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SOA QFI PM > MIP Ch 12: Evaluating Portfolio Performance > Flashcards

MIP Ch 12: Evaluating Portfolio Performance Flashcards

1
Q

Describe how to calculate the time-weighted return (TWR) of an investment portfolio

A

Assuming n external cash flows occur between time 0 and time t at times t1, t2, . . . , tn,
there will be n 􀀀 1 subperiod calculations:
rti
pMVti CFti q MVti1
MVti1
for i 1 to n
rti
pMVti q MVti1
MVti1
for i n 􀀀 1
The TWR is the product of the subperiod growth factors
rTWR p1 􀀀 rt1qp1 􀀀 rt2q p1 􀀀 rtn􀀀1q 1

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2
Q

Describe the money-weighted return of an investment portfolio

A

The growth rate R that solves the following equation:
MVt MV0p1 􀀀 Rq
t
􀀀 CFt1p1 􀀀 Rq
tt1 􀀀 􀀀 CFtn p1 􀀀 Rq
ttn

An IRR calculation can be solved for iteratively with a computer program

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3
Q

Describe a situation for a portfolio when the money-weighted return (MWR) is different
from the time-weighted return (TWR)

A

MWR and TWR can have material differences if funds are contributed/withdrawn
from an account prior to a period of strong or weak performance
Ÿ MWR is sensitive to the size and timing of the cash flows, while TWR is not
Ÿ Example: There will be a positive effect on MWR if funds are invested right before a
strong earnings period

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4
Q

When should an investment portfolio use MWR or TWR for measuring performance?

A

TWR is more appropriate when evaluating managers who have little or no control
over external investments

MWR is more appropriate if the investment manager has control over external
investments
Ÿ Example: Private equity fund managers can determine when they receive and
return capital to investors

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5
Q

Compare and contrast the number of times one needs to value the portfolio for
calculating TWR and MWR

A

TWR requires a valuation of the account each date there is an external cashflow,
which is a drawback

In contrast, the MWR only requires a valuation at the beginning and end of period
Ÿ This is computationally simpler

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6
Q

Describe how to calculate the linked internal rate of return (LIRR) of a portfolio

A

LIRR estimates the TWR by calculating the MWR over time intervals (i.e. weekly),
and then chain-linking these returns together

Valid approximation if there are no large external cash flows and volatile swings in
subperiod performance
Example: Suppose over a month, an account’s MWR is calculated each week

MWR’s are 2.1% in week 1, 0.16% in week 2, -1.4% in week 3, and 1.8% in week
4. The LIRR is:
RLIRR p1 􀀀 0.021q p1 􀀀 0.0016q p1 0.014q p1 􀀀 0.018q 1
0.0265, or 2.65%X

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7
Q

Is it acceptable to annualize a return for an investment period that is shorter than one
year?

A

Returns should not be annualized for periods shorter than a year

Otherwise, we would be extrapolating the account’s returns over a sample period
to the full year

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8
Q

Describe some data quality issues in performance measurement

A

Accounts invested in illiquid assets may have inaccurate valuations

For many thinly traded fixed-income securities, estimated prices may be derived
on dealer quoted prices for securities with similar attributes (i.e. sector, credit
rating)

This is called matrix pricing

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9
Q

Breakdown of portfolio return into market return, style return, and active return

A

The portfolio return, P, can be broken down into the following components:
P M 􀀀 pB Mq 􀀀 pP Bq M 􀀀 S 􀀀 A

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

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10
Q

List properties of a valid benchmark

A
  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)
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11
Q

List seven types of benchmarks

A
  1. Absolute
  2. Manager Universes
  3. Broad Market Indexes
  4. Style Indexes
  5. Factor-Model-Based
  6. Returns-Based
  7. Custom Security-Based
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12
Q

Describe the issues of an absolute benchmark

A

An absolute benchmark specifies a minimum return target for the portfolio (i.e.
must return at least 7%)

