FinQuiz smart summary, evaluating porfolio perfomance

PE = Performance Evaluation MCP = Manager Continuation Policies HF = Hedge Funds YC = Yield Curve Performance Evaluation Performance Measurement Performance Attribution Performance Appra

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2013, Study Session # 17, Reading # 41

1 INTRODUCTION

Calculating accounts’

performance based on investment related∆

PE = Performance Evaluation

MCP = Manager Continuation Policies

HF = Hedge Funds

YC = Yield Curve

Performance Evaluation

Performance Measurement Performance Attribution Performance Appraisal

Analyzing sources of return &

importance of those sources

was generated due to skills or luck

Assessing size & consistency

of accounts relative performance

2 THE IMPORTANCE OF PERFORMANCE EVALUATION

2.1 The Fund Sponsor's Perspective

Fund sponsors ⇒ owners of large pools of investable assets

It provides an exhaustive quality control check of the fund & its constituent parts

It acts as a feedback & control mechanism

2.2 The Investment Manager's Perspective

return of some benchmark

processes

3 THE THREE COMPONENTS OF PERFORMANCE EVALUATION

Account ⇒ one or more portfolios of securities managed by one or more investment management organization

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4.1 Performance Measurement without Intra-period External Cash Flows

= −+

= − −

defined period of time after considering all external CF (contributions

& withdrawals)

If contribution is received at the start of the period:

4 PERFORMANCE MEASUREMENT

4.2 Total Rate of Return

income & capital gains

4.3 The Time-Weighted Rate of Return

period of one unit of money initially invested in the account

& withdrawals made by clients

Not affected by external CF

Advantage/Disadvantage of TWR

occurred

& potentially more error prone

4.4 The Money-Weighted Rate of Return

in the account over the entire evaluation period

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A/C is valued at beginning & end of the evaluation period

Advantage/Disadvantage of MWR

Sensitive to size & timing of external CF

over external CF

4.5 TWR versus MWR

performance MWR > TWR

MWR & TWR provide significantly different results if:

4.6 The Linked Internal Rate of Return

frequent time intervals & then chain links over the entire evaluation period

4.7 Annualized Return

− 1

period < full year

4.8 Data Quality Issues

Illiquid & infrequently priced assets with heavy external CF activity generally not reliable in nature

5.1 Concept of a Benchmark

portfolio-benchmark

P=M+S+A

5 BENCHMARKS

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5.2 Properties of a Valid Benchmark

Unambiguous ⇒ clearly defined identities & weights

Investable ⇒ passive investment alternative

Measureable ⇒ return can readily calculate

Appropriate ⇒ consistent with manager’s style

Reflective of current investment opinions

Specified in advance ⇒ known to all interested parties at the start of evaluation period

Owned ⇒ manager should be aware & accept accountability

5.3 Types of Benchmarks

Absolute

(not investable)

Manager’s Universes

Median manager or fund from a broad universe of mangers or funds as a benchmark

benchmark validity criteria

Advantage

Measureable

Broad Market Indexes

Disadvantages

Broad market indexes as benchmark e.g S&P 500

Style drift Advantages

Measureable & investable

Style Indexes

Using specific portion of asset category as benchmark

in certain securities

manager’s investment process

Advantages

Well known & easy to understand

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Factor Model Based

of return to the returns on an account

Normal portfolio ⇒ portfolio which has exposures to sources

of systematic risk factors that is typical for a manager

Difficult to obtain & expensive

to use

same factor exposures can generate different returns

Advantage

Facilitate manager & fund sponsors to better understand manager’s investment style

Return Based Benchmarks

These benchmarks are constructed using the series of a manager &

investment style indexes return

manager’s investment process

required

who rotate among style exposures

Advantages

Intuitive & easy to use

investable & specified in advance

information regarding account return is available

Custom Security-Based

Reflect manager’s research universe weighted in a particular manner

Expensive to contract &

maintain

Advantage

validity criteria

Effective allocation of risk across all the investment managers

Effective monitoring & control

of investment processes

5.6 Tests of Benchmark Quality

biases relative to the account (Avg historical β

of A/C should be close to 1)

Correlation b/w A & S should be zero

Difference b/w (P-M) & S should be highly correlated

Volatility of account’s return relative to a good benchmark should be < than volatility of the account’s return relative to a market index

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5.6 Tests of Benchmark Quality

similar to those of benchmark

Systematic bias if A/C’s risk characteristics are always greater or always less then benchmark

poor

purchased/sold for the purpose of periodic rebalancing

Passively managed portfolio ⇒ low benchmark turnover

Large no of +ve active position ⇒ good custom security based benchmark has constructed

5.7 Hedge Funds and Hedge Fund Benchmarks

evaluate HF performance due to short positions

traditional methods to calculate return does not yield reliable results

Hedge Fund Benchmarks

= −

Limitation ⇒ not appropriate if rapidly changing leveraged positions

Limitations ⇒ assume normal distribution

6 PERFORMANCE ATTRIBUTION

Macro attribution ⇒ conducted at the fund sponsor level (total fund performance)

Micro attribution ⇒ carried out at the investment manager level (performance of individual portfolios)

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6.1 Impact Equals Weight Times Return

Impact = weight × return

benchmark

6.2 Macro Attribution Overview

6.3 Macro Attribution Inputs

fund & individual managers

Fund sponsor’s risk tolerance & liabilities

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