CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r33 evaluating portfolio performance summary

www.ift.world 2 Form a fund sponsor’s perspective, performance evaluation helps answer the following questions:  What is the fund’s performance relative to investment objectives?. From

Level III

Evaluating Portfolio Performance

Summary

Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved

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Form a fund sponsor’s perspective, performance evaluation helps answer the following questions:

 What is the fund’s performance relative to investment objectives?

 What are the investment program’s strengths and weaknesses?

 What are the successful and unsuccessful strategies?

From an investment manager perspective, performance evaluation is important because:

 Virtually all fund sponsors will insist on performance evaluation

 It helps determine the effectiveness of various elements of investment process and examine relative

contributions of those elements

The three questions related to investment performance of an account are:

1 What was the account’s performance? – Measurement

2 Why did the account produce the observed performance? – Attribution

3 Is the account’s performance due to luck or skill? – Appraisal

Importance of Performance Evaluation

If there is an external cash flow at the beginning of the evaluation

period, then the account’s rate of return can be calculated as: 𝑟𝑡 =

𝑀𝑉1 − (𝑀𝑉0 + 𝐶𝐹

𝑀𝑉0 + 𝐶𝐹

If there is an external cash flow at the end of the evaluation

period, then the account’s rate of return can be calculated as: 𝑟𝑡 =

(𝑀𝑉1 − 𝐶𝐹 − 𝑀𝑉0

𝑀𝑉0

Time-weighted rate of return (TWR) reflects the compound rate of growth of $1 invested at T = 0

rtwr = (1 + r t,1 ) × (1 + r t,2 ) × … × (1 + r t,n) – 1  

Money-weighted rate of return (MWR) measures compound

growth rate of all funds invested in the account over the

evaluation period Put simply, it is the IRR of the portfolio

Performance Measurement

2015 5 C

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Represents growth of a single unit of currency

invested

Represents average growth of all money invested

Unaffected by external cash flows Sensitive to size and timing of external cash

flows

Appropriate measure if investment manager has

little or no control over external cash flows

Appropriate measure if investment manager has control over timing of external cash flows (for example with private equity)

Requires valuation on every day that an external

cash flow takes place This is a major

disadvantage of TWR

Requires valuation at start and end of period

Under normal conditions TWR and MWR will produce similar results However, when large external cash

flows occur and the account’s performance fluctuates significantly during the measurement period, then the MWR and the TWR can differ materially

TWR versus MWR

Benchmark and Decomposition of Portfolio Returns

P = B + (P – B)

P = B + A

P = M + (B – M) + A

Manager’s investment style, S = B – M

Portfolio return has three components: market, style, and active management: P = M + S + A

P = Portfolio Return

B = Benchmark Return

M = Market Return

Properties of a Benchmark

 Unambiguous Identities and weights of securities or factor exposures constituting the benchmark are clearly defined

 Investable Possible to forgo active management and simply hold the benchmark

 Measurable Benchmark’s return is readily calculable on a reasonably frequent basis

 Appropriate Benchmark is consistent with the manager’s investment style or area of expertise

 Reflective of current investment opinions The manager has current investment knowledge (be it positive, negative,

or neutral) of the securities or factor exposures within the benchmark

 Specified in advance The benchmark is specified prior to the start of an evaluation period and known to all parties

 Owned Investment manager should accept accountability for the constituents and performance of the benchmark

2013 11 A

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Systematic Biases Minimal systematic biases or risks in the benchmark relative to the account

Historical beta of account relative to benchmark ≈ 1 on average Manager’s ability to identify attractive and unattractive investment opportunities should be uncorrelated with whether the manager’s style is in or out of favor relative to overall market

Correlation between A = (P – B) and S = (B – M) ≈ 0 on average Tracking Error Benchmark should capture important aspects of manager’s investment style

Volatility of active returns (P – B) should be low relative to volatility of (P – M) Risk

Characteristics

Account’s exposure to systematic sources of risk should be similar to those of the benchmark over time

Coverage Coverage (proportion of portfolio market value that is contained in the benchmark) should be high

High coverage indicates strong correspondence between manager’s universe and benchmark Turnover Benchmark turnover should be low; otherwise investability is impacted

Benchmark turnover = proportion of benchmark’s market value allocated to purchases during periodic rebalancing of benchmark

Positive Active

Positions

Active position = security weight in portfolio – weight in benchmark Largely positive active positions is good

Largely negative active positions implies that benchmark is a poor representation of manager’s investment approach (this shows that manager has no investment opinion on many securities)

