T9 Performance Measurement Flashcards
Why do we measure performance?
- to know if investment is meeting its objectives (fund manager’s investment objectives/expectations and prevailing mkt conditions)
- to get a better understanding of performance in order to improve performance
- to manage asset/liability matching position from an actuarial perspective
note though: actual performance achieved is backward-looking, opinions vary as to how valuable a predictor past performance is of future performance.
HOW can performance be measured?
- relative performance - important to pick a valid benchmark for valid measurement (meaningful performance comparison)
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absolute performance - calc performance w/o reference to a benchmark, which can be either MWR (money weighted R) or TWR (time weighted R)
- MWR return calculates the average growth rate of all money invested in the investment over the evaluation period while TWR calculates the growth of a single unit of capital invested in the account.
What makes a benchmark valid?
It must be
- unambiguous (underlying assets and risk factor exposures must be transparent beforehand),
- investable (can the index be held as a passive investment?),
- measurable (R can be easily measured on a frequent basis),
- appropriate (in line with mgr’s investment style/area of expertise)
- owned (mgr must be aware of the constituents and accept responsibility for the performance of the index)
- matches objectives e.g. if mandate is to invest in large-caps only, then use S&P/ASX 100 accumulation index is better than S&P/ASX 300
How is investment risk measured in general?
- stdev = most common risk measure
- relative stdev (as in relative to benchmark) which is more informative to absolute stdev. note that monthly stdev figures are usually annualised and used for reporting risk.
- generally, risk can be thought of as losing capital, but in superannuation context, you can think of risk as ‘probability of not being able to meet obligations/other objectives’
- better still, we can use relative semi stdev/var as it only considers the negative deviations from benchmark, hence more reflective of investor’s risk tolerance in reality.
- whatever risk measure is used, there needs to be a consensus on it (an agreed measure of risk for communication between clients, fund managers, asset consultants etc. and/or if comparing across several funds.)
What are risk-adjusted Rs for?
use of risk-adjusted R makes it a bit easier for us to answer the age-long question “was it skill or was it fluke?” i.e. risk-adjusted R makes it possible for us to gauge/compare Rs between managers based on the same amount of risk taken. (note though ofc, for comparison to be valid, the investment objectives, syle and size must be similar/same)
What are the commonly used risk-adjusted Return measures?
- Sharpe Index - higher the value, the more skill the mgr is thought to have exhibited (note choice of rf is important)
- IR (information ratio) - relative to a select benchmark (as opposed to rf in sharpe index) used to assess if contribution from active management was achieved by skills or chance over time; direclty influenced by length of evaluation period. in reality, an IR of 0.5+ over the long term is considered exceptional! (if Rs are given in years (p.a.) then remove sqrt(n) in the formula)
- Jensen Index
- Treynor Measure
note market index used affects the ranking of mgr ( with Jensen and Treynor measures) because diff betas can result from diff mkt indices; also, identify the mkt conditions when assessing mgr’s performance e.g. did the conditions favour the mgr’s investment style?
How do derivatives impact performance?
They impact mkt exposure and degree of leverage.
It’s important to tie performance due to derivatives and cash backing those derivatives to the underlying assets.
What is TWR?
time weighted return - aka the growth of a Dollar invested. calculation requires that the investment is valued every time an external CF occurs (inflow/outflow). calc links sub-period Rs together to work out the TWR over the entire evaluation time period, assuming that the dollar and earnings are reinvested from one sub-period to the next ;
unaffected by size and timing of external CF into/out of investment. (basically you have been using twr in the worksheets when calculating monthly Rs i.e. C/O -1 ) hence preferred method for measuring fund manager’s performance (as they have no control over timing and size of CFs).
Also important to value the portfolio just prior to each CF (in practice, CFs often occur intra-month when pf valuations may not be avail.)
What is MWR?
money weighted return, implied IRR, or known as the investor’s earning rate/investor’s return - measures the compound growth rate in the value of all funds invested over the evaluation period; sensitive to size and timing of external CF into/out of investment. MWR is the most appropriate when comparing a fund’s performance with internally determined objectives.
