Performance Measurement (10.31.24) Flashcards
Ex post vs ex ante
ex post - looking back in time
ex ante - looking forward in time
Performance attribution
The process of disaggregating a portfolio’s return to determine the drivers of its performance
How was the performance obtained
Return attribution
A set of techniques used to identify the sources of the excess return of a portfolio against its benchmark
Macro vs. Micro attribution
macro - measures the effect of the sponsor’s choice to deviate from the strategic asset allocation
micro - measures the impact of pm’s allocation and selection decisions on total fund performance
Returns-based attribution
Uses only the total portfolio returns over a period to identify the components of the investment process that have generated returns (Brinson-Hood-Beebower)
when is returns based attribution appropriate
when the underlying portfolio holding information is not available with sufficient frequency at the required level of detail
hedge funds, for example, because it can be difficult to obtain the underlying holdings
easiest to implement, but least accurate
Holdings-based attribution
“Buy and hold” approach which calculates the return of portfolio and benchmark components based upon the price and foreign exchange rate changes applied to daily snapshots of portfolio holdings
when is holdings-based attribution most appropriate
for investment strategies with little turnover (passive strategies)
Transactions-based attribution
Captures the impact of intra-day trades and exogenous events such as significant class action settlement
most accurate, but most difficult to obtain
Geometric attribution
(1+R) / (1+B) - 1
OR
(R-B) / (1+B)
relationship between geometric excess return and arithmetic excess return
geometric = arithmetic divided by wealth ratio of the benchmark (1 + return on benchmark during the period)
Security selection answers which question
Was the return achieved by selecting securities that performed well relative to the benchmark or by avoiding benchmark securities that performed relatively poorly?
Asset allocations answers which question
Was the return achieved by choosing to overweight an asset category (e.g., economic sector or currency) that outperformed the total benchmark or to underweight an asset category that underperformed the total benchmark?
Interaction effect
The impact of overweighting and underweighting individual securities within securities that are themselves overweighted or underweighted
I = (w-w(b)) * (r-r(b))
BHB Model
Built on the assumption that the total portfolio and benchmark returns are calculated by summing the weights and returns of the sectors within the portfolio
Selection and allocation do not completely explain the arithmetic difference, interaction explains the third attribution effect
BF Model
All overweight positions in sectors with positive returns will generate positive allocation effects irrespective of the overall benchmark return, whereas all overweight positions in negative markets will generate negative allocation effects
Carhart four factor model
1) Market
2) Size
3) Value
4) Momentum
3 Approaches to fixed income attribution
1) Exposure decomposition (duration based)
2) Yield curve decomposition
(duration based)
3) Yield curve decomposition (full repricing based)
Exposure Decomposition
- (Duration Based)
- Top-down attribution approach that seeks to explain the active management of a portfolio relative to its benchmark
- Includes portfolio duration bets, yield curve positioning, sector bets (all relative to benchmark)
Yield Curve Decomposition
- (Duration based)
- Can be top-down approach or bottom up from security level, estimating the return of securities, sector buckets, or YTM buckets
%Total return = % Income return + % Price return
% Price return = -Duration * Change in YTM
Duration
measures the sensitivity of bond price to a change in the bond’s YTM
Yield Curve Decomposition
- (Full Repricing)
- Bottom up approach that is more precise and allows for broader range of instrument types and yield changes
- Reprices bonds from zero-coupon curve (spot rates)
Common measure of risk when portfolios are managed against benchmarks
Tracking risk
7 Types of Benchmarks
1) Absolute return benchmark
2) Broad market index
3) Style index
4) Factor-model-based benchmark
5) Returns-based (Sharpe) benchmark
6) Manager universes (peer groups)
7) Custom security-based (strategy) benchmark
Absolute return benchmark
a minimum target return that an investment manager is expected to beat
Broad market index
Measures of broad asset class performance; well known, readily available, and easily understood
Investment style index
a natural grouping of investment disciplines that has some predictive power in explaining the future dispersion of returns across portfolios
Factor-model-based benchmarks
