Total portfolio return 14%
- return due to portfolio risk 10%
- risk-free rate 3%
________________________________
Equals selectivity 1%
Adrian, a portfolio manager, generates a return of 14% when the benchmark returns 11.5%. The manager’s security selection decisions outperform by 150 basis points.
Which is least accurate?
Asset allocation decisions outperform by 250 basis points.
Rationale
Total outperformance can be divided into asset allocation and security selection decisions.
The total outperformance in this case is 250 basis pints. If the manager outperformed in security selection by 150 basis points, the difference had to be made up in the asset allocation decision. Asset allocation had to be 100 basis points
Inputs to the Fama Decomposition model least likely include:
Risk-free rate of interest.
The client’s preferred beta.
The money manager’s market timing skills.
The annualized rate of inflation.
The annualized rate of inflation.
Rationale
Fama does not require the use of the inflation rate. Fama does begin, as do many other models, with the risk-free rate and then adds systematic risk, market timing and security selection skills of the money manager.
In computing portfolio performance, the Sharpe index uses ______________, while the Treynor index uses ________________ for the risk measure.
standard deviation; beta
Sharpe may be remembered as beginning with the letter “‘S” as does standard deviation. This mnemonic device may be helpful.
Which risk adjusted performance is best for each description?
A sector mutual fund with a r-squared (to the S&P 500) of .59
Relative risk adjusted performance measures
A well diversified mutual fund with a r-squared (to the S&P 500) of .88
Absolute risk adjusted performance measures
Solution:
Sharpe Only: A sector mutual fund with a r-squared (to the S&P 500) of .59
Sharpe and Treynor: Relative risk adjusted performance measures
Treynor and Alpha: A well diversified mutual fund with a r-squared (to the S&P 500) of .88
Alpha Only: Absolute ( CAN BE SUES ALONE)
risk adjusted performance measures
- Define & Calculate: TEST
- Sharpe
- Treynor
- Jensen
- When to use Sharpe, Treynor, Jensen ???
- Function of r-squared
SHARP RATIO
SHARP RATIO TEST
Rp - Rf Sp = ---------------------------
SD =( TOTAL RISK )
Rp = Portfolio Return
Rf = Risk Free Rate
SD = Standard Deviation
Sharpe Index is a relative risk adjusted performance
indicator and measures risk premiums of the portfolio relative
to the total amount of risk in the portfolio.
Measures reward to total variability or total risk
Risk -adjusted performance measure, meaning is needs to be compared with another Sharpe Ratio to provide meaning.
Measure of how much return was achieved for each unit of risk.
HIGHER Sharpe ratio = better because that means more return was provided for each unit of risk. MORE RETURN FOR UNIT OF RISK.
Measures risk premiums of the portfolio relative to the total amount of the risk in the portfolio
Does NOT measure a portfolio manager’s performance against that of the market.
Investor seeking to invest in a single fund should select the fund with the highest Sharpe ratio.
- That fund will provide the most return, for each unit of risk.
Treynor Index
TREYNOR INDEX TEST
Rp - Rf Treynor Index Tp = ------------------
βp
Rp = Return of portfolio
Rf = Risk Free return
βp = Beta of portfolio
A relative risk-adjusted performance measure It’s also a “relative risk adjusted performance indication, meaning one Treynor ratio needs to be compared to another Treynor ratio to provide meaning.
A measure of how much return was achieved for each unit of risk.
Higher the Treynor ratio , the better because that means more return was provided for each unit of risk. MORE RETURN FOR UNIT OF RISK.
It measures the reward achieved relative to the level of systematic risk ( BETA )
It justify s use of the model on the assumption that in a well -diversifed portflio, the unsystematic risk is already close to zero.
Measures the reward achieved relative to the level of
systematic risk (as defined by beta).
Treynor Index doesn’t indicate whether a portfolio manager
has outperformed or under performed the market.
Excess return refers to the return earned above the return that could have been earned in a risk-free investment.
EXAMPLE
Assume Portfolio Manager A achieves a portfolio return of 8% in a given year, when the risk-free rate of return is 5%; the portfolio had a beta of 1.5. In the same year, Portfolio Manager B achieved a portfolio return of 7%, with a portfolio beta of 0.8.
The Treynor Index is therefore 2.0 for Portfolio Manager A, and 2.5 for Portfolio Manager B. While Portfolio Manager A exceeded Portfolio Manager B’s performance by a percentage point, Portfolio Manager B actually had the better performance on a risk-adjusted basis.
Jensen’s Alpha TEST
ap = rp - [rf + βp (Rm - Rf)]
Where: Rp = realized portfolio return
Rf = risk-free rate of return
ap = alpha (excess return above expected return)
βp = beta of the portfolio
Rm = ex
The Jensen Model
The Jensen Model ALPHA TEST
Ap = rp - [ rf + Bp(rm - rf) ]
Rp = realized portfolio return
Rf = risk free rate of return
Ap =Alpha an intercept that measures the manages forecasting ability
Bp = Beta of the portfolio
Rm = Expected return of the market
- The Jensen Index is capable of distinguishing a manager’s
performance relative to that of the market. - Treynor and Sharpe are calculations for providing a
measure and ranking of relative performance, Jensen’s
model attempts to construct a measure of absolute
performance on a risk-adjusted basis. - The Jensen Index is capable of distinguishing a manager’s
performance relative to that of the market. - Treynor and Sharpe are calculations for providing a
measure and ranking of relative performance, Jensen’s
model attempts to construct a measure of absolute
performance on a risk-adjusted basis.