Describe in general terms what performance attribution analysis entails.
(note risk can also be analysed this way) the analysis is about understanding how pf was constructed and quantifying how each decision has contributed to performance.
It decomposes performance into
- active R (which could come from aa shift from benchmark or stock selection from benchmark within a sector, or interaction b/w aa decision and stock selection decision)
- benchmark R (usually a diversified pf with a set of weights in asset sectors, multiplied by R from each asset sector).
* note however HOW this analysis is carried out comes down to investment objectivs. e.g. if the mandate is to invest in an international equity pf, then we’d like to know how much the R was attributable to currency allocation and country allocation and stock selection.
It is an important tool, but the analysis result must be assessed in the context of the mandate offered to the manager, prevailing mkt conditions and other factors.
What outcomes does a performance attribution analysis generally lead to?
* diff stories may be revealed by attribution analysis e.g. a particular aspect of performance is consistently losing value, this may lead to inv manager having to adjust mandate accordingly; or, active Rs might have almost always come from active positions in only a few stocks (high concentration of performance) and client will need to determine if such concentration can be relied upon to continue future outperformance.
* also contribution to performance should be consistent with the style of manager (if not consistent, it’s likely fluke rather than skill) e.g. sector specialist manager will be expected to add significant value from stock selection (as opposed to AAA which a balanced manager would be better at for creating value)
* analysis results are useful for investors and inv managers e.g. it can serve as an early warning about problems which may not yet be apparent in the overall active performance ; also can lead to change in aaa decisions ( change proportion b/w growth and defensive, proportion b/w equity and property within growth asset, proportion b/w domestic and overseas equities etc. )
* highlights value added/lost -> insight into the capabilities of the manager -> can identify weaknesses and strengths in the manager’s investment approach.
What is general assessment of value added through AAA?
- mkt conditions -> say Rs from asset classes diverge by a significant margin, then tilts away from SAA may add/subtract from the performance of the pf. the opposite is true if all asset classes perform similarly under some mkt condition.
- period of assessment (typically 3 years. short term deviation in actual R from expected R needs to be considered in relation to manager’s investment style and volatility of relevant assets/asset classes e.g. high alpha seeking mgers more likely deviate away from expected R /benchmarks, but must still be consistent with the mger’s style. hence, difficult based on 1-2 qtrs of performance data to draw strong conclusion about mgr’s ability to outperform over longer term) has a bearing on the strenghth of conclusion drawn from the performance analysis. what would be considered an appropriate period of assessment? depends on: 1. nature of mandate given to mger 2. prevailing financial mkt conditions 3. inv approach used by the mger 4. purpose of the analysis
What is detailed assessment of value added through AAA?
general assessment may lead investor to do more detailed analysis of manager’s performance -> can result in either making changes to the mandate given to the manager or replacing the manager altogether . The detailed assessment can be:
detailed decomposition of performance e.g.
- can examine value added/lost fromindividual tilts away from the SAA;
- can examine the contribution to total performance from individual currency positions or country allocations (if part of AAA)
- can divide results into smaller time periods to consider the performance under varying mkt conditions / to establish trends;
- can examine performance at diff stages of a mkt cycle. (helps investor decide if outperformance was fairly consistent or only over a short period of time from one or very few correct investment decisions.
- can provide insights into mgr’s responses under certain mkt conditions.
- can be used to identify emerging trends in the performance and if necessary take corrective action.
- can involve observing activities around key turning points
- can also involve qualitative investigations (crucial part of detailed performance assessment) so you discuss with managers rather than observing historial results only. quant and qualitative analyses combined delivers a more complete view on mgr’s likely future prospects and capabilities.
- use of statistical techniques (to understand better if performance was fluke or skill of the mgr; to identify if there are persistent characteristics in the AAA performance ); can do statistical test to determine if mgr’s outperformance was statistically significant
