Module 6: Evaluating Active Management Performance

Question 1

Describe the basic premise of “fundamental analysis.”

Answer 1

“Fundamental analysis” attempts to identify situations when securities are mispriced based on an analysis of the securities’ “fundamentals”—characteristics of the economy, industry, and the company that issues the particular security. If the analysis identifies that the “correct” price is higher than the current stock price a fundamental analyst will recommend purchasing the stock.

The goal of fundamental analysis is not simply to identify companies that are good but to identify companies that have higher value than other analysts perceive them to have (as evidenced by the price in the market). Similarly, poorly run companies can be great bargains if they are not quite as bad as their stock prices suggest.

Question 2

Outline the tools fundamental analysts use when trying to identify the “correct” price of a security.

Answer 2

Fundamental analysts use the following tools to identify the “correct” price of a security:

(a) Economic analysis (e.g., expectations of future interest rates)
(b) Industry analysis (e.g., prospects for an industry as a whole)
(c) Company analysis (e.g., financial statement analysis that includes financial ratios, earnings and dividend prospects, the quality of the decision makers and the company’s standing within its industry).

Question 3

Explain the differences between the “top-down” and “bottom-up” approaches used in fundamental analysis.

Answer 3

In a top-down approach the analyst first considers global economics (including factors like growth rates and inflation), then narrows the review to a regional/ industry analysis (looking at sales, prices, competition levels) and finally looks at the best businesses in the area being studied.

A bottom-up approach starts with specific businesses, regardless of the region/ industry, and proceeds in reverse of the top-down approach.

Question 4

Explain the objectives and activities of technical analysts.

Answer 4

“Technical analysis” is an attempt to exploit recurring and predictable patterns in stock prices to generate superior investment performance. Technical analysis attempts to understand the market sentiment behind price trends rather than analyzing a security’s fundamental attributes—essentially searching for recurring and predictable patterns in stock prices.

Technical analysts are sometimes called “chartists” because they study records, or charts, of past stock prices, searching for patterns in price changes that they can exploit to make a profit.

Technical analysts believe that astute traders can exploit price trends to generate superior investment performance.

Question 5

Define “momentum” and describe how moving averages can be used to identify momentum.

Answer 5

Much of technical analysis seeks to uncover trends in price changes—in effect, a search for “momentum.” Momentum focuses on identifying relative value. Analysists search for upward price trends in a security, relative to the price trend of comparable securities. Their objective is to invest in one winning stock or industry sector.

The “moving average” of a stock price is the average price over a given interval, updating the interval as time passes. Comparing the moving average to the current price can identify a shift in momentum from a declining market to a rising market or vice versa.

It is important to note that moving average graphs identify the trends that are taking place but cannot give any assurance of which way the future price will go.

Question 6

Describe “relative strength” and “market breadth,” two measurements used in technical analysis. Provide an example of relative strength.

Answer 6

“Relative strength” measures the extent to which a security has outperformed or underperformed either the market as a whole or its particular industry. For example, an analyst considering the purchase of Honda stock might identify its relative strength compared to all automotive stocks. This could be identified by measuring the movements in a ratio determined as the price of Honda divided by an index of all stocks in the automotive industry. An increase in the ratio implies that |Honda is outperforming its competitors, and if that trend persists, it could be a signal for the analyst to buy that stock. Similarly, the strength of an industry relative to the whole market can be computed by tracking the ratio of the industry price index to the market price index.

The “breadth” of the market is a measure of the extent to which movement in a market index is reflected widely in the price movements of all the stocks in the market. The most common measure of market breadth is the spread between the number of stocks that advance in price and the number of stocks that decline in price. When advances outnumber declines by a wide margin, then the market is viewed as stronger because the rally is widespread.

Question 7

Identify three sentiment indicators commonly used by technical analysts to measure the general level of investor optimism.

