Trading, Performance Evaluation, and Manager Selection

Question 1

Discuss motivations to trade and how they relate to trading strategy of Profit seeking.

Answer 1

• High alpha decay → high urgency
• Low alpha decay → low urgency
• May use dark pools to mitigate information leakage

Question 2

Discuss motivations to trade and how they relate to trading strategy of Risk management/hedging.

Answer 2

Derivatives could be used if contracts exist and mandate permits

Question 3

Discuss motivations to trade and how they relate to trading strategy of Cash flow needs.

Answer 3

• Cash drag on inflows into funds with illiquid holds could be mitigated through equitization strategies
• Client redemptions are usually based on closing NAV (hence, managers will typically target closing prices as execution benchmarks)

Question 4

Discuss motivations to trade and how they relate to trading strategy of Corporate actions/index reconstitutions/margin calls.

Answer 4

• Income may need reinvesting
• Index reconstitutions are usually based around closing prices (hence, managers will typically target closing prices as execution benchmarks)
• Margin calls will likely require high urgency

Question 5

Discuss inputs to the selection of a trading strategy.

Answer 5

Key factors that dictate the appropriate trading strategy are as follows:
* Order characteristics: These are side, quantity, and percentage of ADV.
* Security characteristics: These are type, short-term alpha, volatility, and liquidity.
* Market conditions: A crisis can adversely impact volatility and liquidity.
* Individual risk aversion: Higher risk aversion implies higher urgency to lower execution risk.

The trader’s dilemma: is balancing the market impact cost of trading too quickly versus the execution risk of trading too slowly.

Question 6

The Reference Price benchmarks for Pretrade execution.

Answer 6

• Decision price
• Previous close: often used by quantitative managers
• Opening price: often used by longer-term fundamental managers
• Arrival price: used by profit-seeking managers

Question 7

The Reference Price benchmarks for Intraday execution.

Answer 7

Is based on a price that occurs during the trading period. The most common intraday benchmarks used are:

VWAP: used when managers want to participate with volume

TWAP: used when managers want to trade evenly and mitigate the impact of outliers, and for markets with unpredictable trading volumes

Question 8

The Reference Price benchmarks for Post-trade execution.

Answer 8

Closing price: used by index-tracking managers

Price target benchmarks: usually based on the manager’s view of fair value

Question 9

The Reference Price benchmarks for Price target execution.

Answer 9

Usually based on the fair value estimate of an active manager

Question 10

Recommend and justify a trading strategy (given relevant facts).

Answer 10

The primary goal of a trading strategy is to:
* balance expected costs
* risks, and alpha decay in line with the manager’s objectives
* risk aversion
* other constraints

Question 11

Higher touch—principal

Answer 11

Large urgent trades in illiquid securities

Question 12

Higher touch—agent

Answer 12

Large trades in illiquid securities that are less urgent

Question 13

DMA

Answer 13

Small trades in liquid electronic markets

Question 14

Profit-seeking algorithms

Answer 14

Will determine what to buy and sell and then implement those decisions in the market as efficiently as possible.

Used by electronic market makers, quantitative funds, and high-frequency traders

Question 15

Scheduled algorithms

Answer 15

Are appropriate for orders in which portfolio managers or traders:
* do not have expectations of adverse price movement during the trade horizon
* have greater risk tolerance for longer execution time periods
* more concerned with minimizing market impact.

Scheduled algorithms:
* POV
* VWAP
* TWAP

Relatively small orders in liquid electronic markets for managers with less urgency (portfolio rebalancing)

Question 16

Liquidity-seeking algorithms

Answer 16

Are appropriate for large orders that the portfolio manager or trader would like to execute quickly without having a substantial impact on the security price.

Larger orders in less liquid electronic markets with higher urgency, or when liquidity is sporadic

Question 17

Arrival price algorithms

Answer 17

Are used for orders in which the portfolio manager or trader believes:
* prices are likely to move unfavorably during the trade horizon
* risk-averse and wish to trade more quickly to reduce the execution risk

Relatively small orders in liquid electronic markets with high urgency (profit-seeking managers)

Question 18

Dark strategies

Answer 18

These algorithms are used when order size is:
* large relative to the market volume
* trading in the open market using arrival price or WAP strategies would lead to significant market impact
* trading securities that are relatively illiquid or have relatively wide bid-ask spreads
* trades in which the trader or portfolio manager does not need to execute the order in its entirety

Large orders in illiquid markets and arrival price or scheduled algorithms would likely lead to high market impact

Question 19

SORs

Answer 19

Small market orders with low market impact where the market can move quickly, and small limit orders with low information leakage where there are multiple potential execution venues

Question 20

Contrast key characteristics of the following markets in relation to trade implementation: equity, fixed income, options and futures, OTC derivatives, and spot currency.

