MIP CH 12: Evaluating Portfolio Perfomance

Question 1

Roles of performance measurment, performance attribution, and performance appraisal

Answer 1

• Performance measurement calculates the rates of return on the account
• Performance attribution inestigates the source of the account’s performance relative to a specific benchmark
• Performance appraisal attempts to draw conclusions on the quality (magnitude and consistency) of the account’s relative performance

Question 2

Time-Weighted Rate of Return (TWR)

Answer 2

• Subeperiod returns are calculated every time external cashflows occur, and then are linked together over the entire evaluation period
• Refledts the compound rate of growth over a stated evaluation period of one unit of money initially invested in the account

Question 3

Money-Weighted Rate of Retunr (MWR)

Answer 3

• Measures the compound growth rate in the value of all funds invested in the account over the evaluation period
• it is an internal rate of return (IRR) calculation

Question 4

TWR vs. MWR

Answer 4

• MWR is the average growth rate of all the money in the account
• TWR is the average growth rate of a signle unit initially invested in the account
• MWR and TWR are close when external CFs under normal econ conditions and external CFs are normal
• MWR and TWR can be materially different if external CFs occur before a period of strong or weak performance
• MWR is sensitive to the size and timing of CFs
• TWR is unaffected by external cashflows

Question 5

Linked Internal Rate of Retunr (LIRR)

Answer 5

• LIRR attempts to estimate TWR by calculating the MWR over reasonably frequent time intervals and then chain-linking these returns together.
• LIRR approximation is valid as long as there are no large external cash flows and volitle swings in subperiod performance.
• LIRR is a workaround for the TWR drawback of requiring frequent valutions at each date there is an external cash flow

Question 6

Matrix Pricing

Answer 6

• Used for performance valuation of accounts with illiquid assets
• Used to estimate prices for thinly trader fixed income sercurites that are derived from dealer quoted prices for securities with similar attributes (i.e. sector, crediting rating)

Question 7

Breakdown of Portfolio Return

Answer 7

P = (P - B) + (B - M) + M = A+ S + M

• B = the return of the benchmark
• M = the return of the market index
• S = B - M = return that reflects the manager’s investment style
• A = P - B = returns from active management decisions

Question 8

Properties of a Valid Benchmark

Answer 8

1. Unambiguous (identity and weights of securities are clearly defined)
2. Investable (it’s possible to hold the benchmark as a portfolio)
3. Measurable (benchmark return can be calculated on a frequent basis)
4. Appropriate (consistent with the manager’s style)
5. Reflective of current investment opinions
6. Specified in advance (before the start of an evaluation period)
7. Owned (the investment manager should accept the performance of the benchmark)

Question 9

Types of Benchmarks

Answer 9

1. Absolute: Could be a minimum return target
2. Manager Universes: Frequently uses the median fund manager return as a benchmark
3. Broad Market Indexes: Includes S&P
4. Style Indexes: Represent specific portions of an asset category (e.g., Large-cap)
5. Facrtor-Model-Based: The manager’s beta is the basis for the benchmark that specifies the level of return that the account is expected to generate in the absense of any value added by active management.
6. Return-Based: Weighted average of the investment style indexes that most closely tracks the manager’s account returns.
7. Custom-Security Based: A benchmart that weights a manager’s research universe of investable securities in a particular fashion

Question 10

Problems with Types of Benchmarks

Answer 10

1. Absolute: Does not satisfy the benchmark validity criteria because it is not investable
2. Manager Universe: Fails all tests of benchmark validity except for being measurable
3. Broad Market Indexes: They do not work if the manager has a style that is not reflected well in the market index
4. Style Indexes: Some style indexes may have too large of a weighting in certain sectors, or not accurately represent the manager’s style
5. Factor-Model-Based: Not always intuitive and may not be investable
   
   • Also ambiguous, as it is possible to build multiple benchmarks with the same factor exposures, but generate different returns
6. Return-Based:
   
   1. Some style indexes might have unacceptable positions for managers
   2. Requires many months of historical observations to establish a statistically reliable estimate of the weights to each style index
7. Custom Security-based: Expensive to construct and maintain, and can have the perception of a lack of transparency

Question 11

Tests of Benchmark Quality

Answer 11

1. Systematic Biases: Should be minimal systematic biases in the benchmark relative to the account
2. Tracking Error: should be low for a good benchmark, and less the volatility of the account’s returns relative to alternative benchmarks
3. Risk Characteristics: An account’s exposure to systemic sources of risk should be similar to those of the benchmark over time
4. Coverage: proportion or percentage of the account’s market value that is contained in the benchmark (higher the better)
5. Turnover: proportion of the benchmark’s market value allocated to purchases during a periodic rebalancing of the benchmark (shouldn’t be excessive)
6. Positive Active Positions: A lot of negative active positions indicate the benchmark does not correctly capture the style of the manager.

