Lesson 7

Question 1

7.1.1 Identify two things that are needed to evaluate the performance of a portfolio manager and the associated challenges of each component

Answer 1

1. measurement of the actual returns of the portfolio, This that implies the question of whether past performance is indicative of future performance
2. A way of comparing actual returns to that of one or more benchmarks considering the risk involved, which depends greatly upon the context in which the comparison is made

Question 2

7.1.2 Explain the concept of abnormal return

Answer 2

Returns produced by some active portfolio managers are hard to label as lucky outcomes. These abnormal returns measure how the portfolios actual returns differ from expected returns of its benchmark over a given period of time and can be either positive or negative

Abnormal returns are sometimes triggered by events typically defined as information or occurrences that have not already been priced into the market in expected return calculations. Events that can contribute to abnormal returns including mergers, dividend announcements, company earnings announcements, interest rates, lawsuits etc

Abnormal return is useful to investors for comparing investments returns to market performance. It can also be used as a measure of manager performance to help determine an investment managers skill on a risk-adjusted basis and whether investors were adequately compensated for the amount of risk assumed

Question 3

7.1.3 Assume that stocks actual return for a particular the year was 22% and the expected return if it’s benchmark was 12%. Using the abnormal return formula to calculate and interpret the abnormal return of the stock

Answer 3

The abnormal return is 10%

Some unexpected media event, such as the superior earnings announcement or the resolution of a corporate lawsuit in favour of the company, may have affected the stocks actual return

Question 4

7.1.4 Outline seven factors that can complicate the evaluation of active manager performance

Answer 4

1. The traditional measures are based on CAPM which assumes portfolio mean returns and variance are consistent
2. Managers make available daily return information however the composition of their portfolios is usually only available quarterly which allows for adjusting portfolio holdings close to the reporting date to create the appearance of selection of successful stocks
3. Fund managers have considerable leeway in the presentation of past investment performance and fees charged. This can create presentation bias
4. Measurements are taken in a population his membership varies overtime. Since successful funds may cease operation the returns used for comparison are upwardly biased resulting in survivorship bias
5. When portfolios are actively managed, mean and variance may not be consistent, traditional performance measures assume some stability in portfolio holdings
6. Performance measurement happens after the fact and most risk adjusted performance measures or subject manipulation. Managers can observe their returns over a given evaluation period and adjust portfolio holdings to influence performance measurements
7. Many industry measures of active manager performance are based on comparisons to some benchmark portfolio; this is only appropriate if the risks are similar

Question 5

7.1.5 Define market noise and provide examples

Answer 5

Market noise refers to information or activity that confuses or misrepresented genuine underlying trends.

Economist fisher black in the mid-1980s argued that a disproportionate amount of trading occurred on the basis of noise rather than information which he argued ought to be distinct.

In the context of equities noise signifies stock market activity caused by program trading, dividend payments or other phenomena that don’t reflect market sentiment. Noise can also come through the financial press, the Internet, and even the workplace

Question 6

Define program trading

Answer 6

Program trading is where trades of baskets of securities are executed by a computer program simultaneously based on predetermined conditions

Question 7

7.1.6.a List 4 constraints that can influence pension plan investment policy development and, in turn, impact selection of appropriate manager performance measures

Answer 7

1. Liquidity needs
2. Planned investment horizon
3. Fiduciary responsibilities imposed by regulations
4. Taxation considerations

Question 8

7.1.6.b In the context of a constraint that influences pension plan investment policy define liquidity needs

Answer 8

The quality is the ease or speed with which an asset can be sold at a fair price. It is affected by the time dimension in the price dimension of the asset. That is how long it will take to to dispose of and the discount from fair market price

Cash and money market instruments such as T-bills and commercial papers are the most liquid assets. Investors consider how likely they are to dispose of assets on short notice and from this establish a minimum level of liquid assets they want in their investment portfolio

Question 9

7.1.6.c In the context of a constraint that influences pension plan investment policy define planned investment horizon

Answer 9

This is the plant liquidation date of all or part of an investment.

