Investment Performance Measurement: Evaluating and Presenting Results
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Investment Performance Measurement
Over the past two decades, the importance of measuring, presenting, and evaluating investment performance results has dramatically increased. With the growth of capital market data services, the development of quantitative analytical techniques, and the widespread acceptance of Global Investment Performance Standards (GIPS®), this discipline has emerged as a central component of effective asset management and, thanks in part to the Certificate in Investment Performance Measurement (CIPM) program, has become a recognized area of specialization for investment professionals.
That's why Investment Performance Measurement: Evaluating and Presenting Resultsthe second essential title in the CFA Institute Investment Perspectives serieshas been created. CFA Institute has a long tradition of publishing content from industry thought leaders, and now this new collection offers unparalleled guidance to those working in the rapidly evolving field of investment management.
Drawing from the Research Foundation of CFA Institute, the Financial Analysts Journal, CFA Institute Conference Proceedings Quarterly, CFA Magazine, and the CIPM curriculum, this reliable resource taps into the vast store of knowledge of some of today's most prominent thought leadersfrom industry professionals to respected academicswho have focused on investment performance evaluation for a majority of their careers.
Divided into five comprehensive parts, this timely volume opens with an extensive overview of performance measurement, attribution, and appraisal. Here, you'll become familiar with everything from the algebra of time-weighted and money-weighted rates of return to the objectives and techniques of performance appraisal.
After this informative introduction, Investment Performance Measurement moves on to:
- Provide a solid understanding of the theoretical grounds for benchmarking and the trade-offs encountered during practice in Part II: Performance Measurement
- Describe the different aspects of attribution analysis as well as the determinants of portfolio performance in Part III: Performance Attribution
- Address everything from hedge fund risks and returns to fund management changes and equity style shifts in Part IV: Performance Appraisal
- Recount the history and explain the provisions of the GIPS standardswith attention paid to the many practical issues that arise in the course of its implementationin Part V: Global Investment Performance Standards
Filled with invaluable insights from more than fifty experienced contributors, this practical guide will enhance your understanding of investment performance measurement and put you in a better position to present and evaluate results in the most effective way possible.
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Investment Performance Measurement - Philip Lawton, CIPM
Table of Contents
Praise
Title Page
Copyright Page
Foreword
Introduction
OVERVIEW
PERFORMANCE MEASUREMENT
PERFORMANCE ATTRIBUTION
PERFORMANCE APPRAISAL
GLOBAL INVESTMENT PERFORMANCE STANDARDS
SUMMARY
PART I - OVERVIEW OF PERFORMANCE EVALUATION
CHAPTER 1 - EVALUATING PORTFOLIO PERFORMANCE
THE IMPORTANCE OF PERFORMANCE EVALUATION
THE THREE COMPONENTS OF PERFORMANCE EVALUATION
PERFORMANCE MEASUREMENT
BENCHMARKS
PERFORMANCE ATTRIBUTION
PERFORMANCE APPRAISAL
THE PRACTICE OF PERFORMANCE EVALUATION
NOTES
REFERENCES
PART II - PERFORMANCE MEASUREMENT
CHAPTER 2 - BENCHMARKS AND INVESTMENT MANAGEMENT
FOREWORD
PREFACE
ORIGINS, USES, AND CHARACTERISTICS OF U.S. EQUITY BENCHMARKS
USING BENCHMARKS TO MEASURE PERFORMANCE
BUILDING PORTFOLIOS OF MANAGERS
THE EVOLUTION OF MPT AND THE BENCHMARKING PARADIGM
THE 1990s BUBBLE AND THE CRISIS IN MPT
CRITIQUES OF BENCHMARKING AND A WAY FORWARD
THE IMPACT OF BENCHMARKING ON MARKETS AND INSTITUTIONS
U.S. EQUITY STYLE INDEXES
FIXED-INCOME BENCHMARKS
INTERNATIONAL EQUITY BENCHMARKS
HEDGE FUND BENCHMARKS
POLICY BENCHMARKS
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 3 - THE IMPORTANCE OF INDEX SELECTION
INDEX METHODOLOGIES
INDEX COMPARISONS
MANAGING TO INDEXES
CONCLUSION
NOTE
CHAPTER 4 - AFTER-TAX PERFORMANCE EVALUATION
WHY THE AFTER-TAX FOCUS
FACTORS AFFECTING TAX EFFICIENCY
MEASURING AFTER-TAX PERFORMANCE
CONCLUSION
QUESTION AND ANSWER SESSION
CHAPTER 5 - TAXABLE BENCHMARKS: THE COMPLEXITY INCREASES
STANDARD BENCHMARK RULES
AIMR AFTER-TAX STANDARDS
IMPORTANCE OF THE CAPITAL GAIN REALIZATION RATE
CONVERTING A STANDARD PRETAX BENCHMARK
SHADOW PORTFOLIOS
CONCLUSION
QUESTION AND ANSWER SESSION
NOTE
CHAPTER 6 - OVERCOMING CAP-WEIGHTED BOND BENCHMARK DEFICIENCIES
DIVERSIFICATION
PREVALENCE OF CAP-WEIGHTED BENCHMARKS
WHY MOST BOND BENCHMARKS ARE FLAWED
ANALYSIS OF THREE CAP-WEIGHTED INDICES
HIGH-YIELD SECTOR
BEYOND CASH BONDS
EMERGING MARKET BOND INDICES
GBI-EM
NEEDS SHOULD DICTATE THE BENCHMARK
ALTERNATIVE BENCHMARKS
CONCLUSION
QUESTION AND ANSWER SESSION
REFERENCES
CHAPTER 7 - YIELD BOGEYS
APPROXIMATING PORTFOLIO YIELD
TREASURY YIELD BOGEYS
ARE YIELD BOGEY MISMEASUREMENTS A WASH?
CONCLUSION
NOTES
REFERENCES
CHAPTER 8 - JUMPING ON THE BENCHMARK BANDWAGON
IS IT APPROPRIATE?
A HELL OF A DISCUSSION
MEASURING PURE ALPHA
TOUGH CHOICES
CONSTRUCTING A SYNTHETIC UNIVERSE
A COLLABORATIVE EFFORT
PART III - PERFORMANCE ATTRIBUTION
CHAPTER 9 - DETERMINANTS OF PORTFOLIO PERFORMANCE
A FRAMEWORK FOR ANALYSIS
DATA
RESULTS
RETURN VARIATION
IMPLICATIONS
NOTES
CHAPTER 10 - DETERMINANTS OF PORTFOLIO PERFORMANCE II: AN UPDATE
FRAMEWORK
RESULTS
INTERNAL VERSUS EXTERNAL RISK POSITIONING
CONCLUSION
NOTES
CHAPTER 11 - DETERMINANTS OF PORTFOLIO PERFORMANCE—20 YEARS LATER
CHAPTER 12 - EQUITY PORTFOLIO CHARACTERISTICS IN PERFORMANCE ANALYSIS
USES OF PORTFOLIO CHARACTERISTICS
DATA AND CALCULATION ISSUES
TYPES OF CHARACTERISTICS
MANAGER MONITORING AND STYLE ANALYSIS
ATTRIBUTION ANALYSIS
LIMITATIONS OF PORTFOLIO CHARACTERISTICS ANALYSIS
NOTES
CHAPTER 13 - MUTUAL FUND PERFORMANCE: DOES FUND SIZE MATTER?
