CIPM Principles Review Course

3/2/2017

Reading: Investment Performance Appraisal

Active Management Skill LOS A • The ability of a portfolio manager to add value on a risk‐adjusted basis through investment analysis and insights. • Contrast Active and Passive Management – Passive = Indexing – Skill is in the portfolio construction, not security selection. – Active manager skill is found in asset allocation, and sector and/or security specific insights.

1 3/2/2017

Gross vs. Net Perf. Appraisal LOS B

• What the reading says: – Performance Appraisal should be conducted on the client’s return. (i.e., the net return) • Fees differ among managers. Some charge for superior service. • Some management fees are fixed, and expense ratios are inversely related to AUM. • Better managers may charge more. – Expenses for active management are certain, while the value‐added for active management is uncertain. • What Cairn says: • Management fees add “noise” to the analysis. • Use net returns when comparing rates of return, and deciding if the manager is “worth it.” • Use gross returns when identifying manager skill, and measuring volatility or relative risk measures. • For risk‐adjusted measures, be sure to be consistent in use of gross or net.

Luck vs. Skill LOS C A cautionary statement: • As your population increases its knowledge level, the difference between those with skill and those without diminishes. • Past performance is not indicative of future results. • Skill may come from consistency, not necessarily past outperformance.

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Risk: A Review LOS D • Risk = Uncertainty of outcomes • Investors cannot make decisions based on returns alone: – Investment A: 100% probability of 2% return – Investment B: 50% probability of ‐2% return, 50% probability of 6% return.

Risk: A Review LOS E Types of Risk: • Total Risk (aka “Stand‐Alone” risk): Use Standard Deviation (σ) – Systematic (“Non‐diversifiable”) risk: Use Beta – Non‐Systematic (“Diversifiable”) risk • Downside Risk: Use downside deviation, VaR, etc.

3 3/2/2017

Sharpe Ratio LOS F‐H • Excess Return to (Total) Variability: Sharpe Ratio = • Identifies the fund that offers the most excess return, per unit of volatility. • More appropriate for evaluating the investor’s entire portfolio. • Make sure you compare apples‐to‐apples: • Annualize by SR × √n, where n = # of periods in 1 year. 7

Modigliani & Modigliani Ratio LOS F‐H

• M2 Risk‐Adjusted Performance =

Uses Sharpe ratio, scaled to the same volatility as the Market Turns the Sharpe ratio back into a return statistic

4 3/2/2017

Treynor Ratio LOS F‐H

• Treynor Ratio =

 Excess Return per unit of Systematic Risk  Uses Beta as risk; less useful when analyzing a total portfolio.

Alpha LOS F‐H

• Recall CAPM: E(R) = RFR + β(RMkt –RFR)

• Alpha = Actual Return – Expected Return

• Jensen’s Alpha = Actual Return – E(R)CAPM • Realized Alpha = Actual Return – Required Return

• Do not confuse with Active Return: Actual Return – BM Return

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Jensen’s Alpha Challenges LOS J

Jensen’s Alpha = Actual Return – [RFR + β(RMkt –RFR)] • Beta only captures systematic risk. May not be appropriate for a single‐fund (non‐diversified) investor. • May be misleading if manager tries to “time the market,” as Beta may be artificially low. • Only uses one risk‐factor (beta).

Information & Appraisal Ratio LOS F‐H

• Information Ratio (Active Return) = = Excess Return = Active Return Excess Risk Tracking Error

 Excess Return over a benchmark  Risk measured as deviation from the benchmark

• Treynor‐Black Appraisal Ratio =  Non‐systematic risk  Based on linear regression assumptions.

6 3/2/2017

Information Ratio LOS K Fundamental Law of Active Management

Information Ratio = Information Coefficient × √n • Information Coefficient = correlation of expected & actual returns • N = market breadth (security universe) • Conceptually, this is manager skill times the number of opportunities to use that skill. • There is also assumed to be a trade‐off between IC and n. While a larger universe makes a larger IR, it would also likely lead to a lower IC.

Modification: IR = IC × √n × TC • Transfer Coefficient is the speed in which the manager can transfer opportunities into action.

Downside Risk LOS I & L

• Minimum Acceptable Return (“MAR”): specified by user. • Zero, inflation, risk‐free rate, index, actuarial rate, etc. • Downside Deviation: Similar to standard deviation, but use

only those returns falling below the MAR. ∑

• Sortino Ratio =

7 3/2/2017

Drawdown LOS L

• Measures losses after a peak:

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 9% 13% 5% ‐4% 10% ‐15% 9% ‐4% ‐6% ‐7% 3% ‐10% 1,090 1,232 1,293 1,242 1,366 1,161 1,265 1,215 1,142 1,062 1,094 984

1,500

1,300

1,100

900 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Maximum Drawdown LOS L

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 9% 13% 5% ‐4% 10% ‐15% 9% ‐4% ‐6% ‐7% 3% ‐10% 1,090 1,232 1,293 1,242 1,366 1,161 1,265 1,215 1,142 1,062 1,094 984

DD1: 1,293 – 1,242 51 ‐51/1293 ‐3.94% DD2: 1,366 – 1,161 205 ‐205/1366 ‐15.01% • Drawdowns: DD3: 1,265 – 1,062 203 ‐203/1265 ‐16.05% DD4: 1,094 – 984 110 ‐110/1094 ‐10.05%

• Maximum Drawdown: 984 – 1,366 –382 28% ,

8 3/2/2017

Calmar Ratio LOS L

= | |

.% • Using the data from the previous example… = 0.06 %

Note: This should really use 3‐years of data to be meaningful.

Pros & Cons: • Often used to evaluate hedge funds, as this is more suitable for illiquid investments • Sensitive to outliers • Also implies that investment is sold at the worst possible time, which may not be true.

Multi‐Factor Models LOS M

Single‐Factor models: use β or σ

* Value = low P/BV Multifactor models: BV can be negative  Value = high BV/P • Fama & French 3‐Factor Model:

– E(R) = RFR + β(RMkt –RFR) + βC(RSC –RLC) + βS(RHBV –RLBV) CAPM Cap Premium Style Premium* • Carhart 4‐Factor Model:

– E(R) = RFR + β(RMkt –RFR) + βC(RSC –RLC) + βS(RHBV –RLBV) + βS(RPHP –RPLP)

Momentum Premium 18

9 3/2/2017

Methods for Appraisal LOS N How do we derive the style of a portfolio?

• Returns‐Based: Regression of portfolio and various benchmarks, and look for high correlation. – Minimal data needed – Backward‐looking. May not identify changing trends. • Holdings‐Based: Identify salient characteristics of the current portfolio. – Data intensive. – Requires frequent and regular updating to spot drift. – Grinblatt‐Titman is an example.