2.2 The Investment Manager’s Perspective From investment manager perspective, performance evaluation involves reporting investment returns along with the returns of some designated bench
Trang 1Reading 33 Evaluating Portfolio Performance
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Performance evaluation involves measurement and
assessment of the outcomes of the investment
management decisions Performance evaluation can
be divided into three components:
2 THE IMPORTANCE OF PERFORMANCE EVALUATION
2.1 The Fund Sponsor’s Perspective
Fund sponsors: Fund sponsors refer to owners of large
pools of investable assets i.e corporate and public
pension funds, endowments and foundations
• Fund sponsors need to evaluate the performance
of individual managers, investment results within
the asset categories and their total investment
programs
Importance of Performance Evaluation:
1) Performance evaluation provides an exhaustive
“quality control” check i.e by evaluating both the
performance of the fund and its constituent parts
relative to objectives and the sources of that
performance
2) Performance evaluation is part of the feedback step
of the investment management process; therefore, it
represents a fundamental component of investment
policy of the fund and should be documented in its
IPS
3) Performance evaluation acts as a feedback and
control mechanism i.e
a) It identifies strengths and weaknesses of an investment program and its policies
b) It helps to identify both areas & sources of underperformance
c) It provides insights regarding the results of active management
d) It provides insights regarding need for additional policies/actions and/or changes in currently employed policies
e) It helps the fund trustees to evaluate whether IPS policies are being followed consistently and in an appropriate & effective manner
2.2 The Investment Manager’s Perspective
From investment manager perspective, performance evaluation involves reporting investment returns along with the returns of some designated benchmark Besides, more sophisticated analysis can be provided on client’s request Performance evaluation acts as a feedback and control mechanism i.e
• It is used to measure the effectiveness of all aspects of the investment processes
• It is used to evaluate account’s performance relative to a benchmark
3 THE THREE COMPONENTS OF PERFORMANCE EVALUATION
Account: It refers to one or more portfolios of securities,
managed by one or more investment management
organizations For example,
• An account can be a single portfolio invested by a
single manager
• An account may represent a fund sponsor’s total fund, which may involve several portfolios invested
by many different managers across multiple asset categories
Performance Evaluation
Performance Measurement
→ calculating account's performance based on
investment-related
changes in an account’s value over specified time
periods
Performance Attribution
→ analyzing both the sources of returns relative
to a designated benchmark and the importance of those sources
Performance Appraisal
→ assessing whether the return was generated due to skill or luck
→ assessing size &
consistency of account's relative performance
Trang 2• An account may represent all of a fund sponsor’s
assets invested in a particular asset category
• An account may represent the combination of all
of the portfolios managed by an investment
manager according to a specific mandate
Performance evaluation v/s Performance Measurement:
• Performance measurement is a component of
performance evaluation It represents the first step
in the performance evaluation process i.e
calculating returns for an account
• In Performance evaluation, both the realized
return and risk that was assumed to generate that
return is taken into account
4.1 Performance Measurement without Intraperiod
External Cash Flows Rate of return on an account: It is the percentage
change in the account’s market value over some
defined period of time (known as the evaluation period
or measurement period), after taking into account all
external cash flows It refers to return generated by the
account only through investment-related sources i.e
capital appreciation or depreciation and income
External cash flows: External cash flows refer to
contributions and withdrawals made to and from an
account
Internal cash flows: They include dividends and interest
payments
a)Account’s rate of return during evaluation period ‘t’
when there are no external cash flows:
where,
MV 1 = market value at the end of the period
MV 0 = market value at the beginning of the period
b)Account’s rate of return during evaluation period ‘t’
when a contribution is received at the start of the
period:
c)Account’s rate of return during evaluation period ‘t’
when a withdrawal is made at the start of the period:
d)Account’s rate of return during evaluation period ‘t’
when a contribution is received at the end of the
evaluation period:
e)Account’s rate of return during evaluation period ‘t’ when a withdrawal is made at the end of the evaluation period:
An important practical recommendation: Whenever
possible, it is recommended that a fund sponsor should make contributions to, or withdrawals from, an account
at the end of an evaluation period or equivalently, at the beginning of the next evaluation period when the account is valued
The emphasis on income-related return measures (e.g Current yield (income-to-price) and yield-to- maturity) was due to several factors:
1) Portfolio management emphasis on fixed-income assets
2) Due to limited computing power, return based on external cash flows was difficult to compute In contrast, the income-related return measures were simpler and could be performed by hand 3) Due to less competitive investment environment, there was less demand of accurate performance measures
Total rate of return measures the change in the investor’s wealth due to both investment income (e.g dividends and interest) and capital gains/losses (both realized and unrealized) Use of Total rate of return as investment performance measure increased due to:
i Increase in allocation to equity securities
ii Decrease in computing costs
iii Increase in larger institutional investors
The Bank Administration Institute(BAI)study strongly approves the use of the total rate of return as the only valid measure of investment performance
Practice: Example 1 & 2, Volume 6, Reading 33
Trang 34.3 The Time-Weighted Rate of Return
The time-weighted rate of return (TWR) measures the
compound rate of growth over a stated evaluation
period of one unit of money initially invested in the
account
• In TWR, the account needs to be valued whenever
an external cash flow occurs
• TWR measures the actual rate of return earned by
the portfolio manager
• TWR is preferred to use to evaluate the
performance of the portfolio manager when the
manager has no control over the deposits and
withdrawals made by clients
When there are no external cash flows, TWR is computed
as follows:
In order to calculate time weighted return, first of all,
holding period return for each sub-period is computed
and then these sub-period returns must be linked
together (known as the chain-linking process) to
compute the TWR for the entire evaluation period
• Note that unless the sub-periods represent a year,
the time-weighted rate of return will not be
expressed as an annual rate
• Each subperiod return within the full evaluation
period has a weight = (length of the subperiod /
length of the full evaluation period)
Advantage of TWR: TWR is not affected by any external
cash flows to the account
Disadvantage of TWR:
• TWR requires determining a value for the account
each time any cash flow occurs
• Marking to market an account on a daily basis is
administratively more cumbersome, expensive
and potentially more error-prone
Example:
10,050 10,000 10010,000 1.50%
10,850 10,050 10010,050 8.96%
The annual return (based on the geometric average)
over the entire period is r = [(1.0150) (1.0896)] –1
= 0.10594 or 10.59%
NOTE:
• Chain-linking process implicitly assumes that the initially invested dollar and earnings on that dollar are reinvested (or compounded) from one sub-period to the next
• Generally, pure TWR is not used However despite the limitations of pure TWR, it is preferred by the mutual fund industry
4.4 The Money-Weighted Rate of Return
The money-weighted rate of return (MWR) measures the compound growth rate in the value of all funds invested
in the account over the entire evaluation period It represents an internal rate of return (IRR) of an investment
a)MWR is preferred to use to evaluate the
performance of the portfolio manager when the manager has discretion over the deposits and withdrawals made by clients
In equation form, the MWR is the growth rate R that solves:
MV1= MV0(1+R)m+CF1(1+R)m-L(1)+…+CFn(1+R)m–L(n) where,
m = number of time units in the evaluation period (for example, the number of days in the month)
CFi = the ith cash flow L(i) = number of time units by which the ith cash flow is separated from the beginning of the evaluation period
Advantages of MWR: MWR requires an account to be valued only at the beginning and end of the evaluation period
Disadvantages of MWR:
• MWR is highly affected by the size and timing of external cash flows to an account
• It is not an appropriate to use when the investment manager has little or no control over the external cash flows to an account
Practice: Example 5, Volume 6, Reading 33
Practice: Example 3 & 4, Volume 6, Reading 33
Trang 44.5 TWR versus MWR
1)TWR represents the
growth of a single unit
of money invested in
the account
2)TWR is unaffected by
the size and timing of