Investment horizon is considered when investors choose between assets of various maturities

Question 10

7.1.6.d In the context of a constraint that influences pension plan investment policy define fiduciary responsibilities imposed by regulations

Answer 10

Regulations and governance standards impose fiduciary responsibilities on parties that oversee or manage other peoples money.

The normal standard of care relates to prudence, that is a responsibility to restrict investment to assets approved by a prudent investor.

Also, there are regulations that constrain the type of investments made by institutional investors

Question 11

7.1.6.e In the context of a constraint that influences pension plan investment policy define taxation considerations

Answer 11

The performance of an investment strategy is measured by how much yields in real after-tax investment returns.

Some considerations are the marginal tax rate of an individual investors or that pension plans are tax exempt

Question 12

7.1.7 Explain how the nature of actively managed portfolio is contributes to performance measurement challenges

Answer 12

Getting statistically significant performance measures is difficult when portfolio return distributions are constantly changing as the manager regularly updates to portfolio in accordance with its financial analysis.

Substantial measurement errors may occur if statistics are calculate it over a sample period on the assumption of a constant mean and variance when portfolio return distributions are constantly changing.

For actively managed portfolio, it is critical to keep track of portfolio composition and changes in the portfolio mean and variance

Question 13

7.2.1.a Identify for traditional measures of return used in the evaluation of investment performance

Answer 13

1. Holding period return
2. Arithmetic average
3. Geometric average, time weighted rate of return
4. Internal rate of return, dollar weighted rate of return

Question 14

7.2.1.b Describe the holding period return and list three things it depends on

Answer 14

The HPR is the total return received from holding an asset over the period of time the asset is held.

HPR is commonly used to calculate returns on stocks but can be used for any security who’s market value can fluctuate between the beginning and ending price depends on:

1. The difference between the asset price when it was purchased and the price at the end of the holding period
2. Any income in the form of dividends over the holding period.
3. Any income in the formal interest over the holding period

Question 15

7.2.1.c Describe geometric average as a traditional return measure used in the evaluation of investment performance

Answer 15

The formula for geometric average is you specifically for investments that are compounded.

It is a better method for a good getting investment returns over multiple holding periods.

This method is insensitive to cash flow timing

Question 16

7.2.1.d Describe Internal rate of return, dollar waited rate of return, as a traditional return measure used in the evaluation of investment performance

Answer 16

The formula for internal rate of return incorporates the size and timing of cash flows, so it is an effective method for calculating the return on investment portfolio, particularly a pension fund portfolio with sizeable cash inflows and outflows throughout the year.

It is calculated by finding the rate of return that will set the present values of all cash flows and terminal values equal to the initial investment.

Since the timing of the cash flow (significant investment before a market downturn for example) can have an impact on the IRR it is not appropriate to measure of the performance of an investment manager who has no control over cash flow

Question 17

7.2.2 Explain why the geometric average is a commonly used method of measuring an investment managers performance

Answer 17

The time weighted rate of return is commonly used as a method of measuring the investment managers performance because it minimizes the impact of cash flow’s on rate of return calculations.

This is important when measuring investment manager performance because the manager has no control over the timing of cash flow contributions from a client; the time waited return focusses on the investment managers performance over the period

Question 18

7.2.3 Explain why the internal rate of return is a useful investment performance measure for a defined benefit pension plan

Answer 18

Most defined benefit pension plans of regular inflows and outflows resulting from contributions and benefit payments. The internal rate of return is an effective performance measure for such a pension funds because the calculation incorporates the time and size of cash flows.

Defined benefit pension funds internal rate of return can be used to determine whether the plan has experienced a gain or loss from investments during the period under review

This is done by comparing the upper case IRR to the plans actuarial assumption regarding the expected rate of return

Question 19

7.2.4 Assume your employers D be pension plan held $143 million at the start of the year and $165 million at the end of the year And had a net positive contribution amount in the year equal to $8 million

Use the internal rate of return approximation formula to calculate the internal rate of return

Answer 19

The internal rate of return of the pension fund in the year was approximately 9.52%

Question 20

7.2.5 Assume that the count in your defined contribution pension plan was worth $78,534 at the end of last year and is now worth $93,810.

During the past year you and your employer contributed monthly for a total of $7800 of new contributions.