Answer 20

Equities: Mostly traded electronically on lit exchanges and dark pools. Algorithmic trading.

Fixed-income securities: dealer-driven, high-touch principal markets. Clients use electronic RFQ systems to access quotes from dealers. Algorithmic trading is limited to the most liquid on-the-run U.S. Treasuries.

Exchange-traded derivatives: are traded electronically, algorithmic trading is less common. Buy-side traders generally use DMA.

OTC derivatives: traded in high-touch dealer markets. Since the credit crunch, basic OTC derivatives to be centrally cleared.

Spot foreign exchange: trading OTC markets that use both electronic (algorithms and DMA) and high-touch approaches for larger trades.

Question 21

Explain how trade costs are measured and determine the cost of a trade.

Answer 21

The total implicit and explicit costs of trading are measured by the implementation shortfall

Execution cost: when the execution price is worse than the decision price.

Delay cost: when the arrival price is worse than the decision price.

Trading cost: when the execution price is worse than the arrival price.

Opportunity cost: unexecuted shares when the closing price is worse than the decision price.

Fixed fees: any explicit commissions or fees incurred in executing the trade.

Question 22

Evaluate the execution of a trade. What is the market-adjusted cost?

Answer 22

To not reward or punish a manager for the market movement over the trading horizon, market-adjusted cost removes the cost associated with the market move as follows:

market-adjusted cost (bps) = arrival cost (bps) − β × index cost (bps)

Question 23

Evaluate a firm’s trading procedures, including processes, disclosures, and record keeping with respect to good governance.

Answer 23

An asset manager should have a formal written trade policy that clearly sets out its procedure.

Trade policy has four key areas:
1. the meaning of best execution
2. the factors that determine the optimal trading approach
3. a listing of approved brokers and execution venues
4. details of the monitoring processes used by the asset manager

Question 24

What are the 3 types of markets

Answer 24

Quote-driven (or dealer) markets: are those in which members of the public trade with dealers rather than directly with one another.

Order-driven markets: are those in which members of the public trade with one another without the intermediation of dealers.

Brokered markets: are those in which the trader relies on a broker to find the other side of a desired trade.

Question 25

What is an execution algorithm?

Answer 25

is tasked with transacting an investment decision made by the portfolio manager.

Question 26

What is a TWAP algorithm?

Answer 26

Slices the order into smaller amounts to send to the market following an equal-weighted time schedule.

TWAP algorithms will send the same number of shares and the same percentage of the order to be traded in each time period.

Question 27

What is a VWAP algorithm?

Answer 27

Slices the order into smaller amounts to send to the market following a time slicing schedule based on historical intraday volume profiles.

These algorithms typically trade a higher percentage of the order at the open and close and a smaller percentage of the order during midday. Because of this, the VWAP curve is said to resemble a U-shaped curve.

Question 28

What is a POV algorithm?
(also known as participation algorithms)

Answer 28

Send orders following a volume participation schedule. As trading volume increases in the market, these algorithms will trade more shares, and as volume decreases, these algorithms will trade fewer shares.

Question 29

Explain the following components of portfolio evaluation and their interrelationships: performance measurement, performance attribution, and performance appraisal.

Answer 29

performance measurement: What performance did the fund achieve during the period?

performance attribution: How did the fund manager achieve their performance?

performance appraisal: Did the fund manager achieve their performance via skill or luck?

Question 30

Describe attributes of an effective attribution process.

Answer 30

An effective performance attribution process includes:
* A reflection of 100% of the portfolio’s return or risk exposure.
* The portfolio manager’s current decision-making process.
* The active investment decisions taken by the portfolio manager.
* A full explanation of the portfolio’s excess return and risk.

Question 31

Contrast return attribution and risk attribution.

Answer 31

Return attribution: evaluates the impact of the active portfolio management decisions on the fund’s investment returns.

