Topic 4 - Critically Evaluate the Approaches to and Principles of Performance Measurement

Question 1

What is total return?

Answer 1

Total return = Growth and income from investment.

Financial Planner assesses fund performance they will consider mathematical beta and alpha as analysis tools.

Question 2

Total Return: Holding Period Return

Answer 2

Same as total return. Income plus growth.

Holding Period Return - Total returns of different sizes can be compared.

Different time periods are not relative returns but absolute returns.

Income + growth/loss divided by investment value

Calculation Key:

• HPR = the holding period return as a percentage;
• In = any income, such as dividend or interest;
• D1 = the final selling price of the security or fund;
• D0 = the original buying price of the security or fund.
• HPRs Must have same time period to be directly comparable.
• Cannot be used if cash inflows and outflows are applicable. In this instance money weighted and time weighted return calculations are used.

Question 3

What is Money Weighted Returns?

What are it’s benefits?

What are it’s limitations/drawbacks?

Answer 3

• A.K.A - Internal Rate of Return
• Accounts for money invested at different periods and what return was actually gained from overall investments.
• Considers start and end portfolio values taking into account inflows and outflows
• More accurate than Holding Period Return as takes into account the individual investments at different times
• Still provides direct comparison of investments if there are no inflows or outflows
• Limited - Does not allow for return comparison between two different investors or different investment opportunities
• Less appropriate than time weighted returns as return is dependent on the timing of investments which are outside of the managers control

Question 4

What is Time Weighted Returns?

What are it’s benefits?

Answer 4

• Allows for portfolio measurement movement without distortions caused by timing of cash flows.
• Series of holding period returns multiplied when there is a cash flow movement
• Considered superior to MWR as allows for compounding effect and because return isn’t affected by uncontrollable cash inflows/outflows that could show super-normal returns or losses
• Calculation - Get HPR for each subperiod i.e. 5% and 7% and multiply them together as 1.05 x 1.07 = 1.1235% or 12.35% return.
• To get average return for each period just multiply final number to the power of 0.25 i.e fourth root.

Question 5

What conditions must be met for a benchmark to be considered appropriate for comparison?

Answer 5

1. The benchmark has a specific and unambiguous measurement.
2. The benchmark is appropriate to the underlying asset classes to the portfolio being appraised. An example is the FTSE 100 as a benchmark of a portfolio made of the top 100 UK companies by market capitalisation.
3. The benchmark needs to have the same currency denomination as the portfolio.
4. The benchmark should comprise investments that are open to the public and are not, for example, closed shares.
5. The benchmark return should be freely measurable and calculated.
6. The benchmark’s mathematical calculation should be consistent with the mathematical calculation of the portfolio return of the portfolio, eg MWR, TWR, HPR, geometric or arithmetic. Both calculations should include the same return of either income and/or capital gains.

Only be deemed outperform benchmark in relative and absolute terms if return has been achieved with no additional risk when comparingrisk taken to achieve return of benchmark.

Question 6

What is Attribution Analysis?

Answer 6

• Allows for assessment of how returns are derived and where returns are coming from.
• Explains why portfolio had certain return by breaking down performance and attributing the results to the fund manager’s decisions:
  • Asset allocation
  • Sector choice
  • Security selection
• Can see weighting of over-performing or under-performing securities and how much of this is result of managers selection.
• Only required if manager has discretion to place funds that will be measured by similar risk benchmark
• Calculation relies solely on the holding period return

Question 7

What is the difference between Actual and Relative Performance?

Answer 7

Actual Return looks to justify the modern portfolio theory assumption that all investors are rational and risk averse. Using portfolio return, client expectations and inflation-adjusted return

Absolute Return allows for relative performance to benchmark. The outperformance can then be relatively risk adjusted to ensure the extra risk is proportionate.