The main issue with this type of benchmark is it is not investable

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13
Q

Describe the manager universe benchmark

A

The manager universe benchmark compares the manager’s returns to a universe
of portfolios with similar characteristics

The investment objective may be for the managers’ fund to exceed the median
account return from the manager universe

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14
Q

Describe the problems with a manager universe benchmark

A
  1. The median account return from the universe cannot be specified in advance
  2. It is not investable
  3. Ambiguous, since the identity of the median manager typically remains unknown
  4. Unable to verify the benchmark’s appropriateness by examining whether the
    investment style it represents adequately corresponds to the account being
    evaluated
  5. Survivors bias in the manager universe because poor performing accounts may
    be removed
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15
Q

Describe pros and cons from using broad market indices

A

Pros: Easy to understand, widely available

Cons: Manager’s style may not be reflected in the market index

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16
Q

Describe factor-model based benchmarks

A

Simplest form is a one-factor model
RP aP 􀀀 PRI 􀀀 P
Ÿ RP = the return on the account
Ÿ RI = the return on the market index
Ÿ P = sensitivity to returns on the market index
Ÿ P = nonsystematic component of the return (the residual)

Multi-factor models that consider additional factors such as a company’s size,
industry, and growth characteristics
RP aP 􀀀 b1F1 􀀀 b2F2 􀀀 􀀀 bKFK 􀀀 P

17
Q

Describe the pros and cons from using factor-model based benchmarks

A

Pros: Help managers and fund sponsors better understand a manager’s
investment style, since they capture the systematic sources of return that affect an
account’s performance

Cons: Not always intuitive and may not be investable
Ÿ Ambiguous, because one can build multiple benchmarks with the same factor
exposures, but generate different returns

18
Q

Describe how to construct a Returns-based benchmark

A

This benchmark is constructed as a weighted average of the investment style
indices that most closely track the account’s returns

The weights can be constructed from a regression using historical data

19
Q

Describe the pros and cons from using a Returns-based benchmark

A

Pros: Satisfies most benchmark validity requirements

Cons:
Ÿ Some of the style indexes may have positions that the manager finds unacceptable
Ÿ Requires many months of historical observations to establish a statistically reliable
estimate of the weights to each style index

20
Q

Describe the pros and cons from using custom security benchmarks

A

A custom security benchmark weights a manager’s universe of investable
securities in a particular fashion

Pros: Can be more suitable than a published index

Cons: Expensive to construct and maintain, and can lack transparency

21
Q

List the steps for constructing a custom-security benchmark

A
  1. Identify important aspects of manager’s investment process
  2. Select securities consistent with that investment process
  3. Devise a weighting scheme for the benchmark securities
  4. Review the preliminary benchmark
  5. Rebalance the benchmark on a set schedule
22
Q

List some tests of having good benchmark quality

A

Low systematic biases

Low tracking error

Similar risk characteristics with the fund

Higher coverage

Low turnover

Positive active positions

23
Q

What are the three inputs of macro attribution?

A
  1. Policy Allocations
    Ÿ The fund sponsor determines target asset allocation weights and weightings to
    individual managers within the asset categories
  2. Benchmarks
    Ÿ Broad market indexes (i.e. S&P 500) are normally used as benchmarks for asset
    categories
    Ÿ More narrowly focused indexes (i.e. U.S. Large-Cap Growth) are used to represent
    the manager styles
  3. Fund Returns, Valuations, and External Cash Flows
    Ÿ Returns must be calculated at the manager level for each asset category
24
Q

List six decision-making levels in macro attribution

A
  1. Net Contributions
  2. Risk-Free Asset
  3. Asset Categories
  4. Benchmarks
  5. Investment Managers
  6. Allocation Effects
25
Q