WHY FUND SIZE MATTERS
SAMPLE DESCRIPTION
DESCRIPTIVE STATISTICS
NET EFFECTS OF FUND SIZE
FUND SIZE AND INVESTMENT STYLE
FUND SIZE AND STYLE CONSISTENCY
CONCLUSION
NOTES
REFERENCES
CHAPTER 14 - MULTIPERIOD ARITHMETIC ATTRIBUTION
ARITHMETIC VS. GEOMETRIC MEASURES
SINGLE-PERIOD SECTOR-BASED DECOMPOSITION
METHODS’ CHARACTERISTICS AND PROPERTIES
ARITHMETIC ALGORITHMS
CONCLUSION
APPENDIX 14A: NATURAL SCALING FROM SINGLE-PERIOD TO MULTIPERIOD CASE
NOTES
REFERENCES
CHAPTER 15 - OPTIMIZED GEOMETRIC ATTRIBUTION
SINGLE-PERIOD ATTRIBUTION: REVIEW
MULTIPERIOD ATTRIBUTION
GEOMETRIC ALGORITHMS
ADJUSTED PURE GEOMETRIC METHOD
CONCLUSION
APPENDIX 15A: DERIVATION OF OPTIMIZED GEOMETRIC ATTRIBUTION
NOTES
REFERENCES
CHAPTER 16 - CUSTOM FACTOR ATTRIBUTION
GENERAL ATTRIBUTION
PERFORMANCE ATTRIBUTION FOR CUSTOM FACTORS
RISK ATTRIBUTION FOR CUSTOM FACTORS
RISK-ADJUSTED PERFORMANCE ATTRIBUTION
EXAMPLE
CONCLUSION
APPENDIX 16A: OPTIMAL EXPECTED RETURNS
APPENDIX 16B: FORMULAS FOR VOLATILITIES AND CORRELATIONS
APPENDIX 16C: REMOVING COLINEARITIES THROUGH RESTRICTED LEAST SQUARES
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 17 - RETURN, RISK, AND PERFORMANCE ATTRIBUTION
EXAMPLE 1
EXAMPLE 2
EXAMPLE 3
CONCLUSION
QUESTION AND ANSWER SESSION
CHAPTER 18 - GLOBAL ASSET MANAGEMENT AND PERFORMANCE ATTRIBUTION
FOREWORD
PREFACE
INTRODUCTION
THE GENERAL FRAMEWORK
GLOBAL PERFORMANCE ATTRIBUTION
INTERPRETATION OF GLOBAL PERFORMANCE ATTRIBUTIONS
GLOBAL BALANCED PORTFOLIOS
CONCLUSION
APPENDIX 18A
APPENDIX 18B
NOTES
REFERENCES
CHAPTER 19 - CURRENCY OVERLAY IN PERFORMANCE EVALUATION
PORTFOLIO DECOMPOSITION AND PERFORMANCE MEASUREMENT
ATTRIBUTION ANALYSIS
CONCLUSION
APPENDIX 19A: PERFORMANCE MEASUREMENT EXAMPLES
APPENDIX 19B: PORTFOLIO PERFORMANCE
APPENDIX 19C: COVERED INTEREST RATE PARITY
APPENDIX 19D: ATTRIBUTION VARIABLES
ACKNOWLEDGMENTS
NOTES
REFERENCES
PART IV - PERFORMANCE APPRAISAL
CHAPTER 20 - ON THE PERFORMANCE OF HEDGE FUNDS
DATA AND SAMPLE STATISTICS
FUND FEATURES AND PERFORMANCE
HEDGE FUND PERFORMANCE AND RISK
HEDGE FUNDS VERSUS MUTUAL FUNDS
SURVIVORSHIP BIAS
CONCLUSION
ACKNOWLEDGMENTS
APPENDIX 20A: HEDGE FUND STRATEGIES
NOTES
REFERENCES
CHAPTER 21 - FUNDS OF HEDGE FUNDS
GROWTH OF FUNDS OF FUNDS
ADDED VALUE FROM FUNDS OF FUNDS
FUND-OF-FUNDS PERFORMANCE
EFFECTS OF STYLE AND MANAGER CHOICE
PROSPECTS FOR MULTISTRATEGY FUNDS
CONCLUSION
QUESTION AND ANSWER SESSION
REFERENCES
CHAPTER 22 - HEDGE FUND DUE DILIGENCE
PAYING CAREFUL ATTENTION
SHINING A BRIGHT LIGHT
CREATING A MOSAIC
HANDSHAKE BUSINESS
CHAPTER 23 - PUTTING RISK MEASUREMENT IN CONTEXT
MAKING THE GRADE
LEVERAGING RISK
MAXIMIZING VAR
CHAPTER 24 - CONDITIONAL PERFORMANCE EVALUATION, REVISITED
FOREWORD
PREFACE
CONDITIONAL PERFORMANCE EVALUATION, REVISITED
REVIEW OF CONDITIONAL PERFORMANCE EVALUATION
MEASURING THE STATES OF THE ECONOMY
EMPIRICAL MODELS
DATA
PERFORMANCE OF BROAD FUND GROUPS
INDIVIDUAL FUND PERFORMANCE
PERFORMANCE AND INDIVIDUAL-FUND CHARACTERISTICS
MARKET TIMING
IMPLICATIONS FOR PRACTICING FINANCIAL ANALYSTS
SUMMARY AND CONCLUSIONS
APPENDIX 24A: ADDITIONAL TABLES
NOTES
REFERENCES
CHAPTER 25 - DISTINGUISHING TRUE ALPHA FROM BETA
THE DIMENSIONS OF ACTIVE MANAGEMENT
DO HEDGE FUNDS CHARGE ALPHA FEES FOR BETA PERFORMANCE?
POLICY IMPLICATIONS FOR PENSION FUNDS AND OTHER INVESTORS
QUESTION AND ANSWER SESSION
NOTE
CHAPTER 26 - A PORTFOLIO PERFORMANCE INDEX
ALTERNATIVES TO THE SHARPE RATIO
SHARPE RATIO MAXIMIZATION
BEHAVIORAL HYPOTHESIS
FINDING THE OPTIMAL PORTFOLIO: A DISTRIBUTION-FREE APPROACH
EMPIRICAL EXAMPLE
CONCLUSIONS
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 27 - APPROXIMATING THE CONFIDENCE INTERVALS FOR SHARPE STYLE WEIGHTS
A PRIMER ON STYLE ANALYSIS
THE SIMULATION PROCEDURE
CONCLUSION
APPENDIX: APPROXIMATING THE CONFIDENCE INTERVAL FOR SHARPE STYLE WEIGHTS
REFERENCES
CHAPTER 28 - THE STATISTICS OF SHARPE RATIOS
IID RETURNS
NON-IID RETURNS
TIME AGGREGATION
AN EMPIRICAL EXAMPLE
CONCLUSION
APPENDIX 28A: ASYMPTOTIC DISTRIBUTIONS OF SHARPE RATIO ESTIMATORS
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 29 - RISK-ADJUSTED PERFORMANCE
THE PROBLEM
LUCK VERSUS SKILL
CORRELATION-ADJUSTED PORTFOLIO AND THE M-3 MEASURE
THE M-3 MODEL
RANKING MUTUAL FUNDS
EXTENSION TO MULTIPLE MUTUAL FUNDS
ADJUSTING FOR TIME
CAVEATS
CONCLUSIONS
APPENDIX 29A: DETERMINING a AND b
APPENDIX 29B: MULTIPLE MUTUAL FUNDS
NOTES
REFERENCES
CHAPTER 30 - INDEX CHANGES AND LOSSES TO INDEX FUND INVESTORS
INDEX CHANGES AND RETURN PATTERNS
LOSSES TO INDEX FUND INVESTORS
CORROBORATING EVIDENCE
LIMITATIONS OF TRACKING ERROR
IMPROVING INDEX CONSTRUCTION
CONCLUSION
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 31 - INFORMATION RATIOS AND BATTING AVERAGES
THE GAME
RESULTS FOR VARIOUS INVESTMENT STRATEGIES
GOOD BATTERS ARE SKEWED
CONCLUSION
APPENDIX 31A: FINDING THE IR FROM THE BATTING AVERAGE
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 32 - THE INFORMATION RATIO
THE RATIO DEFINED
INTERPRETATIONS OF THE RATIO
THE SHARPE RATIO AND THE INFORMATION RATIO
INFORMATION RATIOS AND t-STATISTICS
ANNUALIZATION
EMPIRICAL EVIDENCE ON INFORMATION RATIOS
CAVEATS
CONCLUSION
NOTES
REFERENCES
CHAPTER 33 - DOES ASSET ALLOCATION POLICY EXPLAIN 40, 90, OR 100 PERCENT OF PERFORMANCE?
