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

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

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

Question 15

Scheduled algorithms

Answer 15

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

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

Question 17

Arrival price algorithms

Answer 17

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

Question 18

Dark strategies

Answer 18

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.

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

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

Answer 24

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 25

Describe attributes of an effective attribution process.

Answer 25

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 26

Contrast return attribution and risk attribution.

Answer 26

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 27

Contrast macro and micro return attribution.

Answer 27

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 28

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

Answer 28

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 29

Describe the advantages and disadvantages of holdings-based performance attribution

Answer 29

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 30

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

Answer 30

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 31

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

Answer 31

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 32

Interpret the output from fixed-income attribution analyses.

Answer 32

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 33

Discuss considerations in selecting a risk attribution approach.

Answer 33

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 34

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

Answer 34

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 35

Discuss uses of liability-based benchmarks.

Answer 35

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 36

Describe types of asset-based benchmarks.

Answer 36

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 37

Discuss tests of benchmark quality.

Answer 37

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 38

Describe problems that arise in benchmarking hedge funds.

Answer 38

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 39

Describe problems that arise in benchmarking real estate.

Answer 39

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 40

Describe problems that arise in benchmarking Private Equity.

Answer 40

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 41

Describe problems that arise in benchmarking commodity investments.

Answer 41

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 42

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

Answer 42

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 43

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

Answer 43

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 44

Evaluate the skill of an investment manager.

Answer 44

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

Question 45

Calculate and interpret the Sharpe ratio.

Answer 45

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 46

Calculate and interpret the Treynor ratio.

Answer 46

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 47

Calculate and interpret the information ratio (IR).

Answer 47

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 48

Calculate and interpret the appraisal ratio (AR).

Answer 48

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 49

Calculate and interpret the Sortino ratio.

Answer 49

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 50

Calculate and interpret the upside/downside capture ratios.

Answer 50

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

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

Using those amounts, the capture ratio is calculated as upside capture divided by downside capture.

Question 51

Calculate and interpret the Drawdown duration.

Answer 51

Drawdown duration is the total time required to fully recover a drawdown; it is from when the drawdown commences up to when the cumulative drawdown is zero.

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

Question 52

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

Answer 52

In the context of investment manager selection, due diligence consists of the manager universe, quantitative analysis, and qualitative analysis.

The manager universe consists of only those managers who are suitable for the portfolio in terms of the objectives and constraints of the IPS, invest in the relevant style (e.g., value, growth, mixed) desired by the client, and will manage the portfolio with the appropriate balance between active versus passive approaches.

Quantitative analysis focuses on performance attribution and appraisal as well as the analyses of CR and significant drawdowns.

Two important issues arise in qualitative analysis:
1. What is the likelihood that the same level of returns will continue in the future?
2. Does the manager’s investment process account for all the relevant risks?

Question 53

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

Answer 53

Type I errors occur when the null hypothesis is rejected when, in fact, there was no value added. In other words, the hired or kept manager did not demonstrate sufficient skill. Type II errors occur when the null hypothesis is not rejected when, in fact, there was value added. In other words, the manager who was not hired or the manager who was fired did demonstrate sufficient skill.

Type I errors receive much more attention than Type II errors since the former are errors of commission (more visible), while the latter are errors of omission (less visible). Also, Type I errors are easier to determine than Type II errors.

Question 54

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

Answer 54

Style analysis examines the manager’s risk exposures in relation to an appropriate benchmark and the changes in those exposures over time. The risk exposures allow for the classification of managers by style for selection purposes and to perform RBSA and HBSA.

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. Many of the advantages of RBSA are the same as for HBSA (e.g., determine key risk factors and return drivers, comparability between managers and through time, performed on a timely basis).

Question 55

Describe uses of the upside capture ratio, downside capture ratio, maximum drawdown, drawdown duration, and up/down capture in evaluating managers.

Answer 55

The capture ratio (CR) = UC ratio / DC ratio. The CR is a measure of return asymmetry; > 1 = positive asymmetry (convex shape) and < 1 = negative asymmetry (concave shape).

Drawdown is the total peak-to-trough loss for a specified time period; maximum drawdown is the largest peak-to-trough loss during that time period. Drawdown duration is the total time from when the drawdown begins to when the total drawdown recovers to zero (the latter achieved with offsetting gains).

Question 56

Evaluate a manager’s investment philosophy and investment decision-making process.

Answer 56

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 when market prices of securities deviate from their intrinsic values; they will execute active strategies. Active managers will look at behavioral inefficiencies (shorter-term; caused by other investors and their behavioral biases) and structural inefficiencies (longer-term; caused by laws and regulations).

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

Within portfolio construction, the key issues to consider include allocation, risk management, and liquidity.

Question 57

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

Answer 57

SMAs and pooled investment vehicles are used to execute investment strategies. 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. The cost-benefit trade-off of holding investments in an SMA must be evaluated.

Compared to pooled investments, SMAs have higher transaction costs but provide control, customization, tax efficiency, separate reporting, and greater transparency. Customized SMAs require an extra layer of due diligence to evaluate security selection, portfolio construction, and operational issues.

Question 58

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

Answer 58

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.

Investments held in limited partnership structures (e.g., hedge funds, private equity, venture capital) 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 five years into the 10-year average life of the funds. There may be the possibility to extend by the manager for up to two one-year periods, which further lowers liquidity.

With SMAs, the liquidity is determined by the liquidity of the underlying assets.

Question 59

Describe the three basic forms of performance-based fees.

Answer 59

here are three basic forms of performance-based fees:

Symmetrical structure with full upside and downside exposures
Fee = base + performance sharing
The greatest alignment between investor and manager incentives but increased risk to manager due to the full downside exposure

Bonus with full upside and limited downside exposures
Fee = greater of: (1) base, (2) base + sharing of positive performance

Bonus with limited upside and downside exposures
Fee = greater of: (1) base, (2) base + sharing of positive performance (within limit)

Question 60

Analyze and interpret a sample performance-based fee schedule.

Answer 60

There are three basic forms of performance-based fees:

Symmetrical structure with full upside and downside exposures
Fee = base + performance sharing
The greatest alignment between investor and manager incentives but increased risk to manager due to the full downside exposure

Bonus with full upside and limited downside exposures
Fee = greater of: (1) base, (2) base + sharing of positive performance

Bonus with limited upside and downside exposures
Fee = greater of: (1) base, (2) base + sharing of positive performance (within limit)