An absolute performance measure simly means tha that looking at Jenen’s Alpha tells you something
- POSTITIVE Alpha = fund manger provided MORE return that was expected for the risk undertaken GOOD
-NEGATIVE Alpha = Fund manger provided LESS return that was expected for the risk undertaken BAD
-ZERO Alpha = Fund manger provided a return EQUAL to the return for the risk undertaken
A portfolio managers performance is judged relative to the Capital Asset Pricing Model. The ALPHA is indicative of the level of a managers performance.
Donna’s mutual fund returned 15% last year, with a beta of 2. The
risk free rate of return was 3%, the market return was 8%. The
standard deviation is 18%. Calculate alpha.
TEST
Donna’s mutual fund returned 15% last year, with a beta of 2. The
risk free rate of return was 3%, the market return was 8%.
The standard deviation is 18%. Calculate alpha.
Ap = rp - [ rf + Bp (rm - rf) ]
15% - [ 3% + 2 ( 8 - 3 ) ] = 3% POSITIVE ???? check this
If mutual fund ABC has a correlation of .80 to the S&P 500, which
risk adjusted performance measures would be appropriate to
measure the performance of fund ABC?
TEST
If mutual fund ABC has a correlation of .80 to the S&P 500, which
risk adjusted performance measures would be appropriate to
measure the performance of fund ABC?
Correlation = .80
so, R2 = .80 squared = .64
sine .64 is less than .70 cannot use BETA
so cannot use Treynor or Jensen.
Must use Sharpe
?????? check this
Kenny owns a stock with a beta of 2 and a standard deviation of
15%. The stock returned 12%. Lisa owns a stock with a beta of 1.2 and
a standard deviation of 13%. The stock has a total return of 14%. The
risk free rate is 3%. Using the Sharpe ratio, which portfolio
performed better?
TEST check on this ????
Kenny owns a stock with a beta of 2 and a standard deviation of
15%. The stock returned 12%. Lisa owns a stock with a beta of 1.2 and a standard deviation of 13%. The stock has a total return of 14%.
The risk free rate is 3%. Using the Sharpe ratio, which portfolio
performed better?
Rp - Rf Sp = ---------------------------
SD =( TOTAL RISK )
Rp = Portfolio Return
Rf = Risk Free Rate
SD = Standard Deviation
Kenny 12 % - 3 %
——————— = .60
15%
Lisa 14 % - 3%
——————— = .84 «< Best , since higher !!
13%
WHEN TO USE SHARPE, TREYNOR or ALPHA
- Both Treynor and Sharpe use BETAS as the RISK measure
- good for risk -adjusted performance indicators when considering a diversified portfolio
- When determining which Fund preformed better on a risk adjusted basis, always rank the SHARPE or TREYNOR ratios , then select the HIGHEST
SELECT WHICH RISK-ADJUSTED PERFORMANCE MEASURE TO USE BASED ON R SQUARED.:
USE TREYNOR and ALPHA : (R2 at or greater .70 )
* Portfolios are diversified if R -squared is greater then = for greater then .70 (BETA considered a reliable measure of risk )
USE SHARPE : ( R2 less than .70 )
*Portfolio NOT diversified if r-squared is less then .70, therefore Standard deviation is an best to use as risk measurement. So use SHARPE ( uses standard Deviation )
EXAMPLE: Evaluating Funds
STD DEV R2 ALPHA Sharpe FUND A 12% .92 2.0 1.2 FUND B 13% .90 1.8 1.5
Since both portfolios are well diversified ,(R2 = greater than .70), then evaluate the funds based on risk-adjusted performance. indicator that uses Beta. Since ALPHA uses Beta as its measure of risk, the fund with the HIGHER Alpha is best.
EXAMPLE:
If mutual fund ABC has r2 of .64 to the S P 500, which of the following performance measures would be appropriate to measure the performance ?
Treynor
Jenson
Sharpe
Treynor and Shapre
Treynor and jenson
Since r2 = .64%, then only 64% of the return for the ABC fund is due to the S P 500. Therefore .36% is due to diversifiable risk. Since Beta only measures (no-diversiable risk), too much return is due to diversifiable risk, therefore Beta is NOT appropriate .so no Treynor or Jensen. since use Beta.
SHarpe is best since uses standard Deviation, which measures total market risk ( non-diversifiable ) and diversifiable.
Eugene Fama is known for each of the following except:
Research on fixed-income attribution analysis.
Decomposition of portfolio manager’s performance.
Development of the efficient markets hypothesis.
Winner of the Nobel Prize in economic sciences.
Research on fixed-income attribution analysis.
Rationale
Fama is one of the fathers of modern portfolio theory but is not known for work done in fixed-income attribution analysis.
The Big Mountain Mutual Fund is a powerful institutional investor that regular moves prices upward or downward depending on its net position in specific equity securities. Recently, and after substantial due diligence, Big Mountain announced it was short 10 million shares of Galactic Energy, whose price subsequently dropped by 20% overnight. Which statement regarding Big Mountain is most accurate?
Big Mountain’s influence on prices is a violation of modern portfolio assumptions.
Rationale
Modern portfolio theory relies on an assumption that all investors are price takers, implying that no individual or institutional investor can impact prices with their portfolio decisions. Big Mountain is able to move prices with its investment decisions, making it a violation of the assumptions
