Performance Measurement in Finance : Firms, Funds and Managers

PERFORMANCE MEASUREMENT IN FINANCE Butterworth-Heinemann Finance aims and objectives • books based on the work of financial market practitioners and academics • presenting cutting edge research to the professional/practitioner market • combining intellectual rigour and practical application • covering the interaction between mathematical theory and financial practice • to improve portfolio performance, risk management and trading book performance • covering quantitative techniques market Brokers/Traders; Actuaries; Consultants; Asset Managers; Fund Managers; Regulators; Central Bankers; Treasury Officials; Technical Analysts; and Academics for Masters in Finance and MBA market. series titles Return Distributions in Finance Derivative Instruments: theory, valuation, analysis Managing Downside Risk in Financial Markets: theory, practice and implementation Economics for Financial Markets Global Tactical Asset Allocation: theory and practice Performance Measurement in Finance: firms, funds and managers Real R&D Options series editor Dr Stephen Satchell Dr Satchell is Reader in Financial Econometrics at Trinity College, Cambridge; Visiting Professor at Birkbeck College, City University Business School and University of Technology, Sydney. He also works in a consultative capacity to many firms, and edits the journal Derivatives: use, trading and regulations. PERFORMANCE MEASUREMENT IN FINANCE Firms, Funds and Managers Edited by John Knight Stephen Satchell OXFORD AMSTERDAM BOSTON LONDON NEW YORK PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO Butterworth-Heinemann An imprint of Elsevier Science Linacre House, Jordan Hill, Oxford OX2 8DP 225 Wildwood Avenue, Woburn MA 01801-2041 First published 2002 Copyright 2002, Elsevier Science Ltd. All rights reserved No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher British Library Cataloguing in Publication Data Performance measurement in finance: firms, funds and managers. – (Quantitative finance series) 1. Rate of return – Evaluation 2. Portfolio management – Evaluation 3. Investment analysis 4. Investment advisors – Rating of 5. Investments – Econometric models I. Knight, John II. Satchell, Stephen E. 332.6 Library of Congress Cataloguing in Publication Data A catalogue record for this book is available from the Library of Congress ISBN 0 7506 5026 5 For information on all Butterworth-Heinemann finance publications visit our website at www.bh.com/finance Typeset by Laserwords Private Limited, Chennai, India Printed and bound in Great Britain 1 The financial economics of performance measurement............................ 1 INTRODUCTION ...................................................... 1 THE SHARPE RATIO............................................... 4 THE TREYNOR MEASURE ..................................... 4 THE JENSEN MEASURE ........................................ 5 THE TREYNOR MAZUY MEASURE ..................... 11 PARAMETRIC AND NON-PARAMETRIC TESTS OF MARKET TIMING ABILITIES ............................. 13 THE POSITIVE PERIOD WEIGHTING MEASURE ................................................................ 19 CONDITIONAL PERFORMANCE EVALUATION .... 20 THE 4-INDEX MODEL OF PERFORMANCE EVALUATION........................................................... 22 CARHARTS 4-FACTOR MODEL ............................ 23 RISK-ADJUSTED PERFORMANCE ........................ 24 STYLE/RISK-ADJUSTED PERFORMANCE............ 25 THE SHARPE STYLE ANALYSIS............................ 26 THREE INNOVATIVE MEASURES THAT CAPTURE THE DIFFERENT FACES OF A MANAGERS SUPERIOR ABILITIES ...................... 27 DYNAMICS OF PORTFOLIO WEIGHTS: PASSIVE AND ACTIVE MANAGEMENT ................. 31 THE PORTFOLIO CHANGE MEASURE ................. 34 THE MOMENTUM MEASURES............................... 38 THE HERDING MEASURES.................................... 40 STOCKHOLDINGS AND TRADES MEASURE ....... 43 CONCLUSION.......................................................... 46 REFERENCES ......................................................... 47 2 Performance evaluation: an econometric survey........................................ INTERNATIONAL EMPIRICAL RESULTS OF PERFORMANCE...................................................... 67 CONCLUSION AND FUTURE RESEARCH ............ 69 REFERENCES ......................................................... 70 3 Distribution of returns generated by stochastic exposure: an application to VaR calculation in the futures markets......... INTRODUCTION ...................................................... 