You may know withdrawals. Use the internal rate of return approximation formula to calculate the approximate internal rate of return on your defined contribution account over the year.

Answer 20

You are defined contribution pension account earned an internal rate of return in the year of approximately 9.07%

Question 21

7.2.6 Explain how the Markowitz mean variance theory facilitates the valuation of a portfolio managers performance

Answer 21

Markowitz mean variance theory proposes that a portfolio can be described in just two measures it’s mean and it’s variance.

Essentially it separates the construction of the efficient risky portfolio from the allocation of funds between the efficient risky portfolio on the safe asset. The product decision and the consumption decision respectively.

Construction of the optimal risky portfolio results from solving a technical problem using risk return trade-offs that result in a single optimal risky portfolio that is appropriate for all investors to evaluate their choices.

Managers who use the Markowitz methodology to construct the optimal risky portfolio will satisfy all clients regardless of risky version. Clients can then evaluate the managers using statistical methods to draw inference is from related rates of return about expected or prospective sharpe ratios

Question 22

7.2.7 Gives two ways in which the reliability of performance measures can be enhanced

Answer 22

More reliable performance measures can be obtained by:

1. Maximizing the number of observations for taking more frequent return readings
2. Specifying the exact composition of the portfolio to obtain better estimates of the risk parameters of each observation period.

Question 23

7.3.1 Describe relative performance rankings and identify 6 measures used to evaluate active manager performance

Answer 23

Relative performance rankings are used to compare and investments rate of return with those within a comparison universe of other investment funds with similar risk characteristics. The higher the percentile breaking other manager within the comparison universe the better a managers performance relative to that universe. This is not a risk-adjusted measure.

1 sharpe ratio

2. Treynor Ratio
3. Jensen’s Measure (Jensen’s Alpha)
4. Information Ratio
5. Morningstar risk adjusted performance
6. Modigliani Risk-adjusted performance (M^2, M2, Modigliani-Modigliani measure, RAP)

Question 24

7.3.1.b Define the Sharpe ratio in the context of a performance measure of active managers

Answer 24

This is used to asses the attractiveness of an investment portfolio by identifying the ratio of its risk premium to the standard deviation of excess returns.

A higher ratio is preferred and it can be used to compare risk adjusted returns across all fund categories.

Question 25

7.3.1.c Define the Treynor ratio in the context of a performance measure of active managers

Answer 25

This is a measure of a portfolio’s excess return per unit of risk but uses beta (nondiversifiable risk) as a measurement of risk as opposed to the sharpe ratio’s s.d.

Beta identifies the sensitivity of the portfolio to the overall market. The higher the ratio the greater excess return being generated by the portfolio

Question 26

7.3.1.d Define the Jensen’s measure in the context of a performance measure of active managers

Answer 26

Also known as Jensen’s Alpha. Measures the average return n a portfolio or investment above/below that predicted by CAPM given the portfolio’s beta and avg mkt return. The higher the index the greater excess return being generated by the portfolio

Question 27

7.3.1.e Define the Information Ratoi in the context of a performance measure of active managers

Answer 27

Measure the portfolio manager’s ability to generate excess returns relative to the benchmark and attempts to identify the consistency of performance.

The information identifies by how much the manager has beaten the market over a few months. The higher the ratio the more consistent the manager

Question 28

7.3.1.f Define the Morningstar risk adjusted return in the context of a performance measure of active managers

Answer 28

This return measures the risk free equivalent excess return of the portfolio for an investor with a particular degree of risk aversion

Question 29

7.3.1.g Define the Modigliani risk adjusted performance in the context of a performance measure of active managers

Answer 29

This technique measures the portfolio’s returns adjusted for its risk relative to an appropriate benchmark. It is derived from the sharpe ratio but is expressed in units of % return

Question 30

7.3.2 Describe the relative performance ranking approach to evaluating active manager performance

Answer 30

The most popular approach is to evaluate returns and compare with a comparison universe. Within each universe the average returns (usually time weighted) of each fund are ordered from high o low and each portfolio receives a percentile ranking.