FRAMEWORK
DATA
QUESTIONS AND ANSWERS
CONCLUSION
ACKNOWLEDGMENTS
NOTES
REFERENCES
CHAPTER 34 - FUND MANAGEMENT CHANGES AND EQUITY STYLE SHIFTS
DATA
RESEARCH METHODS
RESULTS
CONCLUSIONS
NOTES
REFERENCES
CHAPTER 35 - MANAGING PERFORMANCE: MONITORING AND TRANSITIONING MANAGERS
BACKGROUND
SELECTING AN INVESTMENT MANAGER
MONITORING AN INVESTMENT MANAGER
CATALYSTS FOR CHANGING A MANAGER
TRANSFERRING A TAXABLE PORTFOLIO TO A NEW MANAGER
CONCLUSION
QUESTION AND ANSWER SESSION
CHAPTER 36 - DOES THE EMPEROR WEAR CLOTHES OR NOT? THE FINAL WORD (OR ALMOST) ...
EQUITY STRUCTURE
METHODOLOGY
RESULTS
TIME DEPENDENCY
FIXED-INCOME STRUCTURE
INVESTMENT IMPLICATIONS
CONCLUSIONS
REFERENCES
CHAPTER 37 - DOES HISTORICAL PERFORMANCE PREDICT FUTURE PERFORMANCE?
PREVIOUS RESEARCH
PERFORMANCE MEASURES
STYLE ANALYSIS
SURVIVORSHIP BIAS
THE DATA
METHODOLOGY
EQUITY RESULTS
FIXED-INCOME RESULTS
ACCOUNTING FOR FEES AND EXPENSES
SURVIVORSHIP BIAS
SUMMARY OF RESULTS
CONTEXT
INVESTMENT IMPLICATIONS
CONCLUSIONS
NOTES
CHAPTER 38 - EVALUATING FUND PERFORMANCE IN A DYNAMIC MARKET
A NUMERICAL EXAMPLE
DATA
TRADITIONAL MEASURES OF PERFORMANCE
CONDITIONAL PERFORMANCE EVALUATION
EXPLAINING BETA CHANGES
CONDITIONAL MARKET TIMING
CONCLUSIONS
NOTES
REFERENCES
CHAPTER 39 - INVESTMENT PERFORMANCE APPRAISAL
TOTAL FUND PERSPECTIVE
PERFORMANCE REPORTS
PERFORMANCE RELATIVE TO THE BENCHMARK
PEER GROUP COMPARISONS
PORTFOLIO CHARACTERISTICS ANALYSIS
PERFORMANCE ATTRIBUTION
RISK ANALYSIS
TAKING ACTION
NOTES
CHAPTER 40 - THINKING OUTSIDE THE BOX: RISK MANAGEMENT FIRMS PUT A CREATIVE ...
A SIMPLE REQUEST
POWERFUL SOLUTIONS
ANSWERING THE CALL
THE 90/10 RULE
STRESSING THE DATA
SENSITIVITY ANALYSIS AND SIMULATIONS
OUT OF THE BOX . . .
. . . AND ONTO THE CUTTING EDGE
NOTE
PART V - GLOBAL INVESTMENT PERFORMANCE STANDARDS
CHAPTER 41 - GLOBAL INVESTMENT PERFORMANCE STANDARDS
BACKGROUND OF THE GIPS STANDARDS
PROVISIONS OF THE GIPS STANDARDS
VERIFICATION
GIPS ADVERTISING GUIDELINES
OTHER ISSUES
NOTES
REFERENCES
APPENDIX A - GLOBAL INVESTMENT PERFORMANCE STANDARDS (GIPS®)
APPENDIX B - CORRECTIONS TO GIPS STANDARDS 2005
ABOUT THE CONTRIBUTORS
INDEX
CFA Institute Investment Perspectives Series is a thematically organized compilation of high-quality content developed to address the needs of serious investment professionals. The content builds on issues accepted by the profession in the CFA Institute Global Body of Investment Knowledge and explores less established concepts on the frontiers of investment knowledge. These books tap into a vast store of knowledge of prominent thought leaders who have focused their energies on solving complex problems facing the financial community.
CFA Institute is the global association for investment professionals. It administers the CFA® and CIPM curriculum and exam programs worldwide; publishes research; conducts professional development programs; and sets voluntary, ethics-based professional and performance-reporting standards for the investment industry. CFA Institute has more than 95,000 members, who include the world’s 82,000 CFA charterholders, in 134 countries and territories, as well as 135 affiliated professional societies in 56 countries and territories.
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Library of Congress Cataloging-in-Publication Data:
Investment performance measurement : evaluating and presenting results/Philip Lawton, Todd Jankowski. p. cm.
Includes index.
eISBN : 978-0-470-47371-9
1. Investment analysis. 2. Investments. I. Lawton, Philip (John Philip) II. Jankowski, Todd. HG4529..63’2042—dc22 2009004092
FOREWORD
Investment management firms and their relationship managers need to be able to communicate their results to clients clearly and fairly. Investors, portfolio managers, advisers, and consultants need to be able to evaluate these results and ascertain to what extent performance was attributable to asset allocation, security selection, or other decisions. Technology staff, accountants, and compliance officers also need to understand performance measurement to design and audit systems that generate these results.
The field of performance measurement has made great strides since Gray P. Brinson, L. Randolph Hood, and Gilbert L. Beebower published their pioneering work on attribution analysis in 1986 and the Committee for Performance Reporting Standards of the Financial Analysts Federation (a predecessor of CFA Institute) proposed the development of performance presentation standards in 1987. These Standards have developed progressively over the last 20 years through the work of CFA Institute and almost 30 country sponsors. Today, the Global Investment Performance Standards (GIPS®) articulate a set of industrywide ethical principles that provide investment firms with guidance on how to calculate and report their investment results. Furthermore, a professional designation program has developed for professionals desiring to specialize in this area: the Certificate in Investment Performance Measurement (CIPM®).
This volume provides the reader with the tools necessary to measure, present, and evaluate investment performance results. It is a compilation of some of the best writings on presenting and evaluating investment performance. These include articles from the Research Foundation of CFA Institute, the Financial Analysts Journal, CFA Institute Conference Proceedings Quarterly, CFA Magazine, and the CIPM program. We are grateful to the distinguished team of authors for sharing their knowledge with investors and investment professionals through CFA Institute.
The 41 papers included here are organized in five sections beginning with an overview and followed by sections on performance measurement (what happened), performance attribution (why it happened), performance appraisal (how the investment manager did), and the Global Investment Performance Standards (how results should be presented).