external cash flows to
and from the account
1)MWR represents the average growth rate
of all money invested
in an account
2)MWR is affected by the size and timing of external cash flows to and from the
account
• When funds are contributed to an account prior to
a period of strong (positive) performance, MWR >
TWR
• When funds are withdrawn from an account prior to
a period of strong (positive) performance, MWR <
TWR
• When funds are contributed to an account prior to
a period of weak (negative) performance, MWR
<TWR
• When funds are withdrawn from an account prior to
a period of weak (negative) performance, MWR >
TWR
• Under normal situations, both TWR and MWR
provide similar results
• When large external cash flows occur (i.e > 10% of
account) and during that evaluation period,
account’s performance is highly volatile, then MWR
and TWR will provide significantly different results
NOTE:
BAI and GIPS generally require the use of TWR as a
measure of account performance
4.6 The Linked Internal Rate of Return
Due to limitations of TWR, BAI recommends to use Linked
Internal Rate of Return (LIRR) method In LIRR method,
the TWR is approximated by calculating MWR over
reasonably frequent time intervals and then those returns
are chain-linked over the entire evaluation period
• LIRR method is only appropriate to use under
normal conditions i.e external cash flows are not
large relative to the account (i.e not > 10% of
account’s value) and account’s performance is
not highly volatile
• Under extreme conditions, according to BAI study
recommendation, the account should be valued
on the date of the intra-month cash flow instead
of using LIRR method
The annualized return measures the compound average annual return earned by the account over the
evaluation period It is also referred to as the compound growth rate or geometric mean return
rtwr= (1+rt,1)×(1+rt,2)×…×(1+rt,n)1/n–1
Or
Or where,
n = number of years in the measurement period
NOTE:
Generally, when measurement periods are < a full year,
it is inadvisable to calculate annualized returns
The accuracy of performance measurement process depends on the accuracy of inputs used in measuring account’s performance
• Reported rates of return for accounts that comprise of liquid and transparently priced securities and have less external cash flow activity are relatively reliable measures of performance
• In contrast, reported rates of return for accounts that comprise of illiquid and infrequently priced assets with heavy external cash flow activity are generally not reliable in nature; it is because of the following reasons:
i For thinly traded securities, current market price
is not always available and investors have to use estimated prices based on dealer-quoted prices i.e by using matrix pricing approach
ii For highly illiquid securities, it is difficult or sometimes impossible to obtain reasonable estimates of market prices; in such cases, investors have to value these securities either at cost or the price of the last trade in those securities
Practice: Example 8, Volume 6, Reading 33
Practice: Example 7, Volume 6, Reading 33
Practice: Example 6,
Volume 6, Reading 33
Trang 5It is essential to use appropriate data collection
procedures to have reliable measures of performance
i.e
• Accounts should be valued on the trade date and
on a fully accrued basis
• It is inadvisable to value accounts on the settlement date and without considering the accrued income
Performance evaluation is a relative concept i.e it
involves evaluating an account’s performance relative
to an appropriate designated benchmark
A benchmark reflects the investment style that the fund
sponsor expects the manager to follow, and it is used for
evaluating the manager’s performance
Components of a Portfolio Return:
A portfolio return (P) can be divided into following three
components
1) Market (M)
2) Style (S) = (manager’s benchmark portfolio -
market index) = B - M
3) Active management (A) = (manager’s portfolio –
benchmark) = P – B
P = M + S + A
For example,
• When portfolio represents a broad market index
fund, (B - M) will be 0 It implies that manager has
no distinct investment style i.e S = 0
• Also (P - B) = 0; this implies that there is no active
management i.e A = 0
• Consequently, P = M
5.2 Properties of a Valid Benchmark
A valid benchmark should have the following seven
properties:
1 Unambiguous: The identities and weights of securities
or factor exposures constituting the benchmark are
clearly defined
2 Investable: The benchmark should represent a passive
investment alternative i.e an investor can always opt
to forgo active management and simply hold the
benchmark
3 Measurable: The benchmark’s return can be readily calculated on a reasonably frequent basis
4 Appropriate: The benchmark is consistent with the manager’s investment style or area of expertise
