Lecture 5 Flashcards
Performance metrics
Alpha: measure of active return (excess return over benchmark)
Jensens Alpha: risk-adjusted excess return
Beta represents a measure of systematic risk
Beta > 1 implies that the fund takes more systematic risk than market
Overview of risks
Market risk - all types
Liquidity risk - risk of not being able to sell
Credit risk - risk of default (fixed income)
Interest rate risk - fixed income mainly
Country and currency risk- foreign investments
Risk measures
Volatility: Standard deviation of returns
Value at Risk / CVAR: measures of risk of loss under extreme scenarios
Risk adjusted performance metrics
Sharpe ratio: measure of absolute return (above risk free rate) per unit of volatility
Information ratio: measure of relative return per unit of relative risk of portfolio vs benchmark
Treynor ratio: measure of return relative to systematic risk (beta)
Sortino ratio: measure of absolute return per unit of downside deviation
Portfolio appraisal measures (1)
Alpha
- measure of portfolios excess return compared to return of a benchmark index
- Degree by which fund manager is able to outperform benchmark
- Commonly used to rank fund managers
Beta
- return of benchmark or market index. Beta measures the sensitivity of a portfolios returns to changes in the overall market
R squared or coefficient of determination
- the square of the correlation coefficient
- preserves the magnitude (of correlations) but ignores sign
- shows % of “explained” co movement between 2 variables
- can be used to assess co movement between fund and benchmark returns
Portfolio appraisal measures (2)
Jensens alpha
- measures performance of any diversified portfolio against a benchmark with the same level of systematic risk
Beta represents a measure of systematic risk and is calculated by regressing the return of a given stock or fund on the relative market index
Beta >1 implies fund takes more systematic risk than market
Beta measures the portfolios relationship with market risk (slope), measure of covariance between returns
Alpha: regular addition to return (intercept), above what comes from being exposed to the market
Portfolio appraisal measures (3)
Sharpe ratio
- measure of risk adjusted return
- how much excess return an investment is getting for each unit of risk take
The higher the sharpe ratio the more successful the portfolio
M squared measure
- measures the return that would be achieved if the portfolio had taken the same risk as the benchmark
- the fund with the highest Msquared will have the highest return for any level of risk
- portfolio orderings based on M squared will be the same as orderings based on sharpe ratio
- if portfolio standard deviation = standard deviation of the benchmark, Msquared will be the same as portfolio return
Portfolio appraisal measures (4)
Treynor ratio
- measures returns earned in excess of that which could have been earned on a riskless investment
- uses systematic risk rather than total risk
Sortino ratio
- similar to sharpe ratio but only looks into downside risk (standard deviation of negative returns)
- useful when return distribution is non normal (for example hedge returns)
Portfolio appraisal measure (5)
Appraisal ratio
- compares funds alpha to the portfolios unsystematic risk or residual standard deviation
- Assesses the abnormal return by reference to unrelated systematic risk carried in the client portfolio and not present i. The benchmark portfolio
- if AR exceeds the benchmark sharpe ratio, then the active performance has provided a superior performance contribution, as the extra return has more than compensated for the additional risk
Information ratio
- measures expected active return divided by the amount of risk the manager takes relative to the benchmark
- often used as guage of managers skill
- the higher the IR, the higher the active return of the portfolio, given the amount of risk taken and the better the manager
- however it is always worth remembering that high IR may be product of luck rather than skill especially if calculated over a short history
Portfolio appraisal measures
Total Expense Ratio or Ongoing Charge Figure
- measure of total cost of investing in a fund
- includes management, operating and administrative fees as a % of total assets managed
- includes any costs paid to 3rd parties
- does NOT include transaction costs
TER and OCF are often calculated at least once a year on an ex-post basis and is also detailed with previous year TERs for operating cost comparison purposes
Useful to compare across similar funds
Performance evaluation
Measurement and assessment of outcomes of investment decisions taken by management in an investment process
Performance measurement
Focuses on the determination and accuracy of return measures while
Performance evaluation builds on this by specifying an appropriate benchmark against which the ex post returns are compared
Computing returns
Holding Period Return: total return from income and asset appreciation over a period of time expressed as a %
Total return: capital appreciation (=price return) and income (= income return) over holding period
Average return: mathematical average of returns over a certain period of time.
Types of returns
Time weighted return: compound rate of return of a unit of money invested in an account. Requires recalculation when external cashflows occur
Money weighted return: return of the final value of the fund and the beginning value. Includes intermediate cashflows
For investments denominated in foreign currency
Local currency return : return calculated in Foreign currency with no exchange rate translation
Unhedged return: return calculated in domestic currency and subject to exchange rate risk
Hedged return: return calculated in domestic currency with exchange rate risk hedged away through forward contracts
