Certificate in Investment Performance Measurement
Protecting Investors in the Good TimesPhilip Lawton, PhD, CFA, CMA, CIPM
1 © CFA Institute 2009
Agenda
ll k d h f h• Two Bull Markets and their Aftermath
• Manager Selection
• Manager Monitoring• Manager Monitoring
2 © CFA Institute 2009
The Elements of Performance Evaluation
• Measurement:Wh t th t’ f ?• What was the account’s performance?
• Attribution:• Why did the account produce the observed
performance?
• Appraisal:• Was the account’s performance due to skill or luck?• Was the account s performance due to skill or luck?
• Or fraud?
• Performance evaluation techniques:• Are not designed to detect fraud
• But they may raise timely questions
3 © CFA Institute 2009
S&P 500 Total Return Index Levels
2500
3000
2000
1000
1500
500
0
4 © CFA Institute 2009
The Bezzle
• The inventory of undiscovered embezzlement—the “bezzle” is also cyclicalbezzle —is also cyclical.
• “Just as the boom accelerated the rate of growth, so theJust as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery.”—John Kenneth Galbraith, The Great Crash: 1929
5 © CFA Institute 2009
Shrinking the Bezzle
250
300
2500
3000
200
250
2000
2500
Sta
tem
ents
Leve
l
215
1501500
and P
ublic
S
500 I
ndex
L
50
100
500
1000
SEC
New
s
S&
P
76
0
50
0
500
Jul 04 Jul 05 Jul 06 Jul 07 Jul 08 Jul 09
6 © CFA Institute 2009
Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09
Shrinking the Bezzle
Economic Downturn Accelerates Collapse of Ponzi SchemesEconomic Downturn Accelerates Collapse of Ponzi Schemes
By Del Quentin WilberWashington Post Staff Writer gFriday, June 12, 2009
…The FBI, which is handling about 20 such cases in the Washington region, has almost 500 open Ponzi investigations nationwide—up from about 300 in 2006, bureau officials said.
7 © CFA Institute 2009
Headliners
• 1994–2002:
• Enron
• WorldCom Issuers
• HealthSouth….
• 2003–2009:
• Madoff
• Stanford
ll
Advisors
• Donnelly….
8 © CFA Institute 2009
Manager Selection
• Analysis of Historical Returns
• Transparency and Investment Philosophy
• Independent Confirmation
• Risk Factors and Controls
9 © CFA Institute 2009
Monthly Returns
15.00%
S&P 500 USD‐LIBOR Manager
5.00%
10.00%
‐5.00%
0.00%
‐15.00%
‐10.00%
‐20.00%
10 © CFA Institute 2009
Descriptive Statistics
Mean Monthly Return
StandardDeviation Skewness KurtosisReturn Deviation Skewness Kurtosis
Manager 0.84% 0.71% 0.79 0.51
S&P 500 0.77% 4.12% –0.77 1.86
USD‐LIBOR 0.35% 0.13% –0.50 –0.95
11 © CFA Institute 2009
S&P 500 Distribution
-0.0718 0.0742
5.0%3.7%
90.0%89.4%
5.0%6.8%
14
S&P 500 Total Return
12
14
8
10
Input
N l
4
6Normal
0
2
5 2 5 1 5 0 5 1 5
12
-0.2
5
-0.2
-0.1
5
-0.1
-0.0
5 0
0.05 0.1
0.15
© CFA Institute 2009
Manager Distribution
-0.60 21.40
5.0%10.1%
90.0%86.5%
5.0%3.4%
70
Manager
50
60
30
40
50
Input
Normal
10
20
30 Normal
0
10
-10 -5
1E-1
4 5 10 15 20 25 30 35
13
1
Values in Thousandths
© CFA Institute 2009
Value‐Added PerformanceAnnual Returns
18%
20%
Value‐Added Manager USD‐LIBOR
14%.