74 DISTRIBUTION OF PERFORMANCE RETURNS... 75 IMPLICATIONS FOR VAR CALCULATIONS........... 78 ACTIVELY TRADING THE FUTURES MARKETS ................................................................ 79 CONCLUSION.......................................................... 88 ACKNOWLEDGEMENTS......................................... 89 REFERENCES ......................................................... 89 4 A dynamic trading approach to performance evaluation................................. INTRODUCTION...................................................... TRADITIONAL PERFORMANCE MEASURES........ 92 A NEW PERFORMANCE MEASURE ...................... 94 SAMPLING ERROR ................................................. 97 HEDGE FUNDS AND HEDGE FUND RETURNS.... 99 EVALUATION OF HEDGE FUND INDEX PERFORMANCE...................................................... 102 CONCLUSION.......................................................... 105 REFERENCES ......................................................... 106 5 Performance benchmarks for institutional investors: measuring, monitoring and modifying investment behaviour......................................................... INTRODUCTION ...................................................... 109 WHAT BENCHMARKS ARE CURRENTLY USED BY INSTITUTIONAL INVESTORS? .............. 109 WHAT ARE THE ALTERNATIVES? ........................ 124 BENCHMARKS BASED ON LIABILITIES ................ 128 WHAT HAPPENS IN OTHER COUNTRIES? .......... 135 CONCLUSION.......................................................... 137 APPENDIX: DERIVING THE POWER FUNCTION ............................................................... 138 REFERENCES ......................................................... 140 6 Simulation as a means of portfolio performance evaluation................................. INTRODUCTION ...................................................... 143 OBJECTIVES OF SIMULATIONS ............................ 145 METHODOLOGY ..................................................... 146 ADVANTAGES OF SIMULATION ............................ 146 EXAMPLES OF PORTFOLIO SIMULATION ........... 147 APPLICATIONS ....................................................... 157 SUMMARY AND CONCLUSIONS ........................... 159 7 An analysis of performance measures using copulae.................................................. INTRODUCTION ...................................................... 161 PERFORMANCE MEASURES ................................ 162 EMPIRICAL RESULTS............................................. 166 COPULAE ................................................................ 180 AN AGGREGATE PERFORMANCE MEASURE ..... 193 CONCLUSIONS ....................................................... 195 REFERENCES ......................................................... 196 8 A clinical analysis of a professionally managed portfolio........................................... INTRODUCTION...................................................... THE PORTFOLIO..................................................... 199 THE DATA ................................................................ 200 THE ANALYSES ...................................................... 201 CONCLUSIONS ....................................................... 226 ACKNOWLEDGEMENT ........................................... 226 REFERENCES AND FURTHER READING ............. 227 9 The intertemporal performance of investment opportunity sets.......................... INTRODUCTION...................................................... INVESTMENT OPPORTUNITY SETS WITH CONTINUOUS RISK STRUCTURES ...................... 232 MEASURING THE PERFORMANCE OF INVESTMENT OPPORTUNITY SETS ..................... 234 RATIONALITY RESTRICTIONS ON CONDITIONAL RETURN MOMENTS AND GMM ESTIMATION............................................................ 238 EMPIRICAL ANALYSES .......................................... 246 CONCLUDING REMARKS....................................... 255 ACKNOWLEDGEMENTS......................................... 256 REFERENCES AND FURTHER READING ............. 256 10 Performance measurement of portfolio risk based on orthant probabilities............... INTRODUCTION ...................................................... 262 ORTHANT PROBABILITY DESCRIPTION OF PORTFOLIO DISTRIBUTIONS ................................ 264 IMPLICATIONS FOR ABSOLUTE AND RELATIVE RISK....................................................... 271 EMPIRICAL

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