Performance Measurement

Question 1

What is the Sharpe Ratio?

Answer 1

Shows the risk-adjusted performance of an investment.

Measures the excess return over the ‘risk-free’ return.

The calculation is:-

Return - Risk-free Return
————————————
Standard deviation

Question 2

What are the disadvantages of using the Sharpe Ratio?

Answer 2

1. It relies on standard deviation which isn’t a precise measure of risk.
2. It assumes the risk-free return is always available & easily defined.
3. It can be manipulated using different time periods.
4. It ignores other factors.
5. It takes no account of charges.
6. It relies on past performance which is not necessarily a guide to future performance!

Question 3

What is the Information Ratio?

Answer 3

A more general form of the Sharpe Ratio, which looks at the consistency of performance against a benchmark.

It shows the effect of fund management over and above passive funds.

The calculation is:-

Portfolio Return - Benchmark Return
—————————————————
Tracking error (risk taken relative to benchmark)

Question 4

What is Alpha?

Answer 4

Actual v expected.

The difference between the return expected on a given investment based on its Beta (market risk) & the actual return achieved.

The calculation is:-

Portfolio Return - (Risk-free Return + Beta (Market Return - Risk-free Return) )

Question 5

How does benchmarking work?

Answer 5

It is a performance analysis too used to compare an investment against a benchmark.

It allows you to see how a fund manager is performing compared to a mock portfolio representing the same asset allocation, but using the appropriate indexes for each sector. Eg 20% UK equities would be measured against an index like the FTSE All Share Index.

Question 6

What are the advantages of using a benchmark?

Answer 6

1. They give an objective & neutral comparator against which to measure performance.
2. They can be used to examine returns achieved through both asset allocation & stock selection.
3. They give the investor something against which to hold the manager accountable.

Question 7

What factors should be taken into account when selecting a fund manager?

Answer 7

1. Experience of manager
2. The style of investment.
3. The size of the fund.
4. Staff turnover.
5. Charges.
6. Past performance.

Question 8

What should be taken into account in a Fund Managers ‘investor policy statement’?

Answer 8

1. Changes to taxation
2. Changes in regulation
3. Changes in the market
4. Where the statement is drawn up at Client level, client circumstances

Question 9

What does Beta measure?

Answer 9

Measures the volatility of an investment compared to the market average.

The market has a Beta of 1.

Question 10

What does Standard Deviation measure?

Answer 10

It measures how widely the actual return on an investment varies around the mean.

A low Standard Deviation means lower risk.

It is calculated by taking the square root of the variance.

Question 11

What is the CAPM formula?

Answer 11

Expected return =

Rf + Beta (Rm - Rf)

Question 12

What does the CAPM theory assume?

Answer 12

1. That investors are well diversified.
2. That investors are rational & risk averse.
3. All investors have the same holding period.
4. Market has many buyers & sellers.
5. No one individual can affect the market price.
6. There are no taxes, costs or restrictions.
7. Information is free & simultaneously available to all.
8. Unlimited funds can be borrowed or lent by all investors at the risk free rate.

Question 13

What are the two main limitations of using CAPM?

Answer 13

1. Studies have shown that not all non-systemic risk can be dominated through diversification.
2. Beats are historic and can be unreliable.

Question 14

Which three formulae are used to measure risk-adjusted returns?

Answer 14

The Sharpe Ratio

The Information Ratio

Alpha