Relative rankings are usually displayed in a chart that summarizes performance over 5 periods, quarter, year, 3 years, 5 years, 10 years

Question 31

Define a comparison universe

Answer 31

a comparison universe is composed of a group of funds of portfolios with similar risk characteristics. For example high yield bonds portfolios are grouped into one universe and growth stock equity funds are grouped into another.

Question 32

7.3.3 Outline 2 disadvantages of the relative performance ranking approach to evaluating active managers. provide examples

Answer 32

1. The results can be misleading. If managers in a universe concentrate on particular sub types portfolio characteristics are not truly comparable. In a fixed income universe bond durations may vary across managers. in the equity universe one manager may concentrate on aggressive growth stocks.
2. Unsuccessful managers may be terminated and therefore not included in the comparison universe, creating survivorship bias

Question 33

7.3.4 Compare the sharpe and treynor’s ratios

Answer 33

The sharpe ratio measures the attractiveness of a portfolio by identifying the risk premium to the s.d. Tis is significant because investors are interested in the E return they can ear over T-bills as well as the risk they would incur.

The Treynor Ratio measures the excess return per unit of risk but uses beta rather than s.d.

The Sharpe ratio considers total risk where that Treynor Ratio considers systemic risk.

Question 34

7.3.5 A CFO manages a corporate pension fund. The fund is assigned to several portfolio managers. Explain why the Trevor Ratio is more appropriate to asses their performance than the Sharpe Ratio

Answer 34

When employing a number of managers non-systemic risk will mostly be diversified away. Therefore the Treynor ratio, which measures systemic risk, is more appropriate.

Question 35

7.3.6 Explain the advantage a M^2 ratio has compared to the sharpe ratio

Answer 35

The M^2 ratio characterized return rewards as an investor for the risk taken relative to that of the benchmark portfolio and the risk free rate. A large risk with a small return over the benchmark won’t do well by this measure. Orderings of the M2 will be the same as those of the sharpe ratio.

M2 has the advantage of units in percentage return which is easily interpretable by investors.

Question 36

7.3.7 Compare the information ratio to the sharpe ratio in the context of performance measurement

Answer 36

The information ratio measures the risk adjusted return in relation to a benchmark like the S&P 500. In addition it measures the consistency of performance over the measurement period.

In comparison the shape ratio measures how much a portfolio outperformed the risk free rate on a risk adjusted basis.

Question 37

7.3.8 Describe Jensen’s index and explain its role in measuring the performance of an investment fund

Answer 37

Alpha is the return not a result of general market movements and an alpha of 0 indicated a fund is tracking exactly the benchmark. Jensen’s Alpha compares an investment portfolio’s performance to that of a theoretical performance index rather than a market index and includes a risk adjusted beta. The higher the index the more excess return.

Question 38

7.3.9 Describe how managers can manipulate the results of risk adjusted performance measures and identify the measure that is immune to such manipulation.

Answer 38

They can affect returns over a given period because they can observe returns and adjust accordingly. When this is done the rater of return in the later part of the evaluation period depend on rates at the beginning. The only risk adjusted performance measure that is immune to manipulation is the Morningstar risk adjuseed rating.

Question 39

If you want an active portfolio to mix with an index portfolio which performance measure should you look at

Answer 39

Choose the portfolio with the higher information ratio

Question 40

7.3.11 Identify 4 characteristic a performance measure must have to be completely free of manipulation by investment managers.

Answer 40

1. It produce’s a single value score to rank a portfolio
2. The score doesn’t depend on the dollar value of the portfolio
3. An uninformed investor should not expect to improve the expected score by deviating from the benchmark portfolio
4. The measure is consistent with standard financial market equilibrium conditions

Question 41

7.4.1.a Define style analysis in terms of performance manager evaluation

Answer 41

Style analysis identifies the asset allocation characteristics of an investment portfolio and explains the returns byt that asset allocation.

It might reveal that one portfolio invests in large cap value oriented securities whereas another invests in small-cap growth stocks. Studies have shown over 90% of variations in mutual fund returns can be explained by asset allocation alone.