Risk attribution: is the parallel of return attribution but analyzes the impact of the portfolio manager’s active investment decisions on portfolio risk.

Question 32

Contrast macro and micro return attribution.

Answer 32

Micro attribution: analyzes the portfolio at the portfolio manager’s level and seeks to verify that the portfolio manager did what they said they were going to do and to understand the drivers of the portfolio’s return.

Macro attribution: analyzes investment decisions at the fund sponsor’s level and quantifies the decisions made by the fund sponsors to deviate from their strategic asset allocation and the timing when they made those decisions.

Question 33

Describe the advantages and disadvantages of returns-based performance attribution.

Answer 33

Uses regressions to analyze the portfolio returns over some period and isolates the asset class components through indexes that would have generated these returns.

There is no attempt to determine the actual holdings of the portfolio.

Question 34

Describe the advantages and disadvantages of holdings-based performance attribution

Answer 34

Uses beginning-of-period portfolio assets; the accuracy of analysis improves as the time interval for the analysis becomes smaller.

Since holdings-based attribution does not adjust for any portfolio changes that are made after the initial period, this analysis frequently does not match the actual portfolio returns.

Question 35

Describe the advantages and disadvantages of transactions-based performance attribution.

Answer 35

Improves upon the holdings-based attribution by updating the attribution of the beginning-of-period holdings of the portfolio with any subsequent trades.

Both the weights and the returns of the portfolio will reflect the actual transactions, including any transaction costs.

Question 36

Interpret the sources of portfolio returns using a specified attribution approach.

Answer 36

The Brinson-Hood-Beebower (BHB) and Brinson-Fachler models quantify the portfolio returns into three attribution effects:
1. The allocation effect: refers to the portfolio manager’s decision to overweight or underweight specific sector weightings in the portfolio versus the portfolio benchmark.
2. The security selection: refers to the value the portfolio manager either added or detracted from the portfolio by selecting individual securities within the sector and weighting the portfolio differently compared to the benchmark’s weightings.
3. The interaction effect: refers to the residual amount that ensures the arithmetic return minus the relative benchmark is fully accounted for in the attribution analysis.

Question 37

Interpret the output from fixed-income attribution analyses.

Answer 37

Exposure decomposition: is a top-down approach that utilizes duration to quantify active portfolio manager decisions regarding interest rate decisions relative to its benchmark.

Yield decomposition (duration): can be either top-down or bottom-up and utilizes both duration and yield to maturity (YTM) in computing price return.

Yield decomposition (full repricing): involves repricing based on zero-coupon curves, or spot rates. The full-repricing method is the most accurate measure of price changes in securities.

Question 38

Discuss considerations in selecting a risk attribution approach.

Answer 38

There are 2 general methods

Relative attribution analysis: tracking risk (or tracking error) is the relevant risk measure to consider and the general objective is to determine the returns generated from active management and compare them to the amount of tracking risk assumed.

Absolute attribution analysis: quantifies general risk arising from market, size, and style exposures and specific risk arising from stock picking. A common risk measure to use is standard deviation.

Question 39

Identify and interpret investment results attributable to the asset owner versus those attributable to the investment manager.

Answer 39

Macro attribution analysis: looks at the impact of fund sponsor decisions.

Micro attribution analysis: looks at the impact of portfolio manager decisions.

Both types of analysis utilize the BHB and Brinson-Fachler model computations to determine:
* allocation
* selection
* interaction effects

Question 40

Discuss uses of liability-based benchmarks.

Answer 40

A liability-based benchmark focuses on the cash flows necessary to satisfy the liability and frequently limits the investment choices available to the portfolio manager.

Frequently used assets within a liability-based benchmark include nominal bonds, inflation-adjusted bonds, and high-quality stocks.

Question 41

Describe types of asset-based benchmarks.

Answer 41

1. An absolute benchmark: is a return objective that aims to exceed a minimum target return.
2. Broad market indexes: such as the S&P 500
3. Investment-style indexes: represent specific portions of an asset category (style indexes) and can be used as a benchmark.
4. Factor models: involve relating a specified set of factor exposures to the returns on an account.
5. Returns-based benchmarks: are constructed using the managed account returns over specified periods and corresponding returns on several style indexes for the same periods.
6. A manager universe: looks at a group of managers that have a similar investment process. The median manager or fund from that universe is used as the benchmark.
7. Custom security-based benchmarks: are designed to reflect the manager’s security allocations and investment process.