Answer 7

Technical analysts use the following three measures of market sentiment in attempts to identify a market’s “bullish” or “bearish” characteristics:

(1) Trin Statistic: The ratio of average trading volume of declining stocks to average trading volume in advancing stocks. Ratios above 1 are considered bearish.

(2) Confidence Index: The ratio of the yield on top-rated bonds to the yield on intermediate bonds. Higher values of the confidence index are considered bullish signals.

(3) Put/Call Ratio: The relationship of put options to call options outstanding on a stock. Analysts differ on interpreting this measure as bullish or bearish.

Question 8

Explain how the nature of actively managed portfolios contributes to performance measurement challenges.

Answer 8

Stock returns exhibit high variance. Because the portfolio composition of passive investment strategies is relatively stable, it may be acceptable to assume that the return distributions have a constant and sustained mean and variance.

However, this stability assumption may not hold for actively managed portfolios, resulting in portfolio measurement challenges. This is because:

(a) By design, the manager of an actively managed portfolio regularly updates the portfolio in accordance with its financial analysis. The result is that the portfolio return distributions change regularly. Statistically significant performance measures are difficult to obtain when portfolio return distributions are constantly changing.
(b) Constantly changing portfolio return distributions can lead to substantial measurement errors. The assumption of a constant mean and variance used in calculating return statistics and measurements may be incorrect. For actively managed portfolios, it is critical to keep track of portfolio composition and changes in portfolio mean and variance.

Question 9

Explain the concept of “abnormal return” of an investment.

Answer 9

Abnormal returns are returns that have been produced by some active portfolio managers that are hard to label as lucky outcomes. “Abnormal returns” measure how the portfolio’s actual returns differ from the expected returns of its benchmark over a given period of time.

Abnormal rate of return can either be positive or negative.

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

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

Question 10

Assume that an investment’s actual return for a particular year was 22%, and the expected return of its benchmark was 12%. Using the abnormal return formula, calculate and interpret the abnormal return of the stock.

Answer 10

Using the abnormal return formula:

RAbnormal = RActual - RExpected

Where:

RActual = Actual return
RExpected = Expected return of benchmark
= 22% - 12%

= 10%

The stock’s abnormal return is 10%.

Some unexpected midyear event, such as a superior earnings announcement or the resolution of a corporate lawsuit in favour of the company, may have affected the stock’s actual return.

Question 11

Identify and describe traditional return measures used in the evaluation of investment performance.

Answer 11

Four types of returns typically used in evaluating investment performance are:

(1) Holding-period return (HPR): HPR is the total return received from holding an asset (i.e., income plus changes in its value) over the period of time the asset is held (i.e., its time horizon). HPRs are commonly used to calculate returns on stocks but can be used for any security whose market value can fluctuate between the beginning and ending price. HPR depends on:

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

(2) Arithmetic average: Arithmetic average is the sum of a series of numbers divided by the count of that series of numbers. It is a more valid measure of what a typical a return might be when each value is independent of each other. The arithmetic average is not appropriate for calculating the average annual return on an investment portfolio over a period of years since it doesn’t accurately reflect the impact of capital losses or reinvestment of assets.

(3) Geometric average (time-weighted) rate of return: The geometric average return is the constant annual return over a number of years that would provide the cumulative return over the entire investment period. The geometric average is commonly used for investments that are compounded.

(4) Internal rate of return (IRR): Also called the dollar-weighted rate of return, IRR incorporates the size and timing of cash flows, so it is an effective method for calculating the return on an investment portfolio. 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.

Question 12

Explain why the geometric average (time-weighted rate of return) is a commonly used method of measuring an investment manager’s performance for a defined contribution (DC) pension plan.

Answer 12

The time-weighted rate of return is a commonly used method for measuring performance of investment returns that are compounded. For sponsors and members of defined contribution (DC) plans, the time-weighted rate of return is the most appropriate method of measuring a manager’s investment performance because it minimizes the impact of cash flows on rate of return calculations and focuses on the investment manager’s performance over the period.