5 Reflective of current investment opinions: The manager has current investment knowledge (positive, negative, or neutral) of the securities or factor
exposures constituting the benchmark
6 Specified in advance: The benchmark is specified prior to the start of an evaluation period and known
to all interested parties
7 Owned: The investment manager should be aware of and accept accountability for the constituents and performance of the benchmark
Generally, there are seven primary types of benchmarks 1)Absolute: An absolute return can be a return
objective e.g actuarial rate-of-return assumption or a minimum return target that the fund aims to exceed
Advantage: It is a simple and straightforward
benchmark
Disadvantage: Absolute return objectives are not
investable; consequently, they do not meet the benchmark validity criteria
2)Manager universes: It refers to using the median manager or fund from a broad universe of managers
or funds as a performance evaluation benchmark e.g fund that falls at the median when funds are ranked in descending order
Advantage: It is measurable
Disadvantages:
• Except being measurable, it fails all the benchmark validity criteria i.e it is not investable, not appropriate, ambiguous, not specified in advance, not reflective of current investment opinions and not owned by the managers
• It suffers from survivorship bias
• In order to use these benchmarks, fund sponsors have to rely on the accuracy of the universe Practice: Example 9,
Volume 6, Reading 33
Trang 6compiled by the compiler (third-party)
3)Broad market indexes: It refers to using broad market
indexes as benchmarks e.g S&P 500, Wilshire 5000 etc
for U.S common stocks; the Lehman Aggregate and
the Citigroup Broad Investment-Grade (U.S BIG) Bond
Indexes etc for U.S investment-grade debt
Advantages: Market indexes are
• Well recognized
• Easy to understand
• Widely available
• Unambiguous
• Generally investable
• Measurable
• Specified in advance
Disadvantages: Style reflected in a market index may
not be consistent with manager’s investment style e.g
using S&P 500 benchmark for evaluating a
micro-capitalization U.S growth stock manager
4)Style indexes: It refers to using specific portions of an
asset category as benchmark e.g
large-capitalization growth, large-large-capitalization value,
small-capitalization growth, and small-capitalization
value (Mid-capitalization growth and value common
stock indexes are also available.)
Advantages: Like broad market indexes, investment style
indexes are:
• Well known
• Easy to understand
• Widely available
Disadvantages: It is not appropriate:
• Some style indexes contain weightings in certain
securities and economic sectors that are larger
than considered prudent
• It may be inconsistent with the investment process
of the manager being evaluated
It is ambiguous i.e different definitions of investment style
can produce different results
5)Factor model based: Factor models are used to relate
one or more systematic sources of return to the returns
on an account These specified set of factor
exposures can be used as a factor model-based
benchmark Factors include market index, company’s
size, industry, growth characteristics, financial strength
etc
where,
F 1 , F 2 , F K represent the values of factors 1 through K,
respectively
For example, in one-factor model, the return on a security, or a portfolio of securities, is regressed on the return on a broad market index (over a long period e.g
60 months):
where,
R p = periodic return on an account
R I = periodic return on the market index
ap = “zero factor” term It represents the expected value
of Rp if the factor value was zero
βp = beta
= sensitivity of the returns on the account to the returns on the market index
εp = residual or nonsystematic element of the relationship
Normal portfolio: A normal portfolio is a portfolio, which is exposed to systematic risk factors that are typical for a manager It can be constructed by using the manager’s past portfolios as a guide
Advantages: Factor model-based benchmarks facilitate
managers and fund sponsors to better understand manager’s investment style
Disadvantages:
• Factor model-based benchmarks are not always intuitive to the fund sponsor and particularly to the investment managers
• Factor model-based benchmarks are not always easy to obtain
• Factor model-based benchmarks are potentially expensive to use
• Factor model-based benchmarks are ambiguous i.e different benchmarks with the same factor exposures (e.g same beta) can generate different returns
• Factor model-based benchmarks may not be investable because the composition of a factor-based benchmark is not specified with respect to the constituent securities and their weights