Style analysis s used to construct peer croups and select appropriate style specific benchmarks

Question 42

7.4.1.b Compare style analysis to M-V performance measures

Answer 42

Style analysis can construct a comparison portfolio from many more specialized indexes. Traditional M-V provides a better representation of performance relative to the theoretically prescribed passive portfolio, style analysis reveals the strategy that closely tracks the fund’s performance and measures performance relative to this strategy.

If the strategy revealed is consistent with the one stated in the fund prospectus the performance relative to this measure is a correct measure of the fund’s success

Question 43

7.4.2 Contrast holdings based and returns based approaches to style analysis

Answer 43

1. Holdings based classifies portfolios based on characteristics of underlying securities. It is transparent since stocks and portfolios use he same style framework portfolio managers can see how each holding contributes to their portfolio style and see if it’s drafting from paragraph. Holdings based style analysis generally produces more accurate results than returns based style analysis.
2. Returns based style analysis compares the portfolio’s total return to the returns of various style based indexes (4-12 indexes) and makes inferences about the style based on how closely the portfolio returns resemble those of different indexes. It is most accurate when correlations between the benchmark indices are low

Question 44

7.4.3 Describe the application of holdings based and return based style analysis in manager performance evaluation

Answer 44

Returns based style analysis is more widely used than holdings based approach because the data (monthly returns) is more widely available. The holdings based approach requires access on data on portfolio holdings and because fewer people have access to that data, it can be more difficult to apply. If the returns based analysis is considerably different than the holdings based analysis it may indicate the portfolio manager is no disclosing all of his or her holdings.

Because returns based style analysis requires 20-36 months of performance, this approach cannot be used for portfolios that are brand new or to detect short term changes. Returns based style analysis can be used to validate the completeness of reported portfolio holdings.

Ideally both should be used. Returns based can be more widely applies while holdings based models allow for deeper style analysis.

Question 45

7.5.1 Explain the concept of market timing and provide an example

Answer 45

Market timing is the practice of adjusting portfolios in response to forecasts. Trading in anticipation of market changes. It involves shifting funds between a market index portfolio and a safe asset such as T-Bills.

Question 46

7.5.2 Describe the typical activities of an active portfolio manager who believes in market timing

Answer 46

Market timers believe short term price movements are important and predictable. They refer to statistical anomalies, recurring patterns and other data to support a correlation between certain information and stock prices. Horizon can be months, days, hours or minutes. Market timers are likely to use leverage to produce better returns which introduces more risk.

The constant analysis and increased education required can increase costs as compared to passive management. Costs also include trading commissions and capital gains tax

Question 47

7.5.3 Describe how the results of analyzing the impact of market timing on a portfolio returns highlights a shortcoming of conventional M-V Performance measures

Answer 47

Conventional performance evaluation techniques assume constant mean returns, constant risks and relative stability in portfolio holdings. In active management these change over the measurement period. Market timers shift beta and mean returns by moving into and out of the market. Analysis of the impact of market timing shows that additional analysis beyond M-V may help explain the effect of portfolio composition change.

Question 48

7.6.1.a Explain the role of attribution analysis in evaluating the performance of an investment manager

Answer 48

The focus of attribution analysis is on determining which investment decisions resulted in superior or inferior returns rather than focusing on the risk adjusted returns.

It reveals the impact of the manager’s investment decisions regarding overall investment policy, asset allocation and security selection.

Attribution analysis focuses on the broadest asset allocations first and progressively moves down. It can be used to identify the source of a portfolio managers abnormal returns.

Question 49

7.6.1 List three components of attribution analysis

Answer 49

1. Broad market allocation choices across equity, fixed income and money markets
2. Industry, sector, choice within each market
3. Security choice within each sector

Question 50

7.6.2 Outline the steps in attribution analysis

Answer 50

1) Establish a benchmark level of performance against which performance of the managed portfolio will be compared. The benchmark is called the bogey
2) Determine the neutral weighting for each asset class held in the managed portfolio
3) Calculated to return of the bogey, or benchmark, portfolio for the period under review
4) Identify the return of the managed portfolio for the period under review
5) Allocate any excess return of the managed portfolio to the decisions that contributed to the variance in return. The allocation can include separate contributions of asset allocation, sector selection within each asset class and security selection within each sector.