Benchmarks constructed by examining a portfolio’s sensitivity to a set of factors, such as the return for a broad market index, company earnings growth, industry, or financial leverage
Returns based benchmarks (Sharpe style analysis)
Benchmarks constructed by examining a portfolio’s sensitivity to a set of factors, such as the returns for various style indexes
Manager universe
a broad group of managers with similar investment disciplines; also called manager peer group
Custom security-based benchmark
Custom built to accurately reflect the investment discipline of a particular investment manager
Criteria that a benchmark must satisfy to be valid in use
1) Unambiguous - clearly identifiable
2) Investable
3) Measurable
4) Appropriate
5) Reflective of current investment opinions
6) Specified in advance
7) Accountable
Sharpe ratio
The ratio of mean excess return to standard deviation (excess return)
(Return - risk free rate) / standard deviation
Treynor Ratio
Measures the excess return per unit of systematic risk
(return - risk free rate) / beta
When is treynor ratio useful
when the portfolios being compared as using the same benchmark index
Information ratio
Assesses performance relative to the benchmark, scaled by risk
(return portfolio - return benchmark) / (portfolio StD - benchmark StD)
Appraisal ratio (Treynor-Black Ratio)
Annualized alpha divided by the annualized residual risk, which are both computed from a factor regression
alpha/standard error of regression
Sortino Ratio
modification of sharpe ratio that penalizes only those returns that are lower than a user-specified return
(return - user-specified return) / risk
Drawdown
a percentage peak-to-trough reduction in net asset value
the loss in vale incurred in any continuous period of negative returns
Capture ratio
Measures the manager’s participation in up and down markets
upside capture / downside capture
Upside capture greater than 100% signifies outperformance (convex return profile)
downside capture less than 100% signifies outperformance (concave return profile)
Investment due diligence key points
1) Philosophy
2) Process
3) People
4) Portfolio
Operational due diligence key points
1) Process and procedure
2) Firm
3) Investment vehicle
4) Terms
5) monitoring
Type I Error in manager hiring
Hiring or retaining a manager who subsequently underperforms expectations
rejecting the null of no skill when it is correct
Type II error when hiring a manager
Not hiring or firing a manager who subsequently outperforms, or performs in line with, expectations
not rejecting the null when it is incorrect
Which type error is associated with explicit costs
Type I error
Which type error is associated with opportunity costs
Type II error
The difference in expected cost between Type I and Type II error vs. perceived difference between distribution of skilled and unskilled managers
lower the smaller the perceived difference between the distribution of skilled and unskilled managers
Returns-based style analysis (RBSSA)
A top-down analysis that involves estimating the sensitivities of a portfolio to security market indexes
Holdings-based style analysis (HBSA)
A bottom-up style analysis that estimates the risk exposures from the actual securities held in the portfolio at a point in time
Drawdown duration
The total time from the start of the drawdown until the cumulative drawdown recovers to zero
i.e. drawdown duration of 4 months means portfolio lost money and recovered in 4 months
Active share
a measure of how similar a portfolio is to its benchmark
a manager who precisely replicates the benchmark will have an active share of zero
a manger with no holdings in common with the benchmark will have an active share of one
High tracking risk + low active share
sector rotation
High tracking risk + high active share
concentrated stock pickers
Low tracking risk + low active share
closet indexer
Low tracking risk + high active share
Diversified stock pickers
Risk premiums
extra returns expected by investors for bearing some specified risk
Two categories of market inefficiencies
1) Behavior
2) Structural
Behavior inefficiencies
Perceived mispricings created by the actions of other market participants, usually associated with biases, such as trend following or loss aversion
temporary, lasting long enough for the manager to identify and exploit them before the market price and perceiving intrinsic value converge
Structural inefficiencies
Perceiving mispricings created by external or internal rules and regulations
can be long lived and assume a continuation of the rules and regulations rather than a convergence
Key person risk
the risk that results from over-reliance on an individual or individuals whose departure would negatively affect and investment manager
Groupthink
Behavioral bias that occurs when a team minimizes conflict and dissent in reaching and maintaining a consensus
Authority bias