Question 42

Discuss tests of benchmark quality.

Answer 42

A portfolio return can be broken up into 3 components:
1. market
2. style
3. active management

excess return to style = S = B − M; difference between the manager’s style index (benchmark) return and the market return.

active return = A = P − B; difference between the manager’s overall portfolio return and the style benchmark return.

Question 43

Describe problems that arise in benchmarking hedge funds.

Answer 43

3-general types of benchmarks could be considered for hedge funds:

1. Broad market indexes: are not appropriate to use as a benchmark for hedge funds because hedge funds cover a wide range of investment strategies and differ significantly from each other.
2. The risk-free rate: is not appropriate because the vast majority of hedge funds will carry some systematic risk and the use of leverage will only exacerbate the risk.
3. Hedge fund peer universes: are not suitable because a specific peer group’s risk and return objectives are not likely to match that of a specific hedge fund.

Question 44

Describe problems that arise in benchmarking real estate.

Answer 44

With the many real estate benchmarks that could be used, they may not be suitable for all real estate investments for reasons including:
* small sample size
* bias toward larger investments
* use of appraisal data
* lack of consistency regarding use of leverage
* unrealistic assumptions of no transaction costs
* full transparency
* normal liquidity

Question 45

Describe problems that arise in benchmarking Private Equity.

Answer 45

Private equity benchmarks usually use internal rate of return (IRR) measures but managers may be using different methods of valuation.

IRR may be biased by losses or gains occurring near the beginning of an investment.

Finally, all the results are reported at one common point in time even though the firms are likely in varying stages of development.

Question 46

Describe problems that arise in benchmarking commodity investments.

Answer 46

Benchmarks for commodity investments are usually based on futures as opposed to actual assets. That may result in significant differences between the benchmark and the commodity investments portfolio, which reduces the comparability.

Question 47

Describe problems that arise in benchmarking Managed derivatives & Distressed securities.

Answer 47

Managed derivatives: use specific benchmarks because of the lack of market indexes. As a result, such benchmarks may be too specific or not specific enough for a given investment strategy and therefore not suitable.

Distressed securities: Given the illiquidity and severe lack of marketability, it is almost impossible to determine an appropriate benchmark.

Question 48

Describe the impact of benchmark misspecification on attribution and appraisal analysis.

Answer 48

When an incorrect benchmark is used in the performance evaluation process, then performance measurement, which comprises attribution and appraisal analysis, will not be useful. Misspecified benchmarks will result in “misfit” active return.

Question 49

Evaluate the skill of an investment manager.

Answer 49

The skill of an investment manager can be evaluated through attribution analysis as well as appraisal analysis.

Question 50

Calculate and interpret the Sharpe ratio.

Answer 50

The Sharpe ratio is calculated as the incremental or excess return over the risk-free rate divided by standard deviation.

A key drawback with the ratio is that the denominator does not differentiate between volatility that is upside versus downside.

Question 51

Calculate and interpret the Treynor ratio.

Answer 51

The Treynor ratio is calculated as the incremental or excess return over the risk-free rate divided by beta, so it only considers systematic risk rather than total risk like the latter.

Question 52

Calculate and interpret the information ratio (IR).

Answer 52

The information ratio (IR) is used to measure a portfolio’s performance against the benchmark but accounting for differences in risk.

The numerator is the difference between the mean returns of the portfolio and the benchmark, respectively.

The denominator is known as the tracking risk, or the variability in the portfolio performance with that of its benchmark.

Question 53

Calculate and interpret the appraisal ratio (AR).

Answer 53

The appraisal ratio (AR) is calculated as alpha divided by the standard deviation of the residual/unsystematic risk (the standard error of regression).

Alpha is excess return, calculated as the return earned by the portfolio minus the return suggested by CAPM.

Question 54

Calculate and interpret the Sortino ratio.

Answer 54

The Sortino ratio only considers the standard deviation of the downside risk. It uses a minimum acceptable return (MAR, or target rate of return) and target semi-standard deviation (target semideviation).

The Sortino ratio penalizes managers only for “bad” volatility by considering only returns below the MAR.

Question 55

Calculate and interpret the upside/downside capture ratios.

Answer 55

Capture ratios determine the manager’s relative performance when markets are up or down.