The incremental return contribution of the Asset Category investment strategy

A

rAC
¸A
i1
wi prCi rf q

A = number of asset categories

wi = policy allocation to asset category i

rCi = benchmark return of the ith asset category

rf = risk-free rate

26
Q

The incremental return contribution of Benchmarks investment strategy

A

rIS
¸A
i1
M¸
j1
wi wij prBij rCi q

i is the asset category and j is the manager

wij is the weight assigned to manager j in asset category i

rBij is benchmark return for manager j in asset category i

rCi is benchmark return on the ith asset category

wi is the policy weight assigned to the ith category

A and M are the number of asset categories and managers

27
Q

The incremental return contribution of the Investment Managers strategy

A

rIM
¸A
i1
M¸
j1
wi wij prAij rBij q

rAij is the actual return on manager j’s portfolio with asset category i

Key Assumption: The fund sponsor is invested in each manager according to
the managers’ policy allocations

28
Q

What is the formula for a manager’s value-added return?

A

The manager’s value-added return, rV , is given by:
rV
¸S
j1
wPj rPj
¸S
j1
wBj rBj

wPj and wBj : Portfolio and benchmark weights of sector j

rPj and rBj : Portfolio and benchmark returns for sector j

S = number of sectors

29
Q

Decomposition of the value-added return in micro-attribution

A
  1. Pure Sector Allocation Return
    Pure Sector Allocation
    ¸S
    j1
    pwPj wBj qprBj rBq
  2. Within-Sector Selection Return
    Within-Sector Selection
    ¸S
    j1
    wBj prPj rBj q
  3. Allocation/Selection Interaction Return
    Allocation/Selection Interaction
    ¸S
    j1
    pwPj wBj qprPj rBj q
30
Q

Provide two risk-adjusted performance metrics that use systematic risk (through the
fund’s )

A

Ex-post alpha, or Jensen’s Alpha
Ÿ It is the A from the following regression of account returns against market returns
RAt rft A 􀀀 ApRMt rft q 􀀀 t

Treynor Measure
TA
RA r f

A

31
Q

Provide two risk-adjusted performance metrics that use total risk (through the standard
deviation of the fund’s returns)

A

Sharpe Ratio
SA
RA r f
^A

M2
M2A
r f 􀀀
$’’%
RA r f
^A
,//-
^M
Ÿ Measures what the account would have returned if it had taken on the same total
risk as the market
Ÿ A skillful manager will generate a M2 that is greater than the market index return

32
Q

Describe a situation where the type of risk-adjusted performance metric that is used
will change the evaluation of a fund manager

A

Suppose 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

33
Q

Describe the information ratio

A

IRA
RA RB
^AB

Active Return
Active Risk

^AB = standard deviation of the difference between the returns on the account
and the returns on the benchmark

Written as a long position in the account that is funded by a short position in the
benchmark

Measures the reward earned from the risk of deviating from the benchmark
portfolio

34
Q

Provide criticisms of risk-adjusted performance appraisal methods

A

Jensen’s alpha and Treynor measure rely on CAPM, which is an incomplete
model of security returns

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

The parameters estimated from historical data may be unstable

35
Q

What are three assumptions of quality control charts?

A
  1. The manager has no investment skill (the null hypothesis)
    Ÿ This implies that the fund’s value-added return should not be statistically different
    from zero
  2. The value added-returns in different periods are independent and normally
    distributed with a mean of zero
  3. The manager’s investment process does not change from period to period
    Ÿ This implies the variability of the value-added returns stays constant
36
Q

Describe properties of a manager continuation policy (MCP)

A

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

37
Q

Describe the two steps in the manager continuation policy (MCP)

A
  1. Manager Monitoring
    Ÿ Fund sponsor meets with manager regularly to cover operational matters (e.g.
    personnel changes) and investment strategies (retrospective and prospective)
  2. Manager Review
    Ÿ Occurs if there is something alarming during manager monitoring
    Ÿ Will decide whether or not to rehire the investment manager
38
Q

Describe the type of errors the fund sponsor can make during performance appraisal

A

Type I: Keeping managers that have zero value-added

Type II: Firing managers with positive value-added

SOA QFI PM (49 decks)

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