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

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 Importance of Performance Evaluation 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: What was the account’s performance? – Measurement Why did the account produce the observed performance? – Attribution Is the account’s performance due to luck or skill? – Appraisal www.ift.world Performance Measurement 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: 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 − (𝑀𝑉0 + 𝐶𝐹 𝑀𝑉0 + 𝐶𝐹 𝑟𝑡 = (𝑀𝑉1 − 𝐶𝐹 − 𝑀𝑉0 𝑀𝑉0 Time-weighted rate of return (TWR) reflects the compound rate of growth of $1 invested at T = 2015 C rtwr = (1 + rt,1) × (1 + rt,2) × … × (1 + rt,n) –   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 www.ift.world TWR versus MWR TWR Represents growth of a single unit of currency invested Unaffected by external cash flows MWR Represents average growth of all money invested Sensitive to size and timing of external cash flows Appropriate measure if investment manager has Appropriate measure if investment manager has little or no control over external cash flows control over timing of external cash flows (for example with private equity) Requires valuation on every day that an external Requires valuation at start and end of period cash flow takes place This is a major disadvantage of TWR 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 www.ift.world Benchmark and Decomposition of Portfolio Returns P = B + (P – B) P=B+A P = M + (B – M) + A 2013 11 A P = Portfolio Return B = Benchmark Return M = Market Return Manager’s investment style, S = B – M Portfolio return has three components: market, style, and active management: P = M + S + A 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 www.ift.world Criteria to Test Benchmarks Quality Criteria Comments Systematic Biases Minimal systematic biases or risks in the benchmark relative to the account Historical beta of account relative to benchmark ≈ 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) ≈ on average 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) Account’s exposure to systematic sources of risk should be similar to those of the benchmark over time Tracking Error Risk Characteristics Coverage Turnover Positive Active Positions 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 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 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) www.ift.world 2010 A Advantages and Disadvantages of Different Types of Benchmarks 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 Easy to use and intuitive using 1) series of manager’s account Useful when only information is account returns and 2) series of returns on several return information investment style indexes over the same period Then identify combination that most closely tracks the account’s returns 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 Expensive to construct and maintain Not published and might lack transparency Satisfies all validity criteria www.ift.world 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 2009 11 A  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 www.ift.world 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 rv = rp – rB   where rν = value-added return rp = portfolio return rB = benchmark return www.ift.world 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: Selecting superior performing assets 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) www.ift.world 10 Macro Attribution Asset Category Policy Allocations Domestic equities Use the following sets of inputs Policy allocations: asset categories and weights Benchmark portfolio returns Fund returns, valuations, and external cash flows 75.0% Equity Manager #1 65.0 Equity Manager #2 35.0 Domestic fixed income 2011 A 25.0% Fixed-Income Manager #1 55.0 Fixed-Income Manager #2 45.0 Total fund 100.0% Asset Category Beginning Value Ending Value Net Cash Flows Actual Return Benchmark Return 