1. C The realized profit and loss is calculated using the execution price minus the previous day’s closing price. This is divided by the original benchmark price and weighted by the proportion of the order filled. It is (700 / 1,000) × ($60.07 –
$60.05) / $60.00 = 0.02%. The positive value means that there is a loss (a cost) here. (Study Session 18, Module 35.4, LOS 35.f)
2. C The missed trade opportunity cost is calculated using the difference between the price at which the order is cancelled and the original benchmark price. It is
weighted by the portion of the order that is not filled. It equals (300 / 1,000) × ($60.08 – $60.00) / $60.00 = 0.04%. (Study Session 18, Module 35.4, LOS 35.f) 3. A To calculate the implementation shortfall, we must also add in the delay costs
and the explicit costs. The delay costs are calculated using the difference between the closing price on the day an order was not filled and the benchmark price. It is weighted by the portion of the order filled. It is (700 / 1,000) × ($60.05 – $60.00) /
$60.00 = 0.06%.
The explicit costs are the commission as a percent of the paper portfolio investment: $19 / $60,000 = 0.03%.
The total implementation cost is the sum of the explicit costs, the realized profit and loss, the delay costs component, and the missed trade opportunity cost component: 0.03% + 0.02% + 0.06% + 0.04% = 0.15%.
If the market return was 0.5% over the time period of this trading and the beta was 1.3 for Allen Materials, then the expected return for it would be 0.5% × 1.3 = 0.65%. Subtracting this from the 0.15% results in a market-adjusted
implementation shortfall of 0.15% – 0.65% = –0.50%. With this adjustment, the manager’s trading costs are actually negative. In other words, in the trading process, the manager “lost out” on a return of 0.15%, which is less than the
expected return of 0.65%. So, relatively speaking, the manager did not incur costs from trading. (Study Session 18, Module 35.4, LOS 35.f)
4. C Wienke is correct. The volume-weighted average price (VWAP) is a weighted average of security prices during a day, where the weight applied is the proportion of the day’s trading volume. It is useful because it can be applied quickly and easily.
Brooks is incorrect. Although it is true that a trader may try to game the volume- weighted average price by delaying the trade, the trader would wait until the ask price is less than the volume-weighted average price. Although it would appear that the trader has minimized trading costs in this case, the level of overall prices could have increased so that the trade should have been executed earlier. (Study Session 18, Module 35.4, LOS 35.g)
5. A The trade for stock ABCD is large relative to average daily trading volume (75,000 / 125,000 = 60%) and has a large spread. Because of these characteristics, it should be traded through a skilled broker or through a crossing system to
minimize the spread. (Study Session 18, Module 35.6, LOS 35.l)
6. B The LMNO trade is of small relative size (120,000 / 2,000,000 = 6%), has a small spread, and has high urgency. It should be traded quickly using an implementation shortfall strategy.
Furthermore, an implementation shortfall strategy trades a large volume early in the day, thus stock LMNO is suitable and stock FGHI is not suitable for an implementation shortfall strategy.
The trade for stock WXYZ is relatively small (30,000 / 900,000 = 3.3%) and the spread is low. The WXYZ trade is of low urgency and can be traded over time. It is thus suitable for a simple participation strategy based on VWAP or other benchmark. (Study Session 18, Module 35.6, LOS 35.l)
Video covering this content is available online.
The following is a review of the Performance Evaluation principles designed to address the learning outcome statements set forth by CFA Institute. Cross-Reference to CFA Institute Assigned Reading #36.
READING 36: EVALUATING PORTFOLIO PERFORMANCE 1
Study Session 19
EXAM FOCUS
Performance evaluation is important to both managers and clients. Both want to
understand the sources of value added and lost. The calculations can be long, repetitive, and use extensive subscript notation; begin by understanding the intent of the
calculations and then practice making them. There is an equal chance the questions will focus on understanding the output of performance evaluation as on making calculations.
Also be aware there are differences of opinion on the best way to perform such analysis.
The CFA material is presenting possible approaches. For the exam, do it the way it is presented in the material.
MODULE 36.1: CALCULATING RETURN
LOS 36.a: Demonstrate the importance of performance evaluation from the perspective of fund sponsors and the perspective of investment managers.
CFA® Program Curriculum: Volume 6, page 69 PROFESSOR’S NOTE
In a large portfolio with multiple managers there are typically decisions made by the fund sponsor as well as decisions made by the individual managers within the fund that affect portfolio performance. Performance evaluation can deconstruct return to show which decisions made by whom add or subtract value in the fund. The fund sponsor perspective will capture all value added or lost while the manager perspective will focus only on what a particular manager did to add or lose value for the fund. This material presupposes a large investor like a pension fund, endowment, or foundation using several investment managers.
Fund sponsor’s perspective. Performance evaluation improves the effectiveness of a fund’s investment policy by acting as a feedback and control mechanism. It does the following:
1. Shows where the policy and allocation is effective and where it isn’t.
2. Directs management to areas of value added and lost.
3. Quantifies the results of active management and other policy decisions.
4. Indicates where other, additional strategies can be successfully applied.
5. Provides feedback on the consistent application of the policies set forth in the IPS.
The increased complexity of institutional investment management has led to a greater need for sophisticated performance evaluation from the fund sponsor’s perspective.
Investment manager’s perspective. As with the fund sponsor’s perspective, performance evaluation can serve as a feedback and control mechanism. Some investment managers may simply compare their reported investment returns to a designated benchmark. Others will want to investigate the effectiveness of each component of their investment process.