Question 13

Explain why the internal rate of return (IRR) (dollar-weighted rate of return) is a useful investment performance measure for defined benefit (DB) pension funds.

Answer 13

IRR is often used by a DB pension plan sponsor because it can be compared with the plan actuary’s assumption for the rate of return. That comparison identifies whether an experience gain or loss from investments had occurred during the period.

Question 14

Assume your employer’s DB pension plan held $143,000,000 at the start of the year and $165,000,000 at the end of the year and had net positive contribution amounts in the year equal to $8,000,000. Using the IRR approximation formula, calculate the IRR of the pension fund.

Answer 14

Using the IRR approximation formula:

IRR=(2×I)(A+B−I)

Where:

A = Fund value at beginning of year
B = Fund value at end of year
I = Investment income during year
A = $143,000,000

B = $165,000,000

I = $165,000,000 - $143,000,000 - $8,000,000 = $14,000,000

IRR is approximated as:

IRR=(2×14,000,000)(143,000,000+165,000,000−14,000,000)

= (28,000,000)(294,000,000)

= .0952 or 9.52%

The IRR of the pension fund in the year was approximately 9.52%.

Question 15

Assume that your defined contribution (DC) pension plan account was worth $78,534 at the beginning of the year and now is worth $93,810. Over the year, you and your employer contributed monthly for a total of $7,800 of new contributions. You made no withdrawals from your account. Using the IRR approximation formula, calculate the approximate IRR on your DC account over the year.

Answer 15

Using the IRR approximation formula:

IRR=(2×I)(A+B−I)

Where:

A = Fund value at beginning of year
B = Fund value at end of year
I = Investment income during year
A = $78,534

B = $93,810

I = $93,810 - $78,534 - $7,800 = $7,476

IRR is approximated as:

=(2×7,476)(78,534+93,810−7,476)

=(14,952)(164,868)

= .0907 or 9.07%

Your DC pension account earned an IRR in the year of approximately 9.07%.

Question 16

Describe alpha and beta explain their roles in measuring performance of an investment fund.

Answer 16

Alpha is the difference between the return of a security or portfolio and the return of a benchmark index. Alpha is often represented as a single number, either positive or negative. Alpha equal to 0 means that the portfolio is perfectly tracking the benchmark index. A positive alpha indicates that an investment or portfolio has outperformed its benchmark or the market. A negative alpha suggests that an investment or portfolio has underperformed its benchmark or the market.

Alpha is used to evaluate the performance of all types of investments and is often considered to represent the value that a portfolio manager adds to or subtracts from a fund’s return (e.g., Alpha equal to 0 means that the portfolio is perfectly tracking the benchmark index; the manager has not added or lost any value; a positive alpha mean the investment manager has added value, a negative alpha means they have lost value.)

Beta is a measure of the systematic risk of a security or portfolio (i.e., the tendency of a security or portfolio’s returns to respond to swings in the broad market). A beta value of 1.0 means that the investment’s returns tends to move in line with the benchmark. When beta exceeds 1, the portfolio or security shows above-average sensitivity to market swings, and an investment in such a portfolio would be considered aggressive (i.e., riskier than the overall market but may offer the potential for higher returns). When beta is below 1, the portfolio or security shows below average sensitivity to market swings and would be considered defensive (less risky than the overall market but may offer lower returns).

Question 17

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

Answer 17

The simplest and most popular approach to evaluate returns is to compare the portfolio’s returns with a comparison universe and assign rankings within the universe. A “comparison universe” is composed of a group of funds of portfolios with similar risk characteristics. For example, high-yield bond portfolios are grouped into one “universe,” and growth stock equity funds are grouped into another. Then, within each universe, the average returns (usually time-weighted average returns) of each fund are ordered from high to low.

