Performance Eval. and Attribution - R41/R42 Flashcards
Demonstrate the importance of performance evaluation from the perspective of fund sponsors and the perspective of investment managers.
-
Sponsor Performance Evaluation:
- Feedback mechanism
- Identify strengths and weaknesses
- Attribution of results to key decisions
- Focuses attention on poor performance.
-
Investment Manager Performance Eval:
- Investigate effectiveness of various elements
- The contribution of those elements to results
What are the three components of performance evaluation?
- performance measurement
- performance attribution
- performance appraisal
If there is an external cash flow at the beginning of the evaluation period, what is the formula?
rt =
What is the formula for a cash flow at the end of the evaluation period?
rt =
Demonstrate the decomposition of portfolio returns into components attributable to the market, to style, and to active management
A portfolio return can be broken into 3 components: market, style, and active management.
P = M + S + A
The manager’s active management decisions (A) are assumed to generate the difference between the portfolio and benchmark returns (P-B):
P = B + A
Introducing the market index (M):
P = M + (B - M) + A
The investment style is assumed to generate the difference between the benchmark return and the market index (B - M):
P = M + S + A
Discuss the properties of a valid benchmark and explain the advantages and disadvantages of alternative types of performance benchmarks.
*List 7 properties of a valid benchmark
*List the 7 common types of benchmarks.
A valid benchmark should meet the following - SAMURAI:
- Specified in Advance
- Appropriate
- Measurable
- Unambiguous
- Reflective of current investment opinions
- Accountable
- Investable
Common benchmarks (7) - MBS FRAC:
- Manager Universes
- Broad market indices
- Style indices
- Factor-model-based
- Returns-based
- Absolute
- Custom security based
Explain the steps involved in constructing a custom security-based benchmark.
A custom security-based benchmark is the most appropriate as it meets all the benchmark criteria.
- Identify the manager’s investment process, asset selection (incl. cash) and weighting.
- Use the same assets and weighting for the benchmark.
- Assess and rebalance the benchmark on a predetermined schedule.
Evaluate benchmark quality by applying tests of quality to a variety of possible benchmarks
Good benchmarks should exhibit:
- Minor systematic bias between account and benchmark returns
- Minimal tracking error
- Strong correlation with the manager’s universe. (Risk and coverage)
- Low turnover
Distinguish between macro and micro performance attribution and discuss the inputs typically required for each.
Macro performance attribution is done at the fund sponsor level. The approach can be carried out in percentage terms and/or monetary terms.
Micro performance attribution is done at the investment manager level.
Three main Macro Attribution inputs;
- Policy allocations
- Benchmark Portfolio returns
- Fund returns, valuations, and external CFs
Micro attribution analyses individual portfolios rather than the whole fund. The manager’s value-added return is the difference between the portfolio and benchmark returns.
There are six levels of investment policy decision making, by which the fund’s performance can be analyzed.
Not Nambia but NRABIA
- Net Contributions
- Risk-free Asset
- Asset Categories
- Benchmark
- Investment Managers
- Allocation Effects (basicaly a reconciling factor)
These are six components of IP decision making into which the Fund’s performance might be analyzed. They are logical extensions of a typical fund sponsor’s decision-making process.
Describe the formula of the Allocation/Selection Attribution of Micro Performance Attribution and break down the individual pieces
Pure sector allocation measures the impact on performance only to the sector weighting decisions.
Within-sector selection assumes the manager weights each sector in the same proportion as in the overall benchmark, and the excess returns are due to security selection.
Allocation/selection return involves the joint effect of assigning weights to both sectors and individual securities.
Discuss the use of fundamental factor models in micro performance attribution.
*How do you construct a suitable factor model?
Combining economic sector factors with other fundamental factors. Constructing a suitable factor model would involve the following:
- Identify the fundamental factors that will generate systematic returns
- Determine the exposures of the portfolio and the benchmark to the fundamental factors of the model at the start of the evaluation period.
- Specify a benchmark. This could be the risk exposures of a style or custom index, or it could be a set of normal factor exposures that are typical of the manager’s portfolio.
- Determine the performance of each of the factors.
*What are the strengths and limitations of the allocation/selection and fundamental factor attributions?
Allocation/Selection Attribution
Strengths:
- Disaggregates performance effects of managers’ decisions between sectors and securities
- Relatively easy to calculate
Limitations:
- The need to identify an appropriate benchmark with specified securities and weights at the start of the evaluation period.
- Security selection decisions will have a knock-on effect on sector weighting decisions
- Can cause confusion as it reflects the joint effect of allocating weights to both securities and sectors (ie, difficult to separate the two factors), so often not worth the time and effort.
Fundamental Factor Model Attribution
Strengths:
- Identifies factors other than just security selection or asset allocation
Limitations:
- Exposures to the factors need to be determined at the start of the evaluation period.
- Can prove to be quite complex, leading to potential spurious correlations.
Explain the management factors that contribute to a fixed-income portfolio’s total return and interpret the results of a fixed-income performance attribution analysis.
-
Interest rate management effect
- Ability of manager to predict changes in relevant interest rates
-
Sector/quality effect
- Ability to select and over/underweight out/underperforming sectors and qualities
-
Security selection effect
- Ability to select superior securities to represent sectors
-
Trading activity
- Residual effect. Assumed to measure the return to active trading over the period
Calculate interpret and contrast alternative risk-adjusted performance measures, including:
- Ex-post Alpha
- Information ratio
- Treynor measure
- Sharpe ratio
- M2