6)Returns based benchmarks: These benchmarks are constructed using (1) the series of a manager’s account returns over a specified period and (2) the series of returns on several investment style indexes over the same period Using these return series, an allocation algorithm solves for the particular set of allocation weights for investment style indexes that most closely track the account’s returns The returns-based benchmark is represented by these allocation weights
Advantages:
• Returns-based benchmarks are intuitive and easy Practice: Example 10,
Volume 6, Reading 33
Trang 7to use
• They are unambiguous, measurable, investable,
and specified in advance
• Returns-based benchmarks are useful when only
the information regarding account returns is
available
Disadvantages:
• Like the style indexes, returns-based benchmarks
may contain securities and economic sectors with
greater weights than considered acceptable by
managers
• They may be inconsistent with the investment
process of the manager being evaluated
• They require sufficient number of observations to
construct a statistically reliable pattern of style
exposures
• They are not useful to evaluate managers who
rotate among style exposures
7)Custom security based benchmark: These
benchmarks reflect a manager’s research universe
weighted in a particular manner
Advantages:
• Custom security-based benchmark satisfies all of
the benchmark validity criteria
• It facilitates managers to monitor and control their
investment processes
• It facilitates fund sponsors to effectively allocate or
budget risk across teams of investment managers
Disadvantage:
• Custom security-based benchmarks are expensive
to construct and maintain
• They lack transparency because they are not
composed of published indexes
5.4 Building Custom Security-Based Benchmarks
A valid custom security-based benchmark is constructed
using the following steps:
1) Identify the prominent aspects of the manager’s
investment process, selection of assets (including
cash) and their weights
2) Select securities for the benchmark that are
consistent with the investment process of the
manager
3) Use the weighting scheme for the benchmark
that is consistent with the investment process of
the manager
4) Review the composition of a preliminary
benchmark selected and make necessary
modifications
5) Rebalance the benchmark portfolio regularly as
per a predetermined schedule
NOTE:
A proper benchmark must clearly differentiate between the manager’s “normal” or policy investment decisions and the manager’s active investment judgments 5.5 Critique of Manager Universes as Benchmarks
The median account in a particular peer group can be used as a return benchmark by the fund sponsors However, it has the following drawbacks:
1) The median account cannot be specified in advance: The median account can be established on an ex-post basis only i.e after the returns earned by all accounts have been calculated and ranked
2) Such a benchmark is not investable because no one knows beforehand who the median
manager will be Moreover, the median manager changes from period to period
3) It is not unambiguous because the identity of a median manager remains unknown even after the evaluation period ends
4) As it is ambiguous in nature, it is difficult to verify its appropriateness to determine whether the investment style it represents is consistent with the account being evaluated
5) In order to use manager universes as benchmark, fund sponsors have to rely on the compiler’s representations that accounts have been appropriately screened, the integrity of the input data monitored and a uniform return calculation methodology has been used for all accounts in all periods
6) Manager universes suffer from “survivorship bias” because fund sponsors remove underperforming managers i.e underperforming accounts are removed; median will be biased upwards
Without a valid reference point, using the performance
of a particular manager or fund is not a suitable performance benchmark that can be used to assess investment skill of a manager
5.6 Tests of Benchmark Quality
Benchmarks represent an integral part of risk management at both the investment manager and fund sponsor levels Benchmark choice is critical as it has
a direct impact on measuring a manager’s investment skills
Uses of good benchmark:
• Fairly evaluates the manager and provides a passive alternative
• Enhances the effectiveness of performance evaluation process
• Highlights the contributions of skillful managers
• Enhance the capability to manage investment risk
Trang 8Effects of using Poor benchmarks:
• Using poor benchmarks makes it difficult to
understand and assess manager skills
• Use of poor benchmarks can lead to incorrectly
punishing a good manager and inappropriately
rewarding a poor one
• Poor benchmarks promote inefficient manager
allocations and ineffective risk management
• Poor benchmarks increase the chances of
unpleasant surprises
