Investments Academic Year 2004 - 2005 Lectures n° 9 & 10 Performance Measurement

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. 1. Performance Measurement • 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

7. 1. Performance Measurement • 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

8. 1. Performance Measurement • 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

9. 1. Performance Measurement 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).

10. 1. Performance Measurement 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?

11. 1. Performance Measurement • 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 αwith 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 managementitself (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. 3. Performance Attribution • 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.

18. 3. Performance Attribution • 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 wBi is the weight of the asset class i in the benchmark portfolio, and rBi 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?