CFA Institute is pleased to present Investment Performance Measurement: Evaluating and Presenting Results, the second in our CFA Institute Investment Perspectives series. We hope you will find it a useful guide and resource in performance measurement.
Robert R. Johnson, CFA
Deputy CEO
CFA Institute
INTRODUCTION
Evaluating performance insightfully and presenting it fairly are crucial to the vitality of an investment firm. Security analysts and portfolio managers make decisions under conditions of uncertainty about the relative attractiveness of market sectors and individual investments; the role of performance analysts is to explain the outcome of those decisions. At its best, the intelligent feedback provided by trained, experienced performance analysts can help the firm improve its decision process and refine its investment strategies, and the performance presentations they prepare can contribute to the firm’s success in expanding client relationships and winning new business. Whether markets are rising or falling, resilient investment organizations value highly qualified performance professionals. Indeed, there is a curious countercyclicality to the demand for their expertise: It is when results are most disappointing that cogent explanations are most urgently needed.
In the chapter that opens this volume in the CFA Institute Investment Perspectives series, authors Jeffery V. Bailey, Thomas M. Richards, and David E. Tierney state that three questions arise in the process of evaluating the performance of an account—that is, a portfolio or a group of portfolios:
1. What was the account’s performance?
2. Why did the account produce the observed performance?
3. Is the account’s performance a result of luck or skill?
The first question falls in the domain of performance measurement, more narrowly defined in this context than in common usage. It is answered by calculating the account’s rate of return over the evaluation period. Rate-of-return calculations are relatively straightforward in the case of traditional, long-only equity portfolios holding assets denominated in a single currency, but they are appreciably thornier for portfolios with more esoteric strategies. Once the return of the portfolio has been determined, it remains to judge whether the results meet the client’s expectations, usually by comparing the portfolio’s return with the return of a valid benchmark. Bailey, Richards, and Tierney set forth widely accepted criteria of benchmark validity and useful tests of benchmark quality.
The second question belongs to the realm of performance attribution. It is answered by applying quantitative techniques to establish the sources of the portfolio’s return relative to the benchmark (i.e., to determine which investment decisions added value and, of course, which ones did not). Here, too, the mathematics of attribution analysis is fairly easy to grasp in the case of single-currency, long-only equity portfolios considered over a single evaluation period, but it is more challenging for portfolios holding both long and short positions, measured over multiple periods, or invested in fixed-income securities, derivatives, and assets denominated in multiple currencies. Attribution analysis, often accompanied by portfolio characteristics analysis, enables proficient performance professionals to discern what the firm does well and not so well. It also facilitates productive dialogue with clients who may be reassured to find that the firm is investing as expected, following its mandate and adhering to its discipline even when the agreed-upon strategy is out of favor in the marketplace.
The third, and the most difficult and consequential, question pertains to performance appraisal. When conducting manager searches and monitoring managers’ performance, institutional investors and their consultants seek to identify the investment firms most likely to produce consistently favorable results—firms whose track records arise not merely from fortunate timing but from the competent, disciplined execution of coherent, evidence-based investment strategies. Luck may change at any moment, whereas in stable organizations, skillfulness may reasonably be expected to persist. Because it is costly to terminate an advisory relationship and transfer assets to a new manager, investors must select managers prudently, and if portfolio returns prove disappointing, as they sometimes will, investors must attempt to distinguish between a simple run of bad luck and a much more serious lack, or loss, of skill. It is generally acknowledged, however, that investors cannot definitively establish, in a realistic timeframe, whether investment results are because of the manager’s skill or dumb luck. In practice, therefore, performance appraisal commonly focuses on related and somewhat more decidable issues, to wit, determining whether the manager has taken acceptable risks and whether, over time, the investor has been adequately compensated for them.
In addition to evaluating decisions made on behalf of existing clients, performance professionals employed by investment firms are responsible for preparing presentations for the use of prospective clients. Working in close collaboration with numerous other organizations over the last two decades, CFA Institute has been a leader in developing voluntary performance presentation standards that protect the interests of prospective clients. The Global Investment Performance Standards (GIPS®) advance the ethical ideals of presenting investment results fairly and disclosing them fully. The Standards set forth minimum requirements and recommend best practices related to input data, calculation methodology, composite construction, disclosures, and the presentation and reporting of investment performance—all intended to ensure that a firm claiming compliance gives prospective clients complete and accurate information about its historical results. Now widely endorsed (and still evolving), the GIPS standards are a signal contribution to the investment industry, benefiting investors and investment firms around the world. It behooves anyone with an interest in performance measurement to become familiar with them.
The foregoing survey of the field of investment performance measurement accounts for the way in which we have organized the papers selected for this specialized collection from the wealth of CFA Institute publications. Participants in the Certificate in Investment Performance Measurement (CIPM®) program will recognize some papers from their study of the curriculum; this volume contains most of the Principles-level readings and several Expert-level readings.a
OVERVIEW
The Overview
section contains the outstanding essay, previously mentioned, by Jeffery V. Bailey, Thomas M. Richards, and David E. Tierney. Evaluating Portfolio Performance
is a masterful introduction to performance measurement, attribution, and appraisal. The authors explain the algebra of time-weighted and money-weighted rates of return, evaluate various types of benchmarks (notably including custom security-based benchmarks), present a widely used method of attribution analysis for individual portfolios and a systematic approach to attribution analysis at the total fund level, and give a well-considered account of the objectives and techniques of performance appraisal, including ex post risk measures, quality control charts, and manager continuation policies. To those who are exploring the field for the first time, the value of this paper is inestimable; however, we recommend it no less enthusiastically to readers long acquainted with the challenges of performance evaluation.
PERFORMANCE MEASUREMENT
The section of this book devoted to performance measurement includes only one paper on rate-of-return calculations. In his important treatment of after-tax performance evaluation, James M. Poterba argues that the return calculation methodology should capture the contingent tax liability associated with unrealized gains held in the portfolio at the end of an evaluation period. For the rest, this section centers on issues surrounding the construction and selection of performance benchmarks.
Re-published here in full, Laurence B. Siegel’s monograph Benchmarks and Investment Management
recounts the historical development of benchmarking in the context of modern portfolio theory and judiciously addresses a range of fundamental and often contentious issues. By comparing the philosophies and methodologies of two major index providers, Christopher G. Luck illustrates how the choice of a benchmark can affect the behavior of active portfolio managers. Lee N. Price describes three progressively accurate techniques for approximating the after-tax return of a pre-tax benchmark. Arguing that generic, capitalization-weighted bond indices do not represent the true opportunity set for most fixed-income portfolios, William L. Nemerever suggests using derivative securities to construct alternative benchmarks. Brent Ambrose and Arthur Warga demonstrate that dollar-duration weighting results in significantly more reliable estimates of fixed-income portfolio yields than the conventional market-value-weighted approach. Finally, Crystal Detamore-Rodman presents the views of several thought leaders on selecting appropriate benchmarks, isolating pure alpha (i.e., the risk-adjusted excess return due not to market exposures but to the portfolio manager’s active decisions), and constructing synthetic universes representing the portfolios that might have been formed from the benchmark’s constituent securities. In their diversity, the articles assembled in this section will give thoughtful readers a solid understanding of the theoretical grounds for benchmarking and the trade-offs encountered in practice.
