Study Session 17 | Reading 41 | Evaluating Portfolio Performance
"Chartered Financial Analyst Level 3 Study Materials"
"MacLane Wilkison"
Evaluating Portfolio Performance
Introduction
Measurement Attribution Appraisal
Measurement - What was the account's performance? Attribution - Why did the account produce the observed performance? Appraisal - Is the account's performance due to luck or skill? Evaluation encompasses the task of placing investment results in the context of the account's investment objectives.
Performance Measurement Definition: Procedure of calculating an account's returns
(assumes no external cash flows Total rate of return Time-weighted rate of return
Chain-linking Wealth relative
Money-weighted rate of return
Internal rate of return (IRR) Linked internal rate of return (LIRR) Annualized return
The total rate of return measures the increase in wealth due to both investment income and capital gains. The time weighted return reflects compounded rate of growth over a stated evaluation period of one unit of money initially invested. Money weighted return measures compound growth rate in value of all funds invested in account over evaluation period. The linked IRR is a chain-linked money weighted return.
Benchmarks
Portfolios have 3 components:
Market, style, and active management
Valid benchmarks are:
Unambiguous, investable, measurable, appropriate, reflective of investment opinions, specified in advance, and owned
Tests of quality Systematic biases, tracking error, risk characteristics, coverage, turnover, positive active positions
A benchmark is a standard or point-of-reference in measuring or judging performance.
Performance Attribution
Identification of differential returns Macro vs. micro attribution Impact = weight return
Differential returns are returns different from those of the benchmark. Impact equals the return (selecting superior/inferior assets) multiplied by the weight of said assets in proportion to that of the benchmark.
Macro Attribution Definition: Macro Attribution is the process of decomposing a fund's performance from a macro perspective
Inputs Policy allocations Benchmark portfolio returns Fund returns, valuations, and external cash flows
Macro attribution analysis starts with a fund's beginning and ending values and decomposes the return attributable to each decision- making level. Each incremental return component is compared against a valid benchmark for performance measurement purposes.
Illustrative Macro Attribution Analysis
Micro Attribution Definition: The process analyzing investment results of individual portfolios relative to designated benchmarks
Illustrative Micro Attribution Analysis
The Pure Sector Allocation return equals the difference between the allocation weight for that sector, multiplied by the difference between the sector benchmarks' return and the overall portfolio's benchmark return, summed across all sectors. The Within-Sector Selection return equals the difference between the return on the portfolio's holdings in a given sector and the return on the corresponding sector benchmark, multiplied by the weight of the benchmark in that sector, summed across all sectors. The Allocation/Selection Interaction return equals the difference between the weight of the portfolio in a given sector and the portfolio's benchmark for that sector, multiplied by the difference between the portfolio's and the benchmark's returns in that sector, summed across all sectors.
Performance Appraisal
Alpha: Treynor measure Sharpe ratio: Information ratio:
Alpha is the differential return of an account compared to the return required to compensate for the systematic risk exposure. The Treynor measure relates an account's excess returns to the systematic risk assumed by the account. The Sharpe ratio compares excess returns to the total risk of the account. M is the mean incremental return over a market index of a hypothetical portfolio formed by combining the account with borrowing or lending at the risk-free rate so as to match the standard deviation of the market index. The information ratio is the excess return of an account over its benchmark relative to the variability of its excess return.
THE END
Evaluating Investment Manager Performance Performance evaluation is a necessary step in the portfolio management process. It allows the investor to monitor the progress being made toward goals and also to assess the skill of managers being used. A skill assessment has three components: performance measurement, performance attribution and performance appraisal. Performance measurement is simply determining the rate of return earned on investments. Performance attribution determines the sources of that return, which could include the strategic asset allocation, market timing, and security selection. The performance appraisal compares the managers return to that of the agreed-upon benchmark. Macro Performance Attribution Macro attribution analysis is conducted at the level of the fund sponsor rather than the portfolio manager. The distinction relates not to who conducts the analysis, but to the factors considered. Macro attribution can be expressed either as a rate of return or as a value. It expresses total return in terms of :( Inputs) The policy allocation to each asset class The benchmark portfolio return for each asset class The returns, valuations and external cash flows related to each manager hired Macro performance attribution decomposes the change in portfolio value into a variety of components, which can include: Net contributions how much of the change in value was due to additions and withdrawals from the portfolio Risk-free asset the return that would be generated if the fund and all contributions were invested at the risk free rate Asset categories the return that would be earned on passive investments at the policy weight for each asset class Benchmarks the difference between the sum of the weighted returns of manager benchmarks and the asset category return Investment managers the difference between the weighted average sum of manager returns and that of their benchmarks Allocation effects this category reconciles the difference between the funds actual return and the separate analyses conducted above, in order to account for any differences resulting from deviation from policy weights Micro Performance Attribution: Fundamental Factor Model Micro performance attribution can help determine the sources of return generated by a particular active portfolio manager. Virtually all micro performance attributions involve a factor model. Some such models are limited to economic sectors and industries, and compare the return due to sector selection with that due to security selection within the sector. Other factor models can include a variety of factors, including: Size Growth characteristics Valuation Financial strenth 41a Performance evaluation: Importance and perspective Demonstrate the importance of performance evaluation from the perspective of fund sponsors and the perspective of investment portfolio managers
Why is performance evaluation important to the fund sponsor (ie. investor)? Performance evaluation is a critical part of the feedback loop (at a macro level). Shows you what's working and what's not. Allows you to try to fix what isn't working. Let's you know if active management is worth paying for. Suggests whether the IPS is still appropriate.