Criteria to Test Benchmarks Quality

2010 9 A

Broad Market Indexes Well recognized, easy to understand,

widely available and satisfies most properties of a valid benchmark

At times manager’s style might differ from style reflected in a market index

Style Indexes: Represent specific portions

of an asset category

Well recognized, easy to understand, widely available

Might not pass tests of benchmark validity; certain weights might be too high; style might be ambiguous

Factor-Model-Based: Use a set of factor

exposures as a benchmark

Captures systematic sources of return;

easy to see manager’s investment style

Not intuitive: very few think in terms of factor exposures when designing a portfolio; not easily investable

Returns-Based: Benchmark constructed

using 1) series of manager’s account

returns and 2) series of returns on several

investment style indexes over the same

period Then identify combination that

most closely tracks the account’s returns

Easy to use and intuitive

Useful when only information is account return information

Might hold positions that manager finds unacceptable

Requires many months of data

Custom Security Based: Represents

manager’s research universe weighted in

a particular fashion

Satisfies all validity criteria Expensive to construct and maintain

Not published and might lack transparency

Advantages and Disadvantages of Different Types of Benchmarks

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Steps to Build a Custom Security Benchmark

• Identify prominent aspects of the manager’s investment process

• Select securities consistent with that investment process

• Devise a weighting scheme for the benchmark securities, including a cash position

• Review the preliminary benchmark and make modifications

• Rebalance the benchmark portfolio on a predetermined schedule

Using Manager Universes as Benchmarks

Performing better than the median of a universe of investment managers is a reasonable objective, but it is not a suitable performance benchmark because:

 It cannot be specified in advance

 It is not investable

 It is not unambiguous (who’s the median manager? Is style appropriate?)

 It is subject to survivorship bias, because fund sponsors terminate poor performing managers

2009 11 A

Assigning Benchmarks to Hedge Funds

The hedge fund definition is vague which makes it difficult to identify suitable benchmarks This has led to a

widespread use of the Sharpe ratio It is often used and compared with Sharpe ratio of other hedge funds But

there are issues:

• Comparing with median performance has issues similar to the manager universe benchmark

• Standard deviation as measure of risk is problematic because of high skewness of returns in case of

hedge funds

In a long-short hedge funds the net value of the portfolio is very small Hence, standard return measures don’t

work with hedge funds Therefore, we need another performance measure One method is to measure the

value added with respect to a benchmark

r v = r p – r B  

where

r ν = value-added return

r p = portfolio return

r B = benchmark return

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Performance Attribution

Performance attribution is the comparison of an account’s performance with that of a designated

benchmark and the identification and qualification of sources of differential returns

The two basic forms of performance attribution are:

 Macro attribution: performance attribution at the fund sponsor level

 Micro attribution: performance attribution at the investment manager level

There can be two possible reasons for a positive active return:

1 Selecting superior performing assets

2 Owning superior performing assets in greater proportion relative to the benchmark

The assets themselves can be divided or combined into all sorts of categories: economic sectors, financial

factors, investment strategies, etc

Impact = active weight x return (Similar to Revenue = quantity × price)

Macro Attribution

Use the following sets of inputs

1 Policy allocations: asset categories and weights

2 Benchmark portfolio returns

3 Fund returns, valuations, and external cash flows

Domestic equities 75.0% Equity Manager #1 65.0

Equity Manager #2 35.0 Domestic fixed income 25.0% Fixed-Income Manager #1 55.0

Fixed-Income Manager #2 45.0 Total fund 100.0%

Domestic equities $143,295,254 $148,747,228 $(1,050,000) 4.55% 4.04%

Equity Mgr #1 93,045,008 99,512,122 1,950,000 4.76 4.61

Equity Mgr #2 50,250,246 49,235,106 (3,000,000) 4.13 4.31

Domestic fixed income 43,124,151 46,069,371 2,000,000 2.16 2.56

Fixed-Income Mgr #1 24,900,250 25,298,754 0 1.60 1.99

Fixed-Income Mgr #2 18,223,900 20,770,617 2,000,000 2.91 2.55

Total fund $186,419,405 $194,816,599 $950,000 3.99% 3.94%

2011 9 A

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Conducting a Macro Attribution Analysis

Decision-Making Level

(Investment Alternative)

Fund Value

Incremental Return

Contribution

Incremental Value

Contribution

Beginning value $186,419,405 — — Net contributions 187,369,405 0.00% 950,000 Risk-free asset 187,944,879 0.31% 575,474 Asset category 194,217,537 3.36% 6,272,658 Benchmarks 194,720,526 0.27% 502,989 Investment managers 194,746,106 0.01% 25,580 Allocation effects 194,816,599 0.04% 70,494 Total fund 194,816,599 3.99% 8,397,194

