Evaluating portfolio performance

Performance evaluation There are 2 main performance perspectives; Funds sponsor perspective – capture all value added or lost. Performance evaluation improves the effectiveness of funds investment policy by acting as a feedback and control mechanism. Managers perspective – focus only on what a particular did to add or lose value for the fund. It can also act as feedback and control mechanism

Components of performance evaluation PE will involve; Performance measurement – calculates rates of return based on changes in the account’s value over specified time periods Performance attribution – determine the sources of account’s performance. Performance appraisal – draw conclusions whether the performance was affected primarily investment decisions, by overall market, or by chance.

Return calculations with external cash flows Rate of return on an account is the percentage change in the account's market value over a defined time period. External cash flows refer to contributions and withdrawals made to and/ or from an account, as opposed to internal cash flows, such as interest or dividends.

If there is an external cash flow at the beginning if the evaluation period, the account’s return is calculated as follows; If there is an external cash flow at the end of the evaluation period, it should be subtracted from the account’s ending value

example The Siriga account was valued at $12,000,000 at the start of the month (before any contributions ). At the month end, it value was $12,260,000. During the month, the account received a contribution of $40,000. Calculate the rate of return if the contribution was received On the 1st day of the month (1.8272%) On the last day of the month (1.8333%)

Time and money weighted returns Time weighted rate of return (TWRR) calculates the compounded rate of growth over a stated evaluation period of one unit of money initially invested in the account. It requires a set of subperiod returns to be calculated covering each period that has a external cash flow. The subperiod results are then compounded together TWRR is unaffected by the external cash flows.

example Wayne account was $2,500,000 at the start of the month and $2,700,000 at the end. During the month, there was a cash inflow of $45,000 on day 7 and 25,000 on day 19. The values of the account are $2,555,000 and $2,575,000 (inclusive of cash flows for the day) on day 7 and 19, respectively. Calculate the TWRR (assume 30 days month) TWRR=5.1%

Money weighted rate of return MWRR is an internal rate of return (IRR) on all funds invested during the evaluation period, including the beginning value of the portfolio.

Portfolio return components The three components of return; Overall market return Style of the manager Active mgt decisions the mgr makes P = M + S + A

EXAMPLE Muraru account has a total monthly return of 5.04%. During the same period, the portfolio benchmark returned 5.32% and the market index returned 3.92%. Calculate the amount of portfolio return attributable to the manager’s active management and style A = - 0.28% S = 1.4%

Benchmark properties Specified in advance - known to both the mgr and the fund sponsor. It is specified at the start of an evaluation period Appropriate – consistent with the mgr investment approach and sytle Measurable – its value and return can be determined on a reasonably frequent basis. Unambiguous – clearly defined identities and weights of securities constituting the benchmark. Reflective of the mgr current investment opinions - mgr has current knowledge and expertise of the securities within the benchmark Accountable – mgr should accept the applicability of the benchmark and agree to accept differences in performance between the portfolio and benchmark as caused only by his active mgt Investable – it is possible to replicate the benchmark and forgo active mgt

For individual considerations; Discuss the seven types of benchmarks

Macro and micro performance attributions The basic concept is to identify and quantify the sources of returns that are different from designated benchmark. Types of performance attribution; Macro performance attribution – done at the fund sponsor level Micro performance attribution – done at the investment manager level

Macro performance attribution Three main inputs; Policy allocations – it is up to the sponsor to determine asset categories and weights as well as allocate the total fund among asset managers. Benchmark portfolio returns – may choose broad market indices (asset categories) and use narrowly focused indices for mgrs investment style. Fund returns, valuations, and external cash flows – when using % terms, returns are calculated at the individual mgr level.

Macro attribution analysis It begins with the funds beginning market value and ends with its ending market value. In between are 6 levels of analysis; Net contributions – net sum of external cash flows made by the client into or withdrawn Risk free asset – simulates the funds ending value would have been if the beginning value and external cash flows had earned the risk free rate of return

Asset categories – simulates the ending value of beginning value and external cash flows if funds had been invested in asset category benchmarks weighted in accord with firms strategic policy

Benchmarks – allows the sponsor to select and assign mgrs a benchmark different from the policy benchmark

Investment managers or active management – simulates the results of investing the fund’s beginning value and external cash flows and earning the returns actually produced by the mgrs.

Allocation effects – simply a residual plug to sum to the total portfolio ending value

Micro performance attribution It analyses individual portfolios relative to designated benchmarks Value added can be broken into 3 components; Pure sector allocation Allocation/selection interaction Within-sector selection

Financial sector allocation = 0.0327% Calculate the utilities within sector allocation return (+0.068%) Calculate the allocation/selection interaction for consumer durables (0.000228%)

Risk adjusted performance measures Five commonly used measures are; Jensen’s alpha The information ratio (IR) The Treynor measure The Sharpe ratio M2

Jensen alha

Treynor measure

Sharpe ratio

m2

Information ratio