PERFORMANCE ATTRIBUTION
The section devoted to performance attribution analysis opens with a groundbreaking piece that first appeared almost a quarter century ago, followed by an update published in 1991 and a letter to the Financial Analysts Journal written by one of the authors in 2005. In their short, powerful 1986 article Determinants of Portfolio Performance,
Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower famously presented their finding that, at the total fund level, investment policy—an investor’s decisions about which asset classes to include and what normal weights to assign them—contributes far more to the variation of returns than does active management in the form of market timing and security (or manager) selection. From a performance analyst’s point of view, the decisive importance of this empirical result is matched by the lasting impact of the authors’ conceptual framework for decomposing returns. In Determinants of Portfolio Performance II: An Update,
Brian D. Singer joins Brinson and Beebower in presenting further, confirmatory research on the total return contributions from policy and active management decisions and in extending the analytical method to capture the effect of internal risk positioning, for instance, by using futures, carrying cash, or hedging currency exposures. In Determinants of Portfolio Performance—20 Years Later,
L. Randolph Hood reflects on the debate that followed the appearance of the original article. The consensus,
he writes, . . . appears to have settled in to agree with us that investment policy will be very important in subsequent results and in describing those results.
Philip Lawton and Stephen C. Gaudette explain how equity portfolio characteristics analysis can help performance practitioners discern shifts in strategy, evaluate investment style, and determine the return effects of factor exposures. Taking into account the costs of acquiring and trading on information, Daniel C. Indro, Christine X. Jiang, Michael Y. Hu, and Wayne Y. Lee investigate the relationship between mutual fund size and performance.
Multiperiod Arithmetic Attribution
is the first of three articles by José Menchero included in this collection. The accuracy of widely used arithmetic attribution methodologies, such as the Brinson model, decays when they are applied to extended reporting periods over which portfolios are rebalanced. In light of desirable qualitative characteristics and quantitative properties, Menchero classifies and evaluates competing algorithms designed to eliminate unexplained residuals in multiperiod arithmetic attribution analyses. In Optimized Geometric Attribution,
he presents a metric-preserving method for distributing the residuals that are generated in the process of geometric buy-and-hold attribution analysis so as to minimize the distortion of sector effects. In Custom Factor Attribution,
Menchero collaborates with Vijay Poduri in presenting a framework for explaining the sources of risk-adjusted performance by attributing the information ratio (defined as active return divided by the tracking error) to custom factors that reflect the actual investment strategy and decision-making process. The method proposed by Menchero and Poduri may represent a step forward in realizing the promise of performance attribution analysis by aligning it with controllable aspects of the firm’s portfolio management and risk modeling processes. In an article entitled Return, Risk, and Performance Attribution,
Kevin Terhaar illustrates the need for such consistency by describing cases where attribution analyses that disregard the firm’s investment process, strategy, and risk factors can lead to erroneous results.
Managing portfolios that hold assets issued in foreign markets and denominated in foreign currencies entails making decisions that are not contemplated in domestic investing. We are pleased to republish in its entirety a seminal monograph, Global Asset Management and Performance Attribution,
in which Denis S. Karnosky and Brian D. Singer develop an analytical framework for evaluating global markets and construct a performance attribution system that isolates the effects of market allocation, currency management, and security selection on portfolio returns. Performance analysts who are familiar with the Karnosky-Singer method from formula-centered summaries in secondary sources, or indeed use it in their work, will likely find that grasping its theoretical basis contributes immeasurably to their understanding of global investment management. In Currency Overlay in Performance Evaluation,
Cornelia Paape critiques the Karnosky-Singer approach and presents a performance measurement system whose attribution variables separate the effects of active management decisions into market allocation, security selection, currency allocation, and currency selection.
PERFORMANCE APPRAISAL
The section of this book devoted to performance appraisal opens with four articles about hedge fund risks and returns. Bing Liang introduces the topic by describing salient features of hedge funds and reporting the results of a study conducted during a period of strong performance (1992-1996). Stan Beckers focuses on the risk-adjusted returns achieved by funds of hedge funds over the 10-year period 1997-2006 and cautions that buying beta disguised as alpha is an expensive proposition.
Cynthia Harrington discusses measures investors can take to counteract hedge funds’ characteristic lack of transparency and surveys commonly used risk measures.
Performance analysts may evaluate portfolio managers’ track records in up
and down
markets, but they typically do not take the state of the economy into account. Conditional performance evaluation, however, compares a fund’s returns with the returns of a dynamic strategy that matches the fund’s time-varying risk exposures. In Conditional Performance Evaluation, Revisited,
a Research Foundation of CFA Institute monograph, Wayne E. Ferson and Meijun Qian review the main empirical results of previous studies, expand the list of state variables, present an analysis of mutual funds’ conditional performance at the level of broadly defined style groups, and examine evidence of market-timing ability. By helping to distinguish between luck and skill, conditional performance evaluation may guide investors and consultants toward better decisions about investment managers. Conditional performance evaluation is also presented in a shorter, earlier article by Ferson and Vincent A. Warther that appears further along in this volume.
In his article Distinguishing True Alpha from Beta,
Laurence B. Siegel describes the dimensions of active management; differentiates active, or alpha, risk from policy, or beta, risk; applies those concepts to hedge funds; and draws out their policy implications for pension funds and other investors.
The Sharpe ratio, as traditionally defined, compares a portfolio’s excess return (that is, its return in excess of the risk-free rate) with the total risk of the portfolio, represented by the standard deviation of returns. It is well known, however, that the theoretical foundation for the Sharpe ratio does not apply when excess returns are not normally distributed. Michael Stutzer reviews three approaches to overcoming this limitation and proposes an alternative performance index that reflects investors’ preference for positive skewness. Angelo Lobosco and Dan DiBartolomeo provide a primer on returns-based style analysis—a form of constrained regression used to determine the weighted combination of market indices that most closely matches the historical return pattern of the portfolio being analyzed—and define a method for establishing confidence intervals around the weights. Andrew W. Lo investigates the statistical properties of the Sharpe ratio and reaches conclusions of considerable practical importance about, for instance, the distorting impact of serial correlation in hedge funds’ monthly returns. In an updated version of Risk-Adjusted Performance: The Correlation Correction,
Arun S. Muralidhar argues that current measures of risk-adjusted performance, including the Sharpe ratio and the M² measure, are insufficient bases for ranking mutual funds or constructing portfolios that are likely to earn the highest alpha for a given tracking error. He proposes a new measure, M-3, as a more comprehensive alternative that incorporates the correlation between mutual fund returns and benchmark returns. Muralidhar modestly revised this paper for the present volume, making note of related research into further applications of the M-3 measure in the domain of manager selection.
The reconstitution effect
is one of the ways in which benchmarking affects markets and institutions. Honghui Chen, Gregory Noronha, and Vijay Singal estimate that investors in funds linked to the S&P 500 Index and the Russell 2000 Index may lose more than US$2 billion a year because of arbitrage around the time of index changes. They describe the arbitrage opportunity as an unintended consequence of the widespread evaluation of index fund managers on the basis of tracking error. Indexers rebalance their portfolios on the effective date in order to minimize tracking error; arbitrageurs buy the stocks to be added to the index when the addition is announced and sell the stocks to the indexers at a higher price on the effective date. In addition to suggesting that tracking error targets are inappropriate, the authors recommend policies that indexing firms might adopt to limit arbitrageurs’ front running of index funds.
Two papers center on calculating and interpreting the information ratio, a fundamentally important measure of risk-adjusted performance that compares the benchmark-relative excess return of an investment strategy with its excess risk. Neil Constable and Jeremy Armitage consider the interaction of information ratios with batting averages,
another frequently quoted measure of success defined as the percentage of investment decisions that led to a profit. The information ratio does not describe the series of successes and failures that led to the outcome it expresses, whereas the batting average contains only directional information. Constable and Armitage demonstrate that the two measures can be usefully combined to give investors a more comprehensive view of their choices. Thomas H. Goodwin rigorously sets forth how the information ratio is defined, annualized, and interpreted, including helpful accounts of its relationship to the Sharpe ratio and the t-statistic.
