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
Types of benchmarks
Absolute, manager universe, broad market
indices, style indices, factor-based models, returns-based models, and custom-security-based
models
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.