Behavioral bias which involves groups deferring to a group member that is a subject matter expert or in a position of authority
Aversion of complexity
A behavior bias in which disproportionate attention is given to trivial issues at the expense of important but harder-to-grasp or contested topics
3 keys of information to exploiting inefficiencies in the market
1) Unique
2) Timely
3) Interpreted differently
4 Elements of the investment decision-making process
1) Signal creation
2) Signal capture
3) Portfolio construction
4) Portfolio monitoring
what conclusions does performance attribution draw regarding the quality of a portfolio manager’s investment decisions
none
For top down investment approach, what is the most appropriate risk attribution approach
attribute tracking risk to allocation and selection decisions relative to the benchmark
target semi-standard deviation (target semideviation)
denominator of the sortino ratio
(average portfolio return - MAR) / sortino ratio
MAR = minimum acceptable return
Sq(Sum of all (deviations below MAR^2) / n-1)
what capture ratio indicates convex return profile
capture ratio greater than 1
what capture ratio indicates concave return profile
capture ratio less than 1
Why can holdings-based attribution generate a residual term between the portfolio performance and benchmark performance
1) Timing of transactions
2) Price differences
3) Reinvestment of cash flows
4) Market movements
in other words, not by the the fund manager’s actions
two common approaches for equity attribution
1) brinson - fachler
2) factor-based attribution
Brinson model
widely used performance attribution model to understand the sources of a portfolio’s returns relative to a benchmark; three main components
1) Allocation effect: impact of pm’s decisions to allocate assets differently from the benchmark
2) Selection effect: pm’s ability to select securities within each sector
3) Interaction effect: combined impact of allocation and selection effect, which can sometimes offset each other
Allocation effect
(portfolio weight - benchmark weight) * (benchmark return for that category - total benchmark return)
Selection + Interaction effct
benchmark weight * (portfolio return - benchmark return) + (portfolio weight - benchmark weight) * (portfolio return - benchmark return)
return due to manager style
S = B - M
S = return due to manager style
B = return on the benchmark portfolio
M = return on the appropriate market index
Performance appraisal
indicates whether the portfolio’s performance was achieved through manager skill or through luck
Qualitative consideration most associated with determining whether investment manager selection will result in superior repeatable performance
investment process
when is style analysis most useful
when applied to strategies that hold publicly traded securities where pricing is frequent
4 main advantages of SMA
1) Ownership
2) customization
3) tax efficiency
4) Transparency
3 main disadvantages of SMA
1) Cost
2) Tracking risk
3) Investor behavior
pooled investment
fund where multiple investors combine money to invest together
ETFS and mutual funds
components of qualitative analysis
1) Investment due diligence
2) Operational due diligence
investment due diligence
Which manager “best fits the portfolio need?
1) Philosophy
2) Process
3) People
4) Portfolio
Operational due diligence
Is the manager’s track record accurate, and does it fully reflect risks?
1) Process and procedure
2) Firm
3) Investment vehicle
4) Terms
5) Monitoring
aspects of quantitative analysis
What has been the manager’s return distribution?
1) Attribution and appraisal: has the manager displayed skill?
2) Capture ratio: how does the manager perform in “up” markets versus “down” markets?
3) Drawdown: does the return distribution exhibit large drawdowns?
Which error type is an error of mistaken rejection
Type I
Which error type is an error of failing to detect a true relationship
Type II
Which error type is more easily measured
Type I
Which error type is linked to the compensation of the decision maker
Type I
which style analysis is subject to window dressing
HSBA because it is a snapshot of the portfolio at a single point of time
which style analysis is comparable across managers and to itself across time
returns based because it is able to identify the important drivers of return and the relevant risk factors for the period analyzed, even for complicated strategies
style analysis top down vs bottom up approach
bottom up - holdings based
top down - returns based
soft lock
provision that allows investors to redeem their shares during the lock-up period, but with certain restrictions or penalties
which fee structure decreases the volatility of a portfolio’s net returns
incentive fees because they are charged as a % of returns, reducing net gains in positive months and net losses in negative months