Tests of Benchmark Quality:
1 Systematic biases: Over time, the benchmark should
have minimal systematic biases or risks relative to the
account
a) Systematic bias can be measured by calculating
the historical beta of the account relative to the
benchmark i.e on average the historical beta of
the account relative to the benchmark should be
close to 1.0
b) Systematic bias can be measured by computing
the correlation between A and S i.e correlation
between A and S should be = 0 It implies that
active decisions should be uncorrelated with
style
c) The difference between the account and the
market index i.e E = (P - M) and manager’s style
(S) should be highly positively correlated It implies
that when manager’s style outperforms
(underperforms) relative to the market, we expect
both the benchmark and the account to
outperform (underperform) the market
2 Tracking error: Tracking error refers to the volatility of A
(active return) The volatility (standard deviation) of
an account’s returns relative to a good benchmark
should be less than the volatility of the account’s
returns relative to a market index or other alternative
benchmarks When a benchmark has low tracking
error, it indicates that the benchmark is capturing
important aspects of the manager’s investment style
3 Risk characteristics: Over time, an account’s
exposure to systematic sources of risk should be similar
to those of the benchmark i.e at times, account risk
exposures can be greater or smaller than that of a
benchmark However, when the account’s risk
characteristics are always greater or always smaller
than those of the benchmark, it indicates that a
systematic bias exists A good benchmark should
reflect (not replicate) the manager’s investment
process
4 Coverage: Benchmark coverage is defined as:
market value of securities that are present in both the benchmark &
Total market value of the portfolio
• High coverage indicates that a strong
correspondence exist between the manager’s universe of potential securities and the
benchmark
• Low coverage indicates that the benchmark is
poor
5 Turnover: Benchmark turnover is defined as the percentage of the benchmark’s total market value that is purchased/sold for the purpose of periodic rebalancing of the benchmark
• Passively managed portfolio should employ benchmarks with low turnover
6 Positive active positions:
Active position = weight of a security in an account -
weight of the same security in the benchmark
• When a manager holds large number of positive active positions, it indicates that a good custom security-based benchmark has been
constructed
• When a manager holds a high proportion of negative active positions, it indicates that a benchmark poorly represents the manager’s investment style
5.7 Hedge Funds and Hedge Fund Benchmarks
Hedge funds generally involve both long and short investment positions Due to short positions in an account, hedge funds involve various performance measurement, administrative and compliance issues; therefore, it is inappropriate to use a typical Long-only benchmark to evaluate their performance
Also, hedge funds may have zero net position* (the
value of the portfolio’s long positions equal the value of
the portfolio’s short positions) or even negative net position Hence, using traditional methods to calculate
returns does not yield reliable results
*NOTE:
!=
%&− %&
%&
When MV0 = 0, the account’s rate of return would be either positive infinity or negative infinity
Hedge Fund Benchmarks: Following three approaches can be used
1 Estimate Value-added return i.e
rv = rp- rB
where,
r v = value-added return on a long-short portfolio
r p = portfolio return
r B = benchmark return
Trang 9Note that sum of active weights = 0
a) Return is estimated by adding the performance
impacts of all individual (both long &short) positions
• A return can be calculated for the period during
which the individual security positions were
maintained
• When an individual security position changes, the
previous return period ends and a new return
period starts
b) Rate of return for a long-short portfolio can also be
estimated as follows:
Return = Profit and/or loss resulting from the particular
hedge fund strategy / amount of assets at risk
Return = Profit and/or loss resulting from the particular
hedge fund strategy / (absolute value of all the
long positions + absolute value of all the short
positions)
2 Construct separate long and short benchmarks using either returns-based or security based benchmark building approaches
• These benchmarks are then combined in appropriate proportions to create a valid benchmark for the manager
• Limitation: This approach is not useful for hedge
funds (e.g Macro hedge funds) that involve rapidly changing long/short leveraged positions and different asset categories (i.e equities, bonds, commodities etc.)