Roger G. Ibbotson and Paul D. Kaplan reprise the question raised by Brinson et al., namely, how much of the variability of returns across time is explained by policy (about 90 percent in the sample and over the period the authors studied), and additionally ask how much of the variation in returns among funds is explained by differences in policy (about 40 percent) and what portion of the return level is explained by policy return (on average about 100 percent).
Institutional investors, such as pension plans and charitable foundations, engage managers for specific roles within diversified, multiple-asset-class, multiple-manager investment programs, and they expect the managers to invest in accordance with their mandates. Several papers selected for this volume address key aspects of manager selection and monitoring. John G. Gallo and Larry J. Lockwood present the results of an empirical study of mutual funds that underwent management changes during the 1983-1991 period. They find significant differences in performance, risk, and investment style after the management changes. Louisa Wright Sellers describes how her organization, a well-established family office, selects and monitors hedge funds and other external managers and explains what she considers catalysts for changing managers. Philip Halpern, Nancy Calkins, and Tom Ruggels share lessons derived from their own experience and comment on three possible reasons why it is so difficult for institutional investors to succeed in selecting consistently outperforming managers: The evaluation criteria are inappropriate, the search process is flawed, or the number of truly skillful managers is so small that still greater effort is required to find them. In a paper that deserves to be recognized as a classic, Ronald N. Kahn and Andrew Rudd examine in-sample and out-of-sample track records of equity and fixed-income mutual funds for evidence of persistent performance. They find evidence of persistence of selection returns among fixed-income funds but no such evidence for equity funds, and they consider the investment implications of these findings. Kahn and Rudd advocate basing active manager selections on information that goes beyond historical performance.
John P. Meier focuses on determining whether managers are doing what is expected of them. Written from the total fund perspective, his paper Investment Performance Appraisal
is an integrative case study proficiently demonstrating the application of analytical approaches and the exercise of professional judgment in monitoring and evaluating an investment manager.
Susan Trammell’s informative, nontechnical report on developments in the risk management industry closes the performance appraisal section of this work.
GLOBAL INVESTMENT PERFORMANCE STANDARDS
Presenting investment results is, as we previously observed, one of the ways in which performance professionals contribute to their firms’ growth. In an industry that is based upon credibility and trust, however, the quality of performance presentations has implications greater than the fortunes of any one firm. Founded on the ideals of fair representation and full disclosure of an investment management firm’s performance history, the voluntary Global Investment Performance Standards contain provisions requiring certain practices and recommending others in such areas as input data, rate-of-return calculation methodologies, and performance presentations. Philip Lawton and W. Bruce Remington recount the history and explain the provisions of the GIPS standards, with attention to many practical issues that arise in the course of firmwide implementation. (The official text of the Standards in effect as of this writing is also included as an appendix in this volume.) The development of the GIPS standards continues apace as the GIPS Executive Committee and its technical subcommittees address outstanding and emerging issues, and we encourage readers seeking the most up-to-date guidance to visit the website at www.gipsstandards.org.
SUMMARY
This volume contains the insights of 56 contributors who have spent a great deal of their professional lives focusing on performance evaluation. And as a result, the material presented here is diverse, in depth, and of great practical value. We are delighted to present this resource to the performance measurement community. We hope it serves as a foundation for future innovation in analytical frameworks that address the growing needs of asset management firms and their clients for accurate, useful information about investment results.
Philip Lawton, CFA, CIPM
Todd Jankowski, CFA
PART I
OVERVIEW OF PERFORMANCE EVALUATION
CHAPTER 1
EVALUATING PORTFOLIO PERFORMANCE
Jeffery V. Bailey, CFA Thomas M. Richards, CFA David E. Tierney
The ex post analysis of investment performance stands as a prominent and ubiquitous feature of modern investment management practice. Investing involves making decisions that have readily quantifiable consequences and that, at least on the surface, lend themselves to elaborate dissection and review. We broadly refer to the measurement and assessment of the outcomes of these investment management decisions as performance evaluation. At the institutional investor level, and to a lesser (but growing) extent on the individual investor level, a large industry has developed to satisfy the demand for performance evaluation services. Although some observers contend that performance evaluation is misguided, frequently misapplied, or simply unattainable with any reasonable degree of statistical confidence, we believe that analytic techniques representing best practices can lead to valid insights about the sources of past returns, and such insights can be useful inputs for managing an investment program.
The purpose of this chapter is to provide an overview of current performance evaluation concepts and techniques. Our focus will be on how institutional investors—both fund sponsors and investment managers—conduct performance evaluation. Individual investors tend to use variations of the performance evaluation techniques employed by institutional investors. We define fund sponsors to be owners of large pools of investable assets, such as corporate and public pension funds, endowments, and foundations. These organizations typically retain multiple investment management firms deployed across a range of asset categories. Fund sponsors have the challenge of evaluating not only the performance of the individual managers, but also the investment results within the asset categories and for their total investment programs.
Reprinted from Managing Investment Portfolios: A Dynamic Process, 3rd Edition (John Wiley & Sons, 2007):717-780.
In the section titled The Importance of Performance Evaluation, we distinguish between the perspectives of the fund sponsor and the investment manager. In The Three Components of Performance Evaluation, we divide the broad subject of performance evaluation into three components: performance measurement, performance attribution, and performance appraisal. Under the topic of performance measurement, we discuss several methods of calculating portfolio performance. The next section introduces the concept of performance benchmarks. Turning to performance attribution, we consider the process of analyzing the sources of returns relative to a designated benchmark both from the total fund (fund sponsor) level and from the individual portfolio (investment manager) level. This is followed by performance appraisal, which deals with assessing investment skill. The chapter ends by addressing key issues in the practice of performance evaluation.
THE IMPORTANCE OF PERFORMANCE EVALUATION
Performance evaluation is important from the perspectives of both the fund sponsor and the investment manager.
The Fund Sponsor’s Perspective
A typical fund sponsor would consider its investment program incomplete without a thorough and regular evaluation of the fund’s performance relative to its investment objectives. Applied in a comprehensive manner, performance evaluation is more than a simple exercise in calculating rates of return. Rather, it provides an exhaustive quality control
check, emphasizing not only the performance of the fund and its constituent parts relative to objectives, but the sources of that relative performance as well.
Performance evaluation is part of the feedback step of the investment management process. As such, it should be an integral part of a fund’s investment policy and documented in its investment policy statement. As discussed in Ambachtsheer (1986) and Ellis (1985), investment policy itself is a combination of philosophy and planning. On the one hand, it expresses the fund sponsor’s attitudes toward a number of important investment management issues, such as the fund’s mission, the fund sponsor’s risk tolerance, the fund’s investment objectives, and so on. On the other hand, investment policy is a form of long-term strategic planning. It defines the specific goals that the fund sponsor expects the fund to accomplish, and it describes how the fund sponsor foresees the realization of those goals.
Investment policy gives an investment program a sense of direction and discipline. Performance evaluation enhances the effectiveness of a fund’s investment policy by acting as a feedback and control mechanism. It identifies an investment program’s strengths and weaknesses and attributes the fund’s investment results to various key decisions. It assists the fund sponsor in reaffirming a commitment to successful investment strategies, and it helps to focus attention on poorly performing operations. Moreover, it provides evidence to fund trustees, who ultimately bear fiduciary responsibility for the fund’s viability, that the investment program is being conducted in an appropriate and effective manner.