Portfolio managers receive a percentile ranking depending on their relative performance within the comparison universe. For example, in Canada, the manager with the ninth-best performance in a universe of 100 funds would be the 10th percentile manager: That manager’s performance was better than 90% of all competing funds over the evaluation period.

Relative rankings are usually displayed in a chart form that summarizes performance rankings over various time periods, for example periods of one quarter, one year, three years and five years.

Question 18

Outline some disadvantages of the relative performance ranking approach to evaluating active manager performance. Provide examples.

Answer 18

While comparison of performance with other managers of a similar investment style is a useful first step in evaluating performance, such rankings can be misleading. If some managers within a particular universe concentrate on certain subgroups, portfolio characteristics are not truly comparable. For example, within the equity universe, one manager may concentrate on aggressive growth stocks. Similarly, within fixed income universes, bond durations can vary across managers.

Relative performance rankings are sometimes criticized because unsuccessful managers may close their operations, or merge with other managers, and the resulting “comparison universe” no longer includes those managers’ results. This phenomenon is typically referred to as “survivorship bias.”

These considerations suggest that a more precise means of risk adjustment is desirable.

Question 19

Identify other performance measures used to evaluate active manager performance.

Answer 19

(a) Sharpe ratio and Modigliani (M2) measure: The Sharpe ratio of a portfolio identifies how the difference between the portfolio’s return and the risk-free return compares to the standard deviation of the portfolio’s excess return. An actively managed portfolio must offer a higher Sharpe ratio than the market index if it is to be an acceptable candidate for the investor’s optimal risky portfolio. The

Modigliani risk-adjusted performance measure (M2 measure) is derived from the Sharpe ratio. It identifies how well a portfolio’s return rewards an investor for the amount of risk taken, relative to that of a benchmark portfolio and to the risk-free rate and thus can also be used to compare the performance of investment managers. Unlike the Sharpe ratio, M2 is expressed in units of percentage return, making it more intuitive to interpret than the Sharpe ratio. For example consider two investment portfolios whose M2 measures are 4.2% and 4.8%. Risk adjusted returns vary by 0.6 percentage points per year, with the riskiness adjusted to that of the benchmark portfolio or market index.

Because it is directly derived from the Sharpe ratio, rankings of investments using the M2 measure will exactly match rankings of investments using the Sharpe ratio.

(b) Treynor ratio: Like the Sharpe ratio, this ratio measures the excess return of a portfolio per unit of risk but uses beta as the measurement of risk (instead of standard deviation used in the Sharpe ratio). The higher the Treynor ratio, the greater excess return being generated by the portfolio.

(c) Information ratio: This ratio measures a portfolio manager’s ability to generate excess returns relative to a benchmark such as the S&P/TSX Composite Index. It also attempts to identify the “consistency” of the investment’s performance over the measurement period—whether a manager has beaten the benchmark by a lot in a few months or a little every month. The higher the information ratio, the more consistent the performance of the manager, with consistency being an ideal trait. Conversely, the lower the information ratio, the less consistency in the manager’s performance.

Question 20

Identify when each of Sharpe ratio, M2 measure, Treynor ratio and information ratio is the appropriate risk-adjusted performance measure.

Answer 20

The Sharpe ratio is appropriate when an investor is choosing among portfolios competing for the complete risky portfolio because the focus is on the volatility of the total portfolio, and how through diversification, various components of the portfolio combine to determine that volatility. If applied to a single fund in isolation, the Sharpe ratio ignores the correlation of the fund with the other investments in the portfolio, and so it may not correspond in any meaningful way to the desirability of the fund as an investment.

The M2 measure is useful for comparing portfolios with different risk levels. For example, the M2 measure for a portfolio that took a great deal more risk than a benchmark portfolio, but only had a small performance advantage in its return, might be lower than the M2 measure for another portfolio that took dramatically less risk relative to the benchmark but had similar returns.