Upside capture: in an up market is the manager’s portfolio return is also positive and if it is above or below the benchmark return.

Downside capture: in a down market is the manager’s portfolio return is negative and if it is above or below the benchmark return.

The capture ratio (CR) = UC ratio / DC ratio.

The CR is a measure of return asymmetry:
(> 1) = positive asymmetry (convex shape)
(< 1) = negative asymmetry (concave shape)

Question 56

What is Drawdown?

Answer 56

Is the total peak-to-trough loss for a specified time period

Question 57

What is Maximum drawdown?

Answer 57

It is the largest peak-to-trough loss during that time period.

It occurs at the very end of the drawdown phase and at the very start of the recovery phase.

Question 58

What is Drawdown duration?

Answer 58

It is the total time required to fully recover a drawdown; it is from when the drawdown begins to when the total drawdown recovers to zero.

Question 59

Describe the components of a manager selection process, including due diligence.

Answer 59

In the context of investment manager selection, due diligence consists of:

1. the manager universe: consists of only those managers who are suitable for the portfolio in terms of the objectives and constraints of the IPS
2. quantitative analysis: focuses on performance attribution and appraisal as well as the analyses of CR and significant drawdowns
3. qualitative analysis: important issues
   • What is the likelihood that the same level of returns will continue in the future?
   • Does the manager’s investment process account for all the relevant risks?

Question 60

Contrast Type I and Type II errors in manager hiring and continuation decisions.

Answer 60

Type I errors: occur when the null hypothesis is rejected when, in fact, there was no value added (hired or kept manager did not demonstrate sufficient skill). Type I errors receive much more attention as they are easier to determine.

Type II errors: occur when the null hypothesis is not rejected when, in fact, there was value added (manager who was not hired or the manager who was fired did demonstrate sufficient skill).

Question 61

Describe uses of returns-based and holdings-based style analysis in investment manager selection.

Answer 61

Style analysis examines the manager’s risk exposures in relation to an appropriate benchmark and the changes in those exposures over time.

RBSA: is a top-down approach that estimates the portfolio’s sensitivities to security market indexes for a set of key risk factors.

HBSA: is a bottom-up approach that looks at the actual securities included in the portfolio at one time.

Question 62

Evaluate a manager’s investment philosophy.

Answer 62

The entire investment process should be driven by a succinct and precise investment philosophy.

Some managers believe markets are very efficient and will execute passive strategies. Other managers believe markets are inefficient and can allow for those inefficiencies to be exploited.

Active managers will look at:
* behavioral inefficiencies: shorter-term; caused by other investors and their behavioral biases structural inefficiencies: longer-term; caused by laws and regulations

Question 63

What are the steps in the investment decision-making process.

Answer 63

The investment decision-making process consists of four steps:
1. Idea generation
2. Idea implementation
3. Portfolio construction
4. Portfolio monitoring

Key issues regarding portfolio construction are:
* allocation
* risk management
* liquidity

Question 64

Evaluate the costs and benefits of pooled investment vehicles and separate accounts.

Answer 64

Pooled vehicles: bring together the funds from all investors into one portfolio and there is no customization for any specific investor.

SMAs: hold the funds of one investor in a separate account. Which require an extra layer of due diligence to:
* evaluate security selection
* portfolio construction
* operational issues

Attributions of SMAs:
* higher transaction costs
* provide control & customization
* tax efficiency
* separate reporting
* greater transparency

Question 65

Compare types of investment manager contracts, including their major provisions and advantages and disadvantages.

Answer 65

Closed-end funds and ETFs: have the highest liquidity because they are traded intra-day.

Open-end funds: offer almost as much liquidity in that they are traded based on end-of-day NAV only.

Limited partnership structures: usually involve investment capital that is tied up for more time.

Private equity and venture capital funds: have the lowest liquidity because of capital calls; investors only receive returns after about 5-years into the 10-year average life of the funds.

SMAs: the liquidity is determined by the liquidity of the underlying assets.

Question 66

Analyze and Describe the 3-basic forms of performance-based fees.

Answer 66

Symmetrical structure with full upside and downside exposures: Fee =
* base + performance sharing

Bonus with full upside and limited downside exposures: Fee = greater of:
* base
* base + sharing of positive performance

Bonus with limited upside and downside exposures: Fee = greater of:
* base
* base + sharing of positive performance (within limit)