Fund sponsors are venturing into nontraditional asset categories and hiring a larger assortment of managers exhibiting unique investment styles, with the addition of hedge fund managers representing the latest and perhaps most complex example of this trend. Some fund sponsors are taking more investment decisions into their own hands, such as tactical asset allocation and style timing. Others are taking a quite different direction, giving their managers broad discretion to make asset allocation and security selection decisions. As a consequence of these developments, alert trustee boards are demanding more information from their investment staffs. The staffs, in turn, are seeking to better understand the extent of their own contributions and those of the funds’ investment managers to the funds’ investment results. The increased complexity of institutional investment management has brought a correspondingly greater need for sophisticated performance evaluation from the fund sponsor’s perspective.
The Investment Manager’s Perspective
Investment managers have various incentives to evaluate the performance of the portfolios that they manage for their clients. Virtually all fund sponsors insist that their managers offer some type of accounting of portfolio investment results. In many cases, performance evaluation conducted by the investment manager simply takes the form of reporting investment returns, perhaps presented alongside the returns of some designated benchmark. Other clients may insist on more sophisticated analyses, which the managers may produce in-house or acquire from a third party.
Some investment managers may seriously wish to investigate the effectiveness of various elements of their investment processes and examine the relative contributions of those elements. Managing investment portfolios involves a complex set of decision-making procedures. For example, an equity manager must make decisions about which stocks to hold, when to transact in those stocks, how much to allocate to various economic sectors, and how to allocate funds between stocks and cash. Numerous analysts and portfolio managers may be involved in determining a portfolio’s composition. Just as in the case of the fund sponsor, performance evaluation can serve as a feedback and control loop, helping to monitor the proficiency of various aspects of the portfolio construction process.
THE THREE COMPONENTS OF PERFORMANCE EVALUATION
In light of the subject’s importance to fund sponsors and investment managers alike, we want to consider the primary questions that performance evaluation seeks to address. In discussing performance evaluation we shall use the term account to refer generically to one or more portfolios of securities, managed by one or more investment management organizations. Thus, at one end of the spectrum, an account might indicate a single portfolio invested by a single manager. At the other end, an account could mean a fund sponsor’s total fund, which might involve numerous portfolios invested by many different managers across multiple asset categories. In between, it might include all of a fund sponsor’s assets in a particular asset category or the aggregate of all of the portfolios managed by an investment manager according to a particular mandate. The basic performance evaluation concepts are the same, regardless of the account’s composition.
With the definition of an account in mind, three questions naturally arise in examining the investment performance of an account:
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?
In somewhat simplistic terms, these questions constitute the three primary issues of performance evaluation. The first issue is addressed by performance measurement, which calculates rates of return based on investment-related changes in an account’s value over specified time periods. Performance attribution deals with the second issue. It extends the results of performance measurement to investigate both the sources of the account’s performance relative to a specific investment benchmark and the importance of those sources. Finally, performance appraisal tackles the third question. It attempts to draw conclusions concerning the quality (that is, the magnitude and consistency) of the account’s relative performance.
PERFORMANCE MEASUREMENT
To many investors, performance measurement and performance evaluation are synonymous. However, according to our classification, performance measurement is a component of performance evaluation. Performance measurement is the relatively simple procedure of calculating returns for an account. Performance evaluation, on the other hand, encompasses the broader and much more complex task of placing those investment results in the context of the account’s investment objectives.
Performance measurement is the first step in the performance evaluation process. Yet it is a critical step, because to be of value, performance evaluation requires accurate and timely rate-of-return information. Therefore, we must fully understand how to compute an account’s returns before advancing to more involved performance evaluation issues.
Performance Measurement without Intraperiod 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.¹ (External cash flows refer to contributions and withdrawals made to and from an account, as opposed to internal cash flows such as dividends and interest payments.) Therefore, a rate of return measures the relative change in the account’s value due solely to investment-related sources, namely capital appreciation or depreciation and income. The mere addition or subtraction of assets to or from the account by the account’s owner should not affect the rate of return. Of course, in the simplest case, the account would experience no external cash flows. In that situation, the account’s rate of return during evaluation period t equals the market value (MV1) at the end of the period less the market value at the beginning of the period (MV0), divided by the beginning market value.² That is,
(1.1)
002Example 1.1 illustrates the use of Equation 1.1.
EXAMPLE 1.1 Rate-of-Return Calculations When There Are No External Cash Flows
Winter Asset Management manages institutional and individual accounts, including the account of the Mientkiewicz family. The Mientkiewicz account was initially valued at $1,000,000. One month later it was worth $1,080,000. Assuming no external cash flows and the reinvestment of all income, applying Equation 1.1, the return on the Mientkiewicz account for the month is
003Fund sponsors occasionally (and in some cases frequently) add and subtract cash to and from their managers’ accounts. These external cash flows complicate rate-of-return calculations. The rate-of-return algorithm must deal not only with the investment earnings on the initial assets in the account, but also with the earnings on any additional assets added to or subtracted from the account during the evaluation period. At the same time, the algorithm must exclude the direct impact of the external cash flows on the account’s value.
An account’s rate of return may still be computed in a straightforward fashion if the external cash flows occur at the beginning or the end of the measurement period when the account is valued. If a contribution is received at the start of the period, it should be added to (or, in the case of a withdrawal, subtracted from) the account’s beginning value when calculating the account’s rate of return for that period. The external cash flow will be invested alongside the rest of the account for the full length of the evaluation period and will have the same investment-related impact on the account’s ending market value and, hence, should receive a full weighting. Thus, the account’s return in the presence of an external cash flow at the beginning of the evaluation period should be calculated as
(1.2)
004If a contribution is received at the end of the evaluation period, it should be subtracted from (or, in the case of a withdrawal, added to) the account’s ending value. The external cash flow had no opportunity to affect the investment-related value of the account, and hence it should be ignored.
(1.3)
005EXAMPLE 1.2 Rate-of-Return Calculations When External Cash Flows Occur at the Beginning or End of an Evaluation Period
Returning to the example of the Mientkiewicz account, assume that the account received a $50,000 contribution at the beginning of the month. Further, the account’s ending and beginning market values equal the same amounts previously stated, $1,080,000 and $1,000,000, respectively. Applying Equation 1.2, the rate of return for the month is therefore
006If the contribution had occurred at month-end, using Equation 1.3, the account’s return would be
007Both returns are less than the 8 percent return reported when no external cash flows took place because we are holding the ending account value fixed at $1,080,000. In the case of the beginning-of-period contribution, the account achieves an ending value of $1,080,000 on a beginning value that is higher than in Example 1.1, so its return must be less than 8 percent. In the case of the end-of-period contribution, the return is lower than 8 percent because the ending value of $1,080,000 is assumed to reflect an end-of-period contribution that is removed in calculating the return. In both instances, a portion of the account’s change in value from $1,000,000 to $1,080,000 resulted from the contribution; in Example 1.1, by contrast, the change in value resulted entirely from positive investment performance by the account.³
The ease and accuracy of calculating returns when external cash flows occur, if those flows take place at the beginning or end of an evaluation period, lead to an important practical recommendation: Whenever possible, a fund sponsor should make contributions to, or withdrawals from, an account at the end of an evaluation period (or equivalently, the beginning of the next evaluation period) when the account is valued. In the case of accounts that are valued on a daily basis, the issue is trivial. However, despite the increasing prevalence of daily valued accounts, many accounts are still valued on an audited basis once a month (or possibly less frequently), and the owners of those accounts should be aware of the potential for rate-of-return distortions caused by intraperiod external cash flows.
What does happen when external cash flows occur between the beginning and the end of an evaluation period? The simple comparison of the account’s value relative to the account’s beginning value must be abandoned in favor of more intricate methods.