Question 12

Hedge Funds and Hedge Fund Benchmarks

Answer 12

• Because hedge funds are allowed to have short positions in stocks (i.e. negative allocation), our standard return calculation can give crazy results when the long and short positions tend to cancel out, thus making the market value (MV) close to zero)
• One way to create a benchmark for a hedge fund is to have separate benchmarks be set for the long and short positions, and then combine them in appropriate proportions
• Relative benchmarks might not be appropriate for hedge funds with absolute return mandate

Question 13

Sharpe Ratio as Hedge Fund Manager Performance

Answer 13

• Used because of the ambiguity of a hedge fund manager’s investable universe of securities
• Can be calculated without reference to the manager’s underlying investment universe
• Has the same benchmark validity criticisms that apply any time we compare a fund’s performance to a universe of other manager’s performances
• Not an accurate performance measure when the investment strategy incorporates a high degree of optionality (skewness)

Question 14

Ways in which a manager can have a positive impact on an account’s returns relative to the benchmark

Answer 14

1. Selecting superior (or avoiding inferior) performing assets
2. Owning the superior (or inferior) assets in greater (lesser) proportions than or held in the benchmark

Question 15

Two main forms of performance attribution

Answer 15

1. Macro Attribution (conducted on the fund sponsor level)
2. Micro Attribution (conducted on the investment manager level)

Question 16

Macro Attribution Inputs

Answer 16

1. Policy Allocations:
   
   • fund sponsor determines normal asset allocation weightings, as well as weightings to individual managers within the asset categories
   • Normal weightings are based on the fund sponsor’s risk tolerance, long-term expecations, and liabilities of the fund
2. Benchmark Portfolio Returns:
   
   • Broad market indexes are normally used as benchmarks for asset categories
   • More narrowly focused indexes are used to represent the manager styles
3. Fund Returns, Valuations, and External Cash Flows:
   
   • Returns must be calculated at the manager level for each asset category
   • if macro attribution is extended to include a value-metric approach, then account valuation and external cash flow data are needed to compute the value impacts of the fund sponsor’s investement decisions

Question 17

Level of Macro Attribution Analysis

Answer 17

1. Net Contributions: Net cash flows the fund receives are invested at a zero-rate of return
2. Risk-Free Asset: conservative strategy that invests all the fund assets (including the external cash flows) in a risk-free asset
3. Asset Categories:
   
   • Assumes beg fund value and external cash flows are invested passively in a combination of the asset category benchmarks of the fund
   • Each asset category benchmark’s weights is based on the fund sponsor’s policy allocation
4. Benchmarks:
   
   • Seperates the impact of manager’s investment styles from the effect of managers’ active management decisions
   • This strategy assumes beg fund value and external cash flows are passively invested in the manager’s respective benchmarks
5. Investment Managers: This will determine the impact of the manager’s active management by comparing the manager’s actual return to that of the manager’s benchmark
6. Allocation Effects: Captures the imapct from fund sponsors deviating slightly from their policy allocation weights for the asset categories and individual fund managers

Question 18

Macro Attribution - incremental return contribution of the Asset Category investment strategy

Answer 18

Question 19

Macro Attribution - incremental return contribution of the Benchmarks strategy

Answer 19

Question 20

Macro Attribution - incremental return contribution of the Investment Managers strategy

Answer 20

Question 21

Role of Micro Attribution

Answer 21

• Compares the results of an individual portfolio relative to a benchmark, and focuses on the manager’s value added
• A common form is to perform SectorWeighting / Stock Selection Micro Attribution, which compares the portfolio return to the benchmark return by sector

Question 22

Micro Attribution’s manager’s value-added return

Answer 22

Question 23

Micro Attribution - Pure Sector Allocation Return

Answer 23

Question 24

Micro Attribution - Within-Sector Selection Return

Answer 24

Question 25

Macro Attribution - Allocation/Selection Interaction Return

Answer 25

Question 26

Micro Attribution Componenet for Fixed Income Portfolio

Answer 26

Interest rate management is the primary indicator of effective active interest rate management