Why is performance evaluation important to the portfolio manager? Performance evaluation is also a critical part of the feedback loop for managers (micro level). Performance can be compared to a relevant benchmark. It is a necessary step in the process of performance attribution, such as analyst's recommendations vs. manager's selections.
41b Performance evaluation: Components Explain the following components of portfolio evaluation (performance measurement, performance attribution, and performance appraisal)
There are three components of performance evaluation. Each provides an answer to a relevant question. 1. Performance measurement: What was the account's performance? Quantify the return. 2. Performance attribution: Which factors (ie. asset mix, sector selection or stock picking) drove returns? 3. Performance appraisal: Was this performance due to a manager's decisions (ie. skill) or overall market movements (ie. luck)? 41k Performance attribution: Macro vs. Micro Distinguish between macro and micro performance attribution and discuss the inputs typically required for each
What is "macro performance attribution" Performance analysis conducted at the fund sponsor level. For example, how well are the pension trustees doing at allocating funds to various managers? What are the inputs for macro attribution? 1. Policy Allocations: Strategic Asset Allocation is a very important factor in portfolio returns (see 21a). 2. Benchmark Returns: Superior returns cannot be known unless an appropriate benchmark is used. 3. Returns, valuations and external cash flows: We need to know all these in order to assess managerial performance.
What is "micro performance attribution"? Performance analysis conducted at the investment manager level. For example, how does a manager's performance compare to his relevant benchmark index? How can a manager outperform a benchmark index? 1. Pick better-performing securities. 2. Hold the same well-performing securities, but in larger weightings. And how do I measure this performance? See 41l.
41l Performance attribution: Macro and micro methodologies Demonstrate, justify, and contrast the use of macro and micro performance attribution methodologies to evaluate the drivers of investment performance
How am I supposed to measure Macro Performance Attribution? There are six levels of performance allocation, each requiring a higher level of risk tolerance. Everything above the line comes from something other than pure tracking a broad market index. Allocation Effects: Residual return due to various imprecise allocations Investment Managers: Alpha How am I supposed to measure Micro Performance Attribution? A manager adds value by generating excess returns (alpha) above the return of a relevant benchmark. Alpha comes from: 1. Pure sector allocation: Choosing a style/sector benchmark that generates higher returns than a the overall market 2. Within-sector allocation: Picking better securities or weights than the style/sector benchmark generated above style benchmark (allocation) Benchmarks: Passive investment in relevant style benchmark
Asset Category: Any asset allocation other than 100% risk-free
Risk-free Rate: Safest possible return (minimum acceptable)
Net Contributions: Cash flows invested at the zero-rate Think of each of these as being a layer of delicious cake.
3. Allocation/Selection interaction: A combination of 1 and 2 Think about the returns as being composed of four parts: Within-sector allocation (ie. Overweight Google) Allocation/Selection Interaction Pure Benchmark (ie. The return that you would get if your portfolio was identical to the benchmark) Pure sector allocation (ie. Overweight Tech)
I'm going to need something better than this. You're going to get information on: Portfolio (P) weights and returns for each category/asset class. Benchmark (B) weights and returns for each catetory/asset class. Perform the following multiplications to get the answers you need. Weight Return Pure Sector Allocation P - B B Sector - B Overall
Within Sector Allocation B P - B Allocation/Sector interaction is any difference between the benchmark return and portfolio return that can't be explained by pure sector allocation or within sector allocation. There's all so the formula below, which I find less than useless. By the way, this is going to come up again in 42b.