Total Rate of Return
Interestingly, widely accepted solutions to the problem of measuring returns in the presence of intraperiod external cash flows are relatively recent developments. Prior to the 1960s, the issue received little attention, largely because the prevailing performance measures were unaffected by such flows. Performance was typically measured on an income-only basis, thus excluding the impact of capital appreciation. For example, current yield (income-to-price) and yield-to-maturity were commonly quoted return measures.
The emphasis on income-related return measures was due to several factors:
• Portfolio management emphasis on fixed-income assets. Particularly in the low-volatility interest rate environment that existed prior to the late 1970s, bond prices tended to be stable. Generally high allocations to fixed-income assets made income the primary source of investment-related wealth production for many investors.
• Limited computing power. Accurately accounting for external cash flows when calculating rates of return that include capital appreciation requires the use of computers. Access to the necessary computing resources was not readily available. The income-related return measures were simpler and could be performed by hand.
• Less competitive investment environment. Investors, as a whole, were less sophisticated and less demanding of accurate performance measures.
As portfolio allocations to equity securities increased, as computing costs declined, and as investors (particularly larger institutional investors) came to focus more intently on the performance of their portfolios, the demand grew for rate-of-return measures that correctly incorporated all aspects of an account’s investment-related increase in wealth. This demand led to the adoption of total rate of return as the generally accepted measure of investment performance.
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 a dollar of wealth is equally meaningful to the investor whether that wealth is generated by the secure income from a 90-day Treasury bill or by the unrealized appreciation in the price of a share of common stock.
Acceptance of the total rate of return as the primary measure of investment performance was assured by a seminal study performed in 1968 by the Bank Administration Institute (BAI). The BAI study (which we refer to again shortly) was the first comprehensive research conducted on the issue of performance measurement. Among its many important contributions, the study strongly endorsed the use of the total rate of return as the only valid measure of investment performance. For our purposes, henceforth, it will be assumed that rate of return refers to the total rate of return, unless otherwise specified.
The Time-Weighted Rate of Return
We now return to considering the calculation of rates of return in the context of intraperiod external cash flows. To fully appreciate the issue at hand, we must think clearly about the meaning of rate of return.
In essence, the rate of return on an account is the investment-related growth rate in the account’s value over the evaluation period. However, we can envision this growth rate being applied to a single dollar invested in the account at the start of the evaluation period or to an average
amount of dollars invested in the account over the evaluation period. This subtle but important distinction leads to two different measures: the time-weighted and the money-weighted rates 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 trivial; it is simply the application of Equation 1.1, in which the change in the account’s value is expressed relative to its beginning value. If external cash flows do occur, then the TWR requires computing a set of subperiod returns (with the number of subperiods equaling one plus the number of dates on which external cash flows occur). These subperiod returns must then be linked together in computing the TWR for the entire evaluation period.
EXAMPLE 1.3 Calculating Subperiod Rates of Return
Returning again to the Mientkiewicz account, let us assume that the account received two cash flows during month t: a contribution of $30,000 on day 5 and a contribution of $20,000 on day 16. Further, assume that we use a daily pricing system that provides us with values of the Mientkiewicz account (inclusive of the contributions) of $1,045,000 and $1,060,000 on days 5 and 16 of the month, respectively. We can then calculate three separate subperiod returns using the rate-of-return computation applicable to situations when external cash flows occur at the end of an evaluation period, as given by Equation 1.3:
008For subperiod 1:
009For subperiod 2:
010For subperiod 3:
011The subperiod returns can be combined through a process called chain-linking. Chain-linking involves first adding 1 to the (decimal) rate of return for each subperiod to create a set of wealth relatives. A wealth relative can be thought of as the ending value of one unit of money (for example, one dollar) invested at each subperiod’s rate of return. Next, the wealth relatives are multiplied together to produce a cumulative wealth relative for the full period, and 1 is subtracted from the result to obtain the TWR. Note that this process of chain-linking implicitly assumes that the initially invested dollar and earnings on that dollar are reinvested (or compounded) from one subperiod to the next. The cumulative wealth relative from the chain-linking of the subperiod wealth relatives can be interpreted as the ending value of one dollar invested in the account at the beginning of the evaluation period. Subtracting 1 from this wealth relative produces the TWR for the account:
(1.4)
012Note that unless the subperiods constitute a year, the time-weighted rate of return will not be expressed as an annual rate. Example 1.4 illustrates the calculation of a time-weighted rate of return.
EXAMPLE 1.4 Calculating the TWR
Continuing with the Mientkiewicz account, its TWR is
013The TWR derives its name from the fact that each subperiod return within the full evaluation period receives a weight proportional to the length of the subperiod relative to the length of the full evaluation period. That relationship becomes apparent if each subperiod return is expressed as the cumulative return over smaller time units. In the Mientkiewicz account example, the return in the first subperiod is 0.015 over five days. On a daily compounded basis that return is 0.0030[=(1 + 0.015)¹/⁵ - 1]. Performing the same calculation for the other two subperiods yields the following:
014From this expression for the TWR, we can see that the subperiods 1, 2, and 3 receive compounding weights
of 5/30, 11/30, and 14/30, respectively.
The 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. Of importance for performance measurement, the MWR is the growth rate that will link the ending value of the account to its beginning value plus all intermediate cash flows. With MV1 and MV0 the values of the account at the end and beginning of the evaluation period, respectively, in equation form the MWR is the growth rate R that solves
(1.5)
015where m = number of time units in the evaluation period (for example, the number of days in the month)
CFi = the i th cash flow
L(i ) = number of time units by which the i th cash flow is separated from the beginning of the evaluation period
Note that R is expressed as the return per unit of time composing the evaluation period. For example, in the case of monthly performance measurement, where the constituent time unit is one day, R would be the daily MWR of the account. Extending this thought, [(1 + R)m -1] can be seen to be the account’s MWR for the entire evaluation period, as (1 + R)m = (1 + rmwr). Therefore, in the case of no external cash flows, with some algebraic manipulation Equation 1.4 reduces to Equation 1.1, the simple expression for rate of return:
016EXAMPLE 1.5 Calculating the MWR
Consider the Mientkiewicz account again. Its MWR is found by solving the following equation for R:
$1,080,000 = $1,000,000(1 + R)³⁰ + $30,000(1 + R)³⁰-⁵ + $20,000(1 + R)³⁰-¹⁶
There exists no closed-form solution for R. That is, Equation 1.4 cannot be manipulated to isolate R on the left-hand side. Consequently, R must be solved iteratively through a trial-and-error process. In our example, we begin with an initial guess of R = 0.001. The right-hand side of the equation becomes $1,081,480. Thus our initial guess is too high and must be lowered. Next, try a value R = 0.0007. In this case the right-hand side now equals $1,071,941. Therefore, our second guess is too low.
We can continue this process. Eventually, we will arrive at the correct value for R, which for the Mientkiewicz account is 0.0009536. Remember that this value is the Mientkiewicz account’s daily rate of return during the month. Expressed on a monthly basis, the MWR is 0.0290 [=(1 + 0.0009536)³⁰ - 1], or 2.90%.
As one might expect, a computer is best suited to perform the repetitious task of calculating the MWR. Spreadsheet software to perform these computations is readily available.
TWR versus MWR
The MWR represents the average growth rate of all money invested in an account, while the TWR represents the growth of a single unit of money invested in the account. Consequently, the MWR is sensitive to the size and timing of external cash flows to and from the account, while the TWR is unaffected by these flows. Under normal
conditions, these two return measures will produce similar results. In the example of the Mientkiewicz