3 Sharpe ratio: Sharpe ratio of a hedge fund is compared to the Sharpe ratio of universe of other hedge funds with similar investment mandates
Limitations:
• It suffers from the same drawbacks as that of standard manager universe benchmarks
• It assumes normal distribution and uses S.D as a measure of risk; thus, it is not appropriate to use for investment strategies with non-normal distributions
Performance attribution helps to improve and enhance
the portfolio management process Performance
attribution involves:
• Comparison of an account’s performance with
that of a designated benchmark
• Decomposing the account’s returns relative to
those of the benchmark i.e Identification and
quantification of sources of differential returns
(different-from-benchmark returns) and
• Identification of impact of differential returns on an
account’s performance
A.Macro Attribution: Macro attribution refers to
performance attribution that is conducted at the fund
sponsor level
• It involves examining the performance of a total
fund
B.Micro Attribution: Micro attribution refers to
performance attribution that is carried out at the
investment manager level
• It involves examining the performance of
individual portfolios relative to designated
benchmarks
NOTE:
The distinction between macro & micro attribution is
based on specific decision variables involved; it is not
related to the organization, which is actually conducting the performance attribution
6.1 Impact Equals Weight Times Return
The fundamental rule is:
Impact = (active) weight × return There are two sources of positive impact on an account’s return relative to a benchmark:
1) Selecting superior (or avoiding inferior) performing assets and
2) Investing in the superior (inferior) performing assets
in greater (lesser) proportions relative to that of the benchmark
6.2 Macro Attribution Overview
For a fund sponsor, the term account is referred to as
“Fund” and it is defined as a total fund consisting of investments in various asset categories (e.g domestic stocks, international stocks, domestic fixed income etc.) and these investments are managed by various
investment managers
Practice: Example 11 Volume 6, Reading 33
Trang 106.3 Macro Attribution Inputs
Inputs into Macro Attribution:
1)Policy allocations i.e a fund sponsor sets up a plan
that determines the broad allocation of assets to
stocks, bonds, and other types of securities within the
Fund and to individual managers within the asset
categories Policy allocations are a function of the:
• Fund sponsor’s risk tolerance
• Fund sponsor’s long-term expectations regarding
the investment risks and rewards offered by various
asset categories and money managers, and
• Fund sponsor’s liabilities
2)Benchmark portfolio returns i.e
• Fund sponsor selects broad market indexes as the
benchmarks for asset categories and
• Fund sponsor selects specific benchmarks to
represent the managers’ investment styles
3)Fund returns, valuations and external cash flows:
Macro attribution can be carried out in two ways:
a) Using Rate-of-return metric: In rate-of-return
metric, the results of the analysis are presented in
terms of the effects of decision-making variables
on the differential return
• Rate-of-return metric requires computing fund
returns at the individual manager level
• It is helpful to evaluate fund sponsor’s decisions
regarding manager selection
b) Using a Value metric: In a value metric, the results
of the analysis are presented in terms of the
effects of decision-making variables on the
differential return in Monetary terms
• Value metric requires account valuation and
external cash flow data to compute accurate
rates of return
• It is helpful to evaluate the impact of the fund
sponsor’s investment policy decision making on
the fund’s performance
• Value metric approach is more accessible to
both investment professionals and ordinary
persons
6.4 Conducting a Macro Attribution Analysis
Following are six levels or components of investment
policy decision making used to analyze Fund’s
performance:
1) Net contributions
2) Risk-free asset
3) Asset categories
4) Benchmarks
5) Investment managers
6) Allocation effects
• Each decision-making level in the hierarchy is treated as an investment strategy
• The investment results of each decision-making level are compared to the cumulative results of the previous levels This implies that each decision-making level represents a valid benchmark i.e an unambiguous, appropriate, and specified-in-advance investment alternative
• Fund sponsor determines how much of the total fund’s assets are allocated to each level
• The assets are allocated to a more aggressive strategy only if it is expected to generate positive incremental returns This implies that macro attribution analysis is based on computing
incremental return of each investment strategy
and determining the contribution of each level to the overall return of the fund
Net Contributions:
• Net contributions include additions to the portfolio
• It is assumed that net cash inflows are invested at
a zero rate of return i.e assets earn a zero return Thus,
Change in the value of fund = Total amount of net contributions
Ending value of a fund under the Net Contributions investment strategy = Beginning value + Net contributions
Risk-Free Asset:
• Risk-free asset investment strategy involves investing all of the Fund’s assets in a risk-free asset (i.e 90-day T-Bills)
• It is viewed as a conservative strategy
• This strategy assumes that invested assets i.e the Fund’s beginning value and its net external cash inflows (accounting for the dates on which those flows occur) earn risk-free return i.e
Change in Fund’s value = Ending value of a fund under the Risk-free asset investment strategy – Beginning value (i.e ending value of the fund under the Net Contributions investment strategy) NOTE:
When net contribution does not represent a single, beginning-of-month cash flow, fund’s incremental value (i.e Change in Fund’s value) cannot be obtained simply
by multiplying fund’s Beginning value by risk-free rate Asset Category:
• Asset Category investment strategy assumes that the Fund’s beginning value and external cash
flows are invested passively based on the fund
sponsor’s policy allocations to the specified asset category benchmarks
• Asset Category investment strategy is a pure index fund approach
These investment strategies are presented in increasing order of volatility and complexity