1 Net Contributions: Net sum of

contributions and/or withdrawals

2 Risk-Free Asset: Assumes that everything

is invested in the risk-free asset

3 Asset Categories: Assumes funds are

invested in asset categories per policy

allocation

4 Benchmarks: Measures impact of the

managers’ investment styles

5 Investment Managers: Returns actually

produced by the managers

6 Allocation Effects: It is a reconciliation

factor (plug)

2015 5 A, B

Micro Attribution

Portfolio can be thought of as a collection of sectors which in turn are a collection of securities

The value added by a manager can be broken

down into three components:

1 Pure sector allocation: Decision to

overweight/ underweight a sector

2 Within sector selection: Decision to

overweight/underweight a security

3 Allocation/selection interaction:

Combined effect of 1 and 2

Economic Sectors

Portfolio Weight (%)

Sector Benchmark Weight (%)

Portfolio Return (%)

Sector Benchmark Return (%)

Performance Attribution

Total Value- Added

Pure Sector Allocation

Allocation/

Selection Interaction

Within- Sector Selection

Basic materials 5.97 5.54 –0.79 –0.67 –0.01 0.00 –0.01 –0.01

Capital goods 7.82 7.99 –3.60 –3.95 0.01 0.00 0.03 0.04

…

2011 9 B, 2015 5 D

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Use of Fundamental Factor Models

Normal portfolio return (represents manager’s investment style) 5.85

Cash timing 2.36 0.00 2.36 –0.13

Beta timing 1.02 1.00 0.02 0.04

Growth 1.12 0.85 0.27 –0.15

Size –0.26 0.35 –0.61 –0.35

Leverage –0.33 –0.60 0.27 0.11

Yield –0.03 –0.12 0.09 –0.22

Total fundamental risk factors –0.61

Basic industry 14.10 15.00 –0.90 0.04

Consumer 35.61 30.00 5.61 –0.07

Energy 8.36 5.00 3.36 0.05

Financials 22.16 20.00 2.16 –0.02

Technology 17.42 25.00 –7.58 0.16

Utilities 2.35 5.00 –2.65 –0.01

2010 9 B C

Evaluation Period Returns (%)

I Interest Rate Effect

II Interest Rate Management Effect

III Other Management Effects

Fixed Income Manager Evaluation

The contribution due to skills of the manager can be

broken down into the following components:

Interest rate management effect: Measures how well

the manager predicts interest rate changes

Sector/quality effect: Measures the manager’s ability

to select the right issuing sector and quality group

Security selection effect: Measures the manager’s

ability to select the right securities within each sector

Trading activity: Captures the effect of sales and

purchases of bonds over a given period and is the

total portfolio return minus all the other

components

2011 9 C

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Risk Adjusted Performance Measures

Ex Post Alpha (Jensen’s alpha) R

At – r ft = αA + βA (R Mt – r ft) + εt  

𝛽 𝐴

𝜎 𝐴

𝑀2𝐴 = 𝑟 𝑓 + 𝑅 𝐴 ⎯ 𝑟 𝑓

𝜎 𝐴 𝜎 𝑀 M-Squared

Information

𝑅 𝐴 ⎯ 𝑅 𝐵

𝜎 𝐴−𝐵

M2 and Sharpe ratio will evaluate manager skill in the same way Treynor Measure and ExPost Alpha will evaluate manager skill in the same way

It is possible that M2/Sharpe and Treynor/Ex Post Alpha give us a different conclusion when manager takes a large amount of non-systematic risk

2009 11 B, 2013 11 B

Quality Control Charts

Quality control charts help us evaluate an active manager’s performance relative to his benchmark

The three assumptions underlying quality control charts are:

 Null hypothesis: manager has no investment skill

 Manger’s value-added returns are independent from period to period and are normally distributed

around expected value of 0

 Manager’s investment process does not change from period to period

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Manager Continuation Policy

The purpose of a MCP is as follows:

 to retain superior managers and to remove inferior managers, preferably before the latter can produce

adverse results

 to ensure that relevant nonperformance information is given significant weight in the evaluation process

 to minimize manager turnover

 to develop procedures that will be consistently applied regardless of investment committee and staff changes

We can view MCP as a statistical filter designed to remove negative-value added managers retain positive

value-added managers However, two types of decision errors may occur:

 Type I error: keep managers with zero value-add

 Type II error: reject managers with positive value-add

If statistical significance of zero value added returns is decreased from say 15% to 5%, the probability of

Type 1 errors is reduced Fewer unskilled managers will exceed the more demanding threshold by chance

Lower tolerance for guideline violations will also reduce probability of Type 1 errors

If the filter is made more demanding (or strict) then we will have more Type II errors

2013 11 C