The Treynor ratio is appropriate when an investor is ranking many funds or portfolios that will be mixed to form the overall risky portfolio. For example, if a pension fund is considering a number of candidates to retain as portfolio managers, the Treynor ratio is the appropriate measure.

The information ratio is relevant when evaluating a portfolio to be mixed with the benchmark portfolio (for example, when a largely passive diversified portfolio is considering adding an actively managed strategy.) This could be the situation faced by a pension fund looking to add to its core investments.

Question 21

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

Answer 21

Investment managers can try to manipulate the system by employing strategies designed to improve measured performance. They can affect performance measures over a given evaluation period because they can observe how returns (e.g., average return, standard deviation, Sharpe ratio) unfold over a period and adjust portfolio strategies (to either increase or decrease risk) and influence performance measures before the end of an evaluation period. When this is done, rates of return in the later part of the evaluation period depend on rates in the beginning of the period. Only one performance measure is impossible to manipulate, the Morningstar riskadjusted rating (MRAR).

Question 22

Explain how “investment style analysis” information informs manager performance evaluation.

Answer 22

Investment style analysis identifies the asset allocation characteristics of an investment portfolio and then explains its returns by that asset allocation. Analysis of investment style might reveal that one portfolio invests in large-cap, value-oriented securities while another invests in small-cap growth stocks.

Individual investors use investment style to understand what types of investments they are buying and how they fit into existing portfolios. Financial advisors, money managers and academics, among others, analyze investment style to purchase, classify or construct managed investments as well as to monitor them for drifts from the initially identified investment style. Analysis of investment style is also used to construct peer groups and to select benchmarks specific to the investment style to use in performance measurement.

Question 23

Describe the two main approaches to investment style analysis and the limitations of each.

Answer 23

There are two main approaches to investment style analysis:

(1) Holdings-based. Tools used for holdings-based analysis classify portfolios based on the characteristics of the underlying securities. Holdings-based analysis is dependent on the choice of investment style framework.

This approach is more difficult to apply because fewer people have access to data on portfolio holdings.

(2) Returns-based. Tools used for returns-based analysis compare the portfolio’s total returns (usually three to five years of monthly returns) to the total returns of various indexes based on the investment style (usually four to 12 indexes) and makes inferences about investment style based on how closely the portfolio returns resemble those of different indexes. Returns-based analysis is dependent on the choice of benchmark indexes.

Because returns-based analysis requires 20-36 months of performance, this approach cannot be used for brand-new portfolios or to detect changes to the investment style over shorter time periods. Also, if the market indexes have performed in a highly correlated fashion, it is harder to detect distinct investment style patterns in the total returns.

Question 24

Describe the application of holdings-based and returns-based investment style analysis in manager performance evaluation.

Answer 24

Returns-based analysis is more widely used than holdings-based analysis because the input data (monthly returns) is readily available. Returns-based analysis can be used to validate the completeness and accuracy of reported portfolio holdings.

Holdings-based analysis is transparent. Because stocks and portfolios use the same framework, portfolio managers can see how each holding (e.g., size and value/ growth orientation of the underlying stocks in a fund) contributes to their average portfolio style and can take action if the portfolio’s investment style is drifting from its target. Holdings-based analysis generally produces more accurate results than returns-based analysis.

Returns-based analysis can often be more widely applied, while holdings-based analysis allows for deeper investment style analysis. Ideally, practitioners should use both approaches. If the returns-based analysis is considerably different from the holdings-based analysis, it may indicate that portfolio managers are not disclosing their holdings.

Question 25

Explain the concept of “market timing” and provide an example.

Answer 25

“Market timing” is the practice of adjusting portfolios in response to forecasts of periods of higher or lower return. In essence, market timing involves trying to identify the best times to buy or sell an investment in anticipation of market movements. Perfect market timing is defined as the ability to tell (with certainty) at the beginning of each year whether a certain type of portfolio will outperform the performance of a risk-free asset such as T-bills.

