Portfolio Performance

Question 1

Explain the importance of performance evaluation in the fund sponsor’s perspective and what is does for the fund sponsor.

Answer 1

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.

Question 2

Explain the importance of performance evaluation in the investment manager’s perspective.

Answer 2

Performance evaluation can serve as a feedback and control mechanism. Some managers compare their performance to a designated benchmark. Others will want to investigate the effectiveness of each component of their investment process.

Question 3

Explain the components of portfolio evaluation.

Answer 3

1. Performance measurement to calculate rates of return based on changes in the account’s value over specified time periods.
2. Performance attribution to determine the source of the account’s performance.
3. Performance appraisal to draw conclusions regarding whether the performance was affected primarily by investment decisions, by the overall market, or by chance.

or simply put:

1. What was the account’s performance?
2. Why did the account produce the observed performance?
3. Is the account’s performance due to luck or skill?

Question 4

What are the potential data quality issues as they relate to calculating the rates of return?

Answer 4

1. Estimates may be needed for Illiquid assets.
2. Current market prices may not be available for thinly-traded assets.
3. Highly illiquid assets may be carried at cost or price of last trade, thus not reflecting current price.
4. Account valuations should include trade date accounting, including accrued interest and dividends.

Question 5

What is the decomposition of portfolio returns?

Answer 5

P = M + S + A
where:
P = portfolio return
M = market index return
S = return to style
A = return due to active management
S = B - M
B = portfolio benchmark return
A = P - B

Question 6

What is the criteria for a valid benchmark?

Answer 6

SAMURAI

1. Specified in Advance
2. Appropriate
3. Measurable
4. Unambiguous
5. Reflective of current investment opinions
6. Accountable
7. Investable

Question 7

What are the seven primary types of benchmarks?

Answer 7

1. Absolute - A return objective (e.g., exceed 10%)
2. Manager universe - The median manager or fund from a broad universe of managers of funds.
3. Broad market indicies - (e.g., S & P 500)
4. Style indicies - Represent specific portions of an asset category.
5. Factor-model-based - relating a specified set of factor exposures (systematic sources of returns) to the returns on an account.
6. Returns-based - Constructed using a series of returns over specified periods and corresponding returns over several style indicies for the same periods. These returns are then submitted to an allocation algorithm that solves for the combination of investment style indexes that most closely tracks the account’s returns. The returns-based benchmark is represented by the allocation weights for the style indexes.
7. Custom security-based

Question 8

Describe the steps involved in constructing a custom security-based benchmark.

Answer 8

1. Identify the important elements of the manager’s investment process.
2. Select securities that are consistent with that process.
3. Weight the securities (including cash) to reflect the manager’s process.
4. Review and adjust as needed to replicate the manager’s process and results.
5. Rebalance the custom benchmark on a predetermined schedule.

Question 9

Discuss the validity of using manager universes as benchmarks.

Answer 9

1. It fails several properties of a valid benchmark.
   a) It is impossible to identify the median manager advance.
   b) It is ambiguous, because the median manager is unknown.
   c) The benchmark is not investable.
   d) It is impossible t verify the appropriateness due the the ambiguity of the median manager.
2. Have to rely on the benchmark’s compiler assurance that the manager universe has been screened, input data validated, and calculation methodology approved.
3. Subject to survivorship bias.

Question 10

Describe the test of quality for benchmarks.

Answer 10

Systematic bias: Should be low relative to the account.

Tracking error: The volatility of the excess returns earned due to active management.

Risk characteristics: An account’s exposure to systematic sources of risk should be similar to those of the benchmark over time.

Coverage: The coverage ratio is the market value of the securities that are in both the portfolio and the benchmark as a percentage of the total market value of the portfolio.

Turnover: Passively managed portfolios should utilize benchmarks with low turnover.

Positive active positions

Question 11

Discuss the issues that arise when assigning benchmarks to hedge funds.

Answer 11

The diversity of hedge funds has led to problems when designating a suitable benchmark. In most cases, hedge funds hold both short and long investment positions. This leads to performance issues as well as admin and compliance issues. Given these complications, other performance methods may be more appropriate. These include, Value-added return, separate long/short benchmarks, and the Sharpe Ratio.

Question 12

Describe the value-added return in hedge fund performance analysis.

Answer 12

This approach evaluates in terms of performance impact. a return can be calculated by summing up the performance impacts of the individual security positions, both long and short.

Question 13

What are the three main inputs into the macro attribution approach in performance attribution.

Answer 13

1. Policy allocation
2. Benchmark portfolio returns
3. Fund returns, valuations, and external cash flows

Question 14

What are the six levels of investment policy decision-making, by which the fund’s performance can be analyzed?

Answer 14

1. Net contribution.
2. Risk-free asset.
3. Asset categories.
4. Benchmarks.
5. Investment managers.
6. Allocation effects.

Question 15

Describe the steps involved in constructing a multifactor model to conduct micro attribution.

Answer 15

1. Identify the fundamental factors that will generate systematic returns.
2. Determine the exposures of the portfolio and the benchmark to the fundamental factors at the start of the evaluation period.
3. Determine the manager’s active exposure to each factor.
4. Determine the active impact. This is the added return due to the manager’s active exposures.

Question 16

Evaluate the effects of the external interest rate environment and active management on fixed-income portfolio returns.

Answer 16

Attribution analysis of a fixed portfolio amount to comparing the return on the active manager’s portfolio to the return on a passively managed, risk-free portfolio. The difference between the two can be attributed to the effects of the external interest rate environment and the manager’s contribution.

Question 17

List the management factors that contribute to a fixed-income portfolio’s total return and interpret the results of a fixed-income performance attribution analysis.

Answer 17

1. Interest rate management effect.
2. Sector/quality effect.
3. Security selection effect.
4. Trading activity.

Question 18

List the 5 methods of performance appraisal in their ex post forms.

Answer 18

1. Ex post alpha (Jensen’s alpha)
2. Information ratio
3. Treynor measure
4. The Sharpe ratio
5. M^2

Question 19

What is a Type I error in manager continuation decisions.

Answer 19

Rejecting the null hypothesis (The manager adds no value) when it is true. Thus, keeping managers who are returning no value-added.

Question 20

What is a Type II error in manager continuation decisions.

Answer 20

Failing to reject the null (The manager adds no value) when it is false. Thus, firing good managers who are adding value.