1. Investments Academic Year 2004 - 2005 Lectures n° 9 & 10 Performance Measurement & Commenting Mutual Funds Strategies & Performance

2. Performance Assessment Performance Measurement Benchmarks Performance Attribution AIMR Norms Operational risks in private banking Cases and exercises

3. 1. Performance Measurement Absolute return Return = total proceeds/initial investment Which average to use? –Arithmetic Average : for future expected performance –Geometric Average : for past performance Example : +10% in year 1 and –10% in year 2 =>arithmetic average = 0 geometric average =

4. 1. Performance Measurement Returns compared to risk – Which risk? –Performance of investment funds is usually estimated by comparing gross returns of funds with similar risk characteristics (equity growth, equity world, high-yield bond,…). –Then funds are ranked comparatively to one another within the same “investment universe”. –This way you can rank financial institutions or funds managers. Example : Ranking system Micropal from S&P –It ranks the investment funds by comparing them to one another within the same category : same types of assets, currency, geographical zones, industries, etc. –A single type of performance measure is not suitable for all types of portfolio.

5. 1. Performance Measurement Sharpe ratio : unit of excess return per unit of risk  good for the performance of an entire portfolio,  or to compare with other portfolios,  and to the market portfolio  the higher the better  if negative : value destruction (an investment in cash would have been better)

6. Information ratio : unit of excess return over the benchmark per unit of risk  same concept as the Sharpe ratio  used by practitioners,  highly dependant of the benchmark chosen,  the higher the better  if negative : a passive strategy would have been better 1. Performance Measurement

7. Treynor ratio : unit of excess return per unit of systematic risk  suited when a well diversified portfolio is mixed with others  allows to compare the performances of several managers of a well diversified portfolio  the higher the better  if negative : value destruction 1. Performance Measurement

8. Appraisal ratio : unit of Jensen’s alpha return per unit of non systematic risk  suited for parts of portfolios  suited for concentrated portfolios  measure the benefit-to-cost of a not well diversified portfolio  capture the benefits of an active stock selection  if negative : a passive strategy would have been better 1. Performance Measurement

9. Sharpe ratio of a composite portfolio : unit of excess return per unit of risk for a composite portfolio (C) made of an active part (P) and a passive part (M). 1. Performance Measurement

10. Key performances measures - 3. Example : Which one is : Riskier ? Better diversified ? Outperforming the market? Better if a single fund? Better if part of a larger passive fund? Of an active fund? 1. Performance Measurement

11. Limits to the reliability of performance results : –Changing portfolio composition Practical difficulty in performance measurement : –large number of observations required for statistical significance, –but changing pattern of risk in case of active portfolio management. A help : –keep track of portfolio composition and changes (in µ and s), –keep a data series of coherent ratio measurement.

12. 1. Performance Measurement Statistical significance –Number of observations required for statistical significance : increased by the noise in return data (due to external random effects) –If N is the required number of observations to perform a significant test at 5% over the non-zero value of α with σ(e) being the sample estimate of nonsystematic risk, we have : At 5% level of significance, t = 1.96. If monthly α = 0.2% and  (e)=2%, then N =....

13. 1. Performance Measurement N = 384 months = 32 years ! In case of low significativity of the results (on alphas, for instance), how to tell ability (or disability) from luck (or bad luck)? Or flat results from low alphas? Quite impossible. This is one of the reasons why performance of portfolio managers seems to be so erratic through the years.

14. 2. Benchmarks Benchmark : reference portfolio - Characteristics: –Representative of the funds’s investment strategy and risk level –Or, representative of the client’s demanded return (in private banking only) –Can be external : reference index, per market, per geographical zone, even per sector. External benchmarks are preferable whenever possible, both for independence and methodological reasons –Index vendors : Moody’s, JPM, S&P… –Can be internal : built by the asset management itself (even by the client, sometimes, in private banking).

15. 2. Benchmarks Key roles of the benchmarks –In asset management : Managers work in relative terms, based on the benchmark More and more systematic use of benchmarks –In performance measurement : Benchmarks used a departure point for assessing performance (see further)

16. 2. Benchmarks Key roles of the benchmarks –In risk management Basis for establishing various management goals or limits: –targeted surperformance rates, –tracking errors limits (difference between the return of the portfolio and the benchmark, in %), –stop-loss procedures. –In Marketing and Communication help clarify and communicate the investment objective of a fund to the clients

17. Performance attribution = decomposition of the performance of a portfolio into its various components, in order to identify the decisions that caused the sur- or subperformance of the overall portfolio. Useful when it fits the investment process, following the top- down procedure of the decisions taken by the management. For global portfolios, performance attribution starts from the broadest asset allocation choices and progressively focus on ever-finer details portfolio choices. 3. Performance Attribution

18. Example of attribution system for fixed-income portfolio : –overall duration –market allocation : currency markets maturity segments credit classes –issue selection : sector and rating –currency allocation : FX transactions within a same type of issue Example of attribution system for a mixed fund: –asset allocation decisions : bonds - equity - cash, –sector choices between each market, –security selection within each sector.

19. 3. Performance Attribution Performance Attribution – Equations : –If return of the benchmark portfolio: where w Bi is the weight of the asset class i in the benchmark portfolio, and r Bi is the return of that asset class over the period. –And return of the active portfolio: –The difference in returns writes :

20. 3. Performance Attribution Performance Attribution – Equations : –If can be rewritten as:

21. 3. Performance Attribution

22. 4. AIMR Norms Performance Evaluation Standards : –Returns must be total returns (income + capital gain). –Annual returns reported for all years individually, and longer periods. –Time-weighted average rates of return and geometric average linked returns. –Performance reported before fees. –Composite results reflect the record of the firm, not of individual managers. –Composite returns reported for at least a 10-year period. –Risk measures such as beta, duration, or standard deviation are encouraged.

23. 5. Operational Risk in Private Banking Operational risk is the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. Categories of OR events Execution, Delivery & Process Management (processing error, information transfer, data coding,...) Clients, Products & Business Practices (clients misinformation, complaints and discounts due to errors, products misspecification...) Internal fraud (thefts and frauds by employees) External fraud (hold-up, thefts,..) Employment practices & workplace safety (contract termination, disputes with employees...) Damage to physical assets Business disruption & system failures (IT break-down, hacking...)

24. 5. Operational Risk in Private Banking Main risks –Clients, Products & Business Practices : Inappropriate advice to the clients leading to clients claims Inappropriate clients protection and delegation contracts At the verge of legal risk – huge risk in private banking and asset management activities 2. Execution, Delivery & Process Management : Errors in back-office procedures : buy – sell confusion, wrong asset bought, … « Commercial interventions » : cut-off in price and rebates allowed by front office manager to clients, either to hide a mistake, or for pure commercial reason : could be uncontrolled 3. Internal fraud : Cash-flow embezzlement, at the detriment of one client, to another, or to the employee himself

25. 6. Cases and Exercises Please refer to the mutual funds summaries enclosed and comment: –The active strategies used in this portfolio –The type of client it should suit / it would not suit at all –Comment the performance results –What would you change if it were your own portfolio?