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 1.60 1.99 Fixed-Income Mgr #2 18,223,900 20,770,617 2,000,000 2.91 2.55 $186,419,405 $194,816,599 $950,000 3.99% 3.94% Total fund www.ift.world 11 Conducting a Macro Attribution Analysis Net Contributions: Net sum of contributions and/or withdrawals Risk-Free Asset: Assumes that everything is invested in the risk-free asset Asset Categories: Assumes funds are invested in asset categories per policy allocation Benchmarks: Measures impact of the managers’ investment styles Investment Managers: Returns actually produced by the managers Allocation Effects: It is a reconciliation factor (plug) 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 2015 A, B www.ift.world 12 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: Pure sector allocation: Decision to overweight/ underweight a sector Within sector selection: Decision to overweight/underweight a security Allocation/selection interaction: Combined effect of and 2011 B, 2015 D Economic Sectors Sector Benchmark Return (%) Performance Attribution Portfolio Weight (%) Sector Benchmark Portfolio Weight Return (%) (%) Basic materials 5.97 5.54 –0.79 Capital goods 7.82 7.99 –3.60 Pure Sector Allocation Allocation/ Selection Interaction WithinTotal ValueSector Selection Added –0.67 –0.01 0.00 –0.01 –0.01 –3.95 0.01 0.00 0.03 0.04 … www.ift.world 13 Use of Fundamental Factor Models Portfolio Exposure Normal Exposure Market return Normal portfolio return (represents manager’s investment style) Cash timing 2.36 0.00 Beta timing 1.02 1.00 Total market timing Growth 1.12 0.85 Size –0.26 0.35 Leverage –0.33 –0.60 Yield –0.03 –0.12 Total fundamental risk factors Basic industry 14.10 15.00 Consumer 35.61 30.00 Energy 8.36 5.00 Financials 22.16 20.00 Technology 17.42 25.00 Utilities 2.35 5.00 Total economic sectors Specific (unexplained) Actual portfolio return Active Exposure Active Impact 2.36 0.02 –0.13 0.04 Return 6.09% 5.85 –0.09 0.27 –0.61 0.27 0.09 –0.15 –0.35 0.11 –0.22 –0.61 –0.90 5.61 3.36 2.16 –7.58 –2.65 www.ift.world 0.04 –0.07 0.05 –0.02 0.16 –0.01 0.15 0.72 6.02% 2010 B C 14 Evaluation Period Returns (%) 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 C BAM MA Benchmark Expected 0.44 0.44 0.44 Unexpected 0.55 0.55 0.55 Subtotal 0.99 0.99 0.99 Duration 0.15 –0.13 0.00 Convexity –0.03 –0.06 0.00 Yield-curve shape change 0.04 0.13 0.00 Subtotal (options adjusted) 0.16 –0.06 0.00 Sector/quality –0.09 1.15 0.00 Bond selectivity 0.12 –0.08 0.00 Transaction costs 0.00 0.00 0.00 Subtotal 0.03 1.07 0.00 IV Trading activity return 0.10 0.08 0.00 V Total return (sum of I, II, III, IV) 1.28 2.08 0.99 I Interest Rate Effect II Interest Rate Management Effect III Other Management Effects www.ift.world 15 Risk Adjusted Performance Measures Ex Post Alpha (Jensen’s alpha) RAt – rft = αA + βA(RMt – rft) + εt   𝑅𝐴 ⎯𝑟𝑓 Treynor Measure 𝑇𝐴 = Sharpe Ratio 𝑅𝐴 ⎯ 𝑟𝑓 𝑆𝐴 = 𝜎𝐴 M-Squared Information Ratio 𝑀2𝐴 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 𝛽𝐴 𝑅𝐴 ⎯ 𝑟𝑓 = 𝑟𝑓 + 𝜎𝑀 𝜎𝐴 𝑅𝐴 ⎯ 𝑅𝐵 𝐼𝑅𝐴 = 𝜎𝐴−𝐵 www.ift.world 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 16 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  Manager’s investment process does not change from period to period www.ift.world 17 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 2013 11 C If statistical significance of zero value added returns is decreased from say 15% to 5%, the probability of Type 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 errors If the filter is made more demanding (or strict) then we will have more Type II errors www.ift.world 18 ... $1 43, 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... 2 .36 0.00 Beta timing 1.02 1.00 Total market timing Growth 1.12 0.85 Size –0.26 0 .35 Leverage –0 .33 –0.60 Yield –0. 03 –0.12 Total fundamental risk factors Basic industry 14.10 15.00 Consumer 35 .61... –0.67 –0.01 0.00 –0.01 –0.01 3. 95 0.01 0.00 0. 03 0.04 … www.ift.world 13 Use of Fundamental Factor Models Portfolio Exposure Normal Exposure Market return Normal portfolio return (represents