CFA 2018 r33 evaluating portfolio performance

Level III Evaluating Portfolio Performance www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Contents Introduction The Importance of Performance Evaluation The Three Components of Performance Evaluation Performance Measurement Benchmarks Performance Attribution Performance Appraisal The Practice of Performance Evaluation www.ift.world Introduction • Performance evaluation is the ex post analysis of investment performance  Performance measurement  Performance attribution  Performance appraisal • Fund sponsors and investment managers are concerned with performance evaluation  Fund sponsors are owners of large pool of investable assets www.ift.world The Importance of Performance Evaluation • Fund sponsor perspective:  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 Feedback and Control Mechanism • Investment manager perspective:  Virtually all fund sponsors will insist on performance evaluation  Determine effectiveness of various elements of investment process and examine relative contributions of those elements www.ift.world Feedback and Control Mechanism Three Components of Performance Evaluation Account: one or more portfolios managed by one or more investment managers Three questions related to investment performance of an account: Measurement Attribution Appraisal www.ift.world Performance Measurement • • • • • • • • • Rate of return with no external cash flows Rate of return with cash flows at start or end of period Total rate of return Time weighted rate of return Money weighted rate of return TWR versus MWR Linked internal rate of return Annualized return Data quality issues www.ift.world www.ift.world www.ift.world Total Rate of Return Prior to 1960s performance measurement focused on income Since then the focus has shifted to total rate of return which measures increase in wealth due to income and capital gains Two major methods: Time-weighted rate of return (TWR) reflects the compound rate of growth of $1 invested at T = Money-weighted rate of return (MWR) measures compound growth rate of all funds invested in the account over the evaluation period www.ift.world Review of TWR www.ift.world 10 Captures effect of sales and purchases over a given period: total portfolio return – all other components www.ift.world 51 Broughton claims expertise in: 1) Interest rate management 2) Security selection Mathews claims expertise in: 1) Identifying undervalued sectors Do results validate their claims? www.ift.world 52 Performance Appraisal • Risk-Adjusted Performance Appraisal Measures      Ex Post Alpha Treynor Measure Sharpe Ratio M2 Information Ratio • Quality Control Charts • Interpreting the Quality Control Chart www.ift.world 53 Risk-Adjusted Performance Appraisal Measures Ex Post Alpha Treynor Measure Sharpe Ratio M2 www.ift.world 54 M2 and Sharpe ratio will evaluate manager skill in the same way Treynor Measure and Ex Post Alpha will evaluate manager skill in the same way It is possible that M2/Sharpe and Treynor/Ex Post give us a different conclusion when manager takes a large amount of non-systematic risk We can think of the Sharpe ratio as representing selffinancing strategy where we borrow at the risk free rate Sharpe ratio can be generalized to use the manager’s benchmark rather than the risk free asset: this gives us the information ratio: active return/active risk www.ift.world 55 Quality Control Charts • Quality control charts help us evaluate an active manager’s performance relative to his benchmark • Three assumptions underlying quality control charts  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  Manager’s investment process does not change from period to period Say σ of value-added returns = 4.1% Ex ante, 80% of expected returns will be 1.28 σ from mean  +/5.2% www.ift.world 56 www.ift.world 57 www.ift.world 58 The Practice of Performance Evaluation www.ift.world 59 www.ift.world 60 Manager Continuation Policy Some fund sponsors have adopted formal, written manager continuation policies (MCP) to guide their manager evaluations The purpose of a MCP is as follows: www.ift.world 61 Manager Continuation Policy MCP can be viewed as a two-part process: manager monitoring and manager review www.ift.world 62 Manager Continuation Policy as a Filter • Divide managers into three categories  Positive value-add  beat benchmark by 2% per year on average  Zero value-add  Negative value-add  Lose to their benchmark on percent per year on average • We can view MCP as a statistical filter designed to remove negative-value added managers retain positive value-added managers • 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 www.ift.world 63 Manager Continuation Policy as a Filter Fund sponsor must determine how fine a filter to construct Course filter  More Type I errors Fine filter  More Type II errors Both types of errors are expensive Control probabilities of Type I and Type II errors by adjusting width of confidence band within quality control chart • Many fund sponsors endure the discomfort of keeping several unskillful to avoid the expense of firing a truly superior manager • • • • • www.ift.world 64 Conclusion • Examples • Summary • Practice Problems • Learning Objectives www.ift.world 65 ... Importance of Performance Evaluation The Three Components of Performance Evaluation Performance Measurement Benchmarks Performance Attribution Performance Appraisal The Practice of Performance. .. Evaluation www.ift.world Introduction • Performance evaluation is the ex post analysis of investment performance  Performance measurement  Performance attribution  Performance appraisal • Fund sponsors... with performance evaluation  Fund sponsors are owners of large pool of investable assets www.ift.world The Importance of Performance Evaluation • Fund sponsor perspective:  What is the fund’s performance