In its pure form, market timing involves shifting funds between a market index portfolio and a safe asset, such as T-bills or a money market fund, depending on whether the market as a whole is expected to outperform the safe asset.

It is extremely difficult to consistently time the market successfully. It requires making the decision to enter and exit the markets at the correct time.

Market timers seek to sell at the “top” and buy at the “bottom.” For example, if interest rates increase, market timers may sell some or all of their stocks and purchase more bonds to take advantage of what may be a “peaked” market for stocks and the beginning of a boom for bonds.

Question 26

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

Answer 26

Market timers believe short-term price movements are important and often predictable. They refer frequently to statistical anomalies, recurring patterns and other data that support a correlation between certain information and stock prices. A market timer’s investment horizon can be months, days, hours or even minutes. Market timers are more likely to use leverage to produce better results. This in turn introduces more risk into their portfolios but may also provide higher returns.

In general, the constant analysis associated with market timing involves more asset reallocation and trading activity than passive management. It often also requires more time and education than passive management, and the extra trading commissions and capital gains taxes may translate to higher management fees and return requirements.

Question 27

Describe how the results of analyzing the potential impact of market timing on portfolio returns highlights a shortcoming of conventional performance measures.

Answer 27

Conventional performance evaluation techniques assume constant mean returns, constant risks and relative stability in the portfolio holdings. The reality of active management is that portfolio holdings and, as a result, risk and return change through the measurement period.

For example, market timers will allocate more to equities when they have a higher expected return and less when they have a lower expected return. Market timers constantly shift beta and mean return by moving into and out of the market. The return for a perfect (annual) market timer in each year is the maximum of the return on stocks and the return on bills. This analysis of the potential impact of market timing shows that additional analysis, beyond conventional evaluation, may help explain the effects of portfolio composition change.

Question 28

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

Answer 28

“Attribution analysis” is a performance evaluation tool used to analyze the ability of portfolio managers who follow an active management strategy. The focus of attribution analysis is on identifying the source of an investment manager’s abnormal returns (i.e., whether at the asset category, sector or individual security level). Attribution analysis focuses first on the broadest asset allocation choices and progressively moves down to security selection. Commonly the analysis is broken down across three components:

(a) Broad asset market allocation choices across equity, fixed income and money markets
(b) Industry (sector) choice within each market
(c) Security choice within each sector.

The difference between a managed portfolio’s performance and that of a benchmark portfolio may then be expressed as the sum of the contributions to performance of a series of decisions made at various levels of the investment process.

Question 29

Describe how the Statement of Investment Policy and Procedures (SIPP) for a pension plan may impact the attribution analysis performed on the plan’s investments.

Answer 29

Attribution analysis for pension plan assets must take into consideration the degree of flexibility that has been given to the active manager(s) within the plan’s SIPP. The SIPP will normally identify a “neutral asset mix” (sometimes referred to as “benchmark asset mix”) for each asset class.

A SIPP will also include a description of the benchmark against which a manager’s investment performance is to be measured. Sometimes the manager’s performance is measured against a universe of similar funds, but often performance is measured against a “benchmark portfolio” constructed in a similar way to that described in the Text.

To provide flexibility for investment managers to rebalance the fund periodically when the actual asset mix begins to deviate from the neutral asset mix, most SIPPs include minimum and maximums within the asset mix constraints. The need to rebalance can occur as a result of investment gains or losses from one asset class. Active managers also require flexibility in the event they wish to make adjustments in accordance with their market outlook. Regardless though, the neutral asset mix will form the reference point for the manager’s active management skills.

In attribution analysis, the value added through security selection is measured by comparing the benchmark portfolio return against the investment manager’s returns for each asset classes, weighted according to the neutral asset mix. The value added through asset allocation is measured by comparing the actual total portfolio return accomplished by the manager to the manager’s returns for each asset class weighted according to the neutral asset mix.