1. Portfolio Management Unit – V Performance Evaluation Unit – V Performance Evaluation

2. Unit 5 Evaluating Portfolio Performance: Introduction Importance of Performance Evaluation Three Components of Performance Evaluation Performance Measurement Benchmarks: Concept, Properties, Types

3. Performance Evaluation Investing involves making decisions that have readily quantifiable consequences and that, at least on the surface, lend themselves to elaborate dissection and review. The measurement and assessment of the outcomes of these investment management decisions as performance evaluation. Why Performance Evaluation? To employers, to evaluate whether the portfolio manager has done a good job For investors, to uncover who has superior investment skills

4. Performance Evaluation Importance of Performance Evaluation Performance evaluation is important from the perspectives of both the fund sponsor and the investment manager. From Fund Sponsor(Custodian) perspective: – For regular evaluation check the investment objectives. – A simple exercise to calculate risk and return – To form of long-term strategic investment planning – To enhances the effectiveness feedback and control mechanism – To identifies an investment program’s strengths and weaknesses – It provides evidence to fund trustees

5. Performance Evaluation Importance of Performance Evaluation From Investment Manager perspective: – To manage portfolios for their clients – To offer portfolios results to clients in the form of reports – For analysis – To investigate the effectiveness of various elements of their investment processes – Performance evaluation can serve as a feedback and control loop, helping to monitor the proficiency of various aspects of the portfolio construction process

6. Performance Evaluation Performance Measurement Performance measurement is the relatively simple procedure of calculating returns for an account. Performance evaluation requires accurate and timely rate-of-return information. Performance measurement is the first step in the performance evaluation process

7. Performance Evaluation Methods of Performance Measurement a)Rate of Return (without Intra-period External Cash Flows) b)Total Rate of Return c)Time-Weighted Rate of Return d)Money-Weighted Rate of Return e)Linked Internal Rate of Return f)Annualized Return

8. Performance Evaluation a). Rate of Return (without Intra-period External Cash Flows) The rate of return on an account is the percentage change in the account’s market value over some defined period of time (the evaluation period), after accounting for all external cash flows. r 1 = Return; MV 1 = Market Value at the end of the period MV 0 = Market Value at the beginning of the period

9. Performance Evaluation Winter Asset Management manages institutional and individual accounts, including the account of the Martin family. The Martin account was initially valued at $1,000,000. One month later it was worth $1,080,000. What is the Rate-of-Return when there are No External Cash Flows ? Ans:

10. Performance Evaluation b). Total Rate of Return Total rate of return measures the increase in the investor’s wealth due to both investment income (for example, dividends and interest) and capital gains (both realized and unrealized). The total rate of return implies that value of wealth is equally meaningful to the investor.

11. Performance Evaluation c). Time-Weighted Rate of Return The time-weighted rate of return (TWR) reflects the compound rate of growth over a stated evaluation period of one unit of money initially invested in the account. Its calculation requires that the account be valued every time an external cash flow occurs. If no such flows take place, then the calculation of the TWR is insignificant. If external cash flows do occur, then the TWR requires computing a set of sub period returns.

12. Performance Evaluation d). Money-Weighted Rate of Return The money-weighted rate of return (MWR) measures the compound growth rate in the value of all funds invested in the account over the evaluation period. In the corporate finance literature, the MWR goes by the name internal rate of return, or IRR. The MWR is the growth rate that will link the ending value of the account to its beginning value plus all intermediate cash flows.

13. Performance Evaluation m = number of time units in the evaluation period (for example, the number of days in the month) CFi = the ith cash flow L(i) = number of time units by which the ith cash flow is separated from the beginning of the evaluation period

14. Performance Evaluation e). Linked Internal Rate of Return Linked Internal Rate of Return (LIRR) method and originally was developed by Peter Dietz (1966). The TWR should be approximated by calculating the MWR over reasonably frequent time intervals and then chain-linking those returns over the entire evaluation period, this process is known as LIRR. R LIRR = (1+MWR 1 ) + (1+MWR 2 ) ………….. (1+MWR n ) - 1

15. Performance Evaluation f). Annualized Return The annualized return represents the compound average annual return earned by the account over the evaluation period. The calculation is also known as the compound growth rate or geometric mean return. CAGR = (Final Value / First Value) 1/n -1 r a = [(1+ r 1 ) x [(1+ r 2 ) x ….. [(1+ r n )] 1/n - 1