Question 27

Goal of Performance Appraisal

Answer 27

Help fund sponsor decide if it should retain or modify the investment program

• Difficult to distinguish between investment skill and luck
• Regardless of skill, every manager’s valued-added return will be positive in some periods, and negative in others
• It is recommended to focus on the level of value-added return relative to the volatility of the value-added return

Question 28

Types of risks considered in Risk-adjusted Performance Measures

Answer 28

1. Systematic risk (measured by the account’s beta)
2. Total risk (measured by the account return standard deviation)

Question 29

Ex-Post Alpha (Jensen’s alpha)

Answer 29

Question 30

Treynor Measure

Answer 30

Question 31

Sharpe Ratio

Answer 31

Question 32

M²

Answer 32

Question 33

Comparing the different risk-adjusted performance measures

Answer 33

• Jensen’s alpha and the Treynor ratio measure systematic risk through beta, and will produce the same conclusions regarding investment manager skill
• Similarly, the Sharpe ratio and M2 both measure total risk through the standard deviation of the fund’s return, and will produce the same manager assessment
• However, if there is a large amount of nonsystematic risk in an account, it is possible for the Sharpe ratio and M2 to identify a manager as not skillful, but have Jensen’s alpha and the Treynor ratio come to the opposite conclusion

Question 34

Information Ratio

Answer 34

Question 35

Criticisms of Risk-Adjusted Performance Appraisal Methods

Answer 35

• Jensen’s alpha and Treynor measure rely on CAPM, which has been under attack for several reasons, including it being a single-factor model
• It may not be appropriate to use proxies like the S&P 500 for the market portfolio
• Benchmark returns are not attainable because of transaction costs associated with reinvesting cash flows and rebalancing
• The parameters estimated from historical data may be unstable

Question 36

Three Assumptions that underlie the Quality Control Chart’s Construction

Answer 36

1. The manager has no investment skill (the null hypothesis)
   
   • Fund added-value returns should not be statistically different from zero
2. The value-added returns in different perdiods are independent and normally distributed with a mean of zero
3. The manager’s investment process does not change from period to period
   
   • Implies the variability of the value-added returns stays constant

Question 37

How to Interpret the Quality Control Chart

Answer 37

• We are asking if the manager’s performance results provide enough statistical evidence to reject the null hypothesis that the manager has no skill
• If the cumulative value-added annualized percentages are within the confidence bands (such as in Exhibit 12-15), the null hypothesis cannot be rejected
• However, if the cumulative value-added annualized percentages are consistently outside the confidence bands, then the null hypothesis can be rejected

Question 38

Noisiness of Performance Data in Manager’s Performance Evaluation

Answer 38

• Empirical evidence shows past performance is not that related to future results
• Even good managers have a significant probability of underperforming the benchmark over a multi-year period (3-5 years)
• Thus, using historical performance as the only criteria for valuating investment managers is problematic because it will generate high manager turnover

Question 39

Manager Continuation Policy (MCP) In manager’s Performance Evaluation

Answer 39

A manager continuation policy (MCP) helps fund sponsors evaluate investment managers, and has the following purposes:

1. Retain superior managers and remove inferior managers
2. Utilize relevant nonperformance information in the evaluation process
3. Minimize manager turnover (firing a manager is expensive!)
4. Develop a consistent procedure

Question 40

Manager Continuation Policy Process

Answer 40

1. Manager Monitoring
   
   • Fund sponsor meets with manager regularly to cover operational matters (e.g. personnel changes) and investment strategies (retrospective and prospective)
   • An attribution analysis can be performed to check if the fund’s performance has been consistent with the managers’ stated investment styles
   • Typically the manager monitoring stage reveals nothing serious
2. Manager Review
   
   • Occurs if there is something alarming during manager monitoring
   • The process becomes a decision of whether or not to rehire the investment manager, and should consider the following questions:
     
     • What has fundamentally changed, and is it significant?
     • What are the likely ramifications of the change?
     • Are the costs of firing the manager greater than the potential benefits

Question 41

Manager Continuation Policy as a Filter

Answer 41

The MCP is designed to terminate the negative-value-added managers and retain the positivevalue-added managers, but there are two potential errors:

• Type I: Keeping managers with zero value-added
  
  • Will occur more often if the MCP is very relaxed (i.e. fire managers very infrequently)
• Type II: Firing managers with positive value-added
  
  • Will occur more often if the MCP filter is very strict (i.e. fire managers frequently)