16%
18%
10%
12%
4%
6%
8%
0%
2%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
14 © CFA Institute 2009
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Value‐Added Performance
Manager’s Returns minus USD‐LIBOR
From the Beginning ofTo the End of 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
2007 6.26 5.94 5.68 5.55 5.52 5.49 5.40 5.22 5.04 4.70 4.80 4.59 4.17 3.70 3.28 3.05 1.982006 6.53 6.21 5.94 5.83 5.82 5.82 5.75 5.58 5.43 5.09 5.26 5.11 4.72 4.26 3.94 4.132005 6.69 6.35 6.08 5.97 5.97 5.98 5.93 5.76 5.61 5.25 5.48 5.34 4.91 4.33 3.752004 6 91 6 56 6 28 6 17 6 20 6 24 6 20 6 05 5 92 5 55 5 92 5 87 5 48 4 902004 6.91 6.56 6.28 6.17 6.20 6.24 6.20 6.05 5.92 5.55 5.92 5.87 5.48 4.902003 7.07 6.70 6.41 6.30 6.35 6.41 6.40 6.25 6.13 5.72 6.26 6.36 6.072002 7.16 6.76 6.45 6.33 6.39 6.46 6.45 6.29 6.15 5.60 6.36 6.662001 7.20 6.77 6.42 6.29 6.34 6.42 6.41 6.19 5.97 5.05 6.052000 7.32 6.85 6.47 6.32 6.39 6.50 6.50 6.23 5.93 4.031999 7.69 7.21 6.81 6.70 6.87 7.12 7.33 7.34 7.841998 7 67 7 12 6 64 6 48 6 62 6 87 7 07 6 841998 7.67 7.12 6.64 6.48 6.62 6.87 7.07 6.841997 7.79 7.16 6.61 6.39 6.55 6.89 7.301996 7.87 7.13 6.43 6.08 6.18 6.491995 8.14 7.29 6.41 5.88 5.871994 8.71 7.76 6.68 5.891993 9.66 8.70 7.471992 10.79 9.951991 11.65
15 © CFA Institute 2009
Ex Post Risk Measures
Manager S&P 500 USD‐LIBOR
Semideviation(Monthly Basis) 0 44% 3 16% 0 11%(Monthly Basis) 0.44% 3.16% 0.11%
AnnualizedTracking Error — 14.14% 2.39%
AnnualizedAnnualized Information Ratio — 0.06 1.99
16 © CFA Institute 2009
Textbook Quality Control Chart (1)80% Confidence Interval80% Confidence Interval
Source: Jeffery V. Bailey, Thomas M. Richards, and David E. Tierney, “Evaluating Portfolio Performance,” Ch 1 i hili d dd k ki d f l i
17 © CFA Institute 2009
Chapter 1 in Philip Lawton and Todd Jankowski, eds., Investment Performance Measurement: Evaluating and Presenting Results (CFA Institute, 2009).
Textbook Quality Control Chart (2)80% Confidence Interval80% Confidence Interval
Source: Bailey, Richards, and Tierney, “Evaluating Portfolio Performance” (CFA Institute, 2009)
18 © CFA Institute 2009
Actual Quality Control Chart99% Confidence Interval99% Confidence Interval
15%
Manager Annual Excess Return Manager Cum. Annualized Excess Return
Upper Edge of Confidence Band Lower Edge of Confidence Band
10%
15%
eturn
5%
ualized
Excess Re
‐5%
0%
Cumulative An
n
‐10%
5 10 15December 1990—October 2008
19 © CFA Institute 2009
Transparency
The Asset Manager Code of Conduct (2nd ed., 2009)
F. Disclosures
Managers must…
4. Disclose the following:c. The investment process, including information regarding lock‐up
periods strategies risk factors and use of derivatives and leverageperiods, strategies, risk factors, and use of derivatives and leverage.
20 © CFA Institute 2009
Transparency
CFA Institute Standards of Professional Conduct
B. Communication with Clients and Prospective Clients.
Members and Candidates must…Members and Candidates must…
1. Disclose to clients and prospective clients the basic format and general principles of the investment processes used to analyze investments,principles of the investment processes used to analyze investments, select securities, and construct portfolios and must promptly disclose any changes that might materially affect those processes.
21 © CFA Institute 2009
Transparency
“H i h i d ?”“How is the gain made?”
“To tell that would ruin me. That known, everyone would be going into h b i d i ld b d A ll I h dthe business, and it would be overdone. A secret, a mystery—all I have to do with you is to receive your confidence, and all you have to do with me is, in due time, to receive it back, thrice paid in trebling profits.”
Herman Melville, The Confidence‐Man: His Masquerade (1857)
22 © CFA Institute 2009
An Investment Philosophy
A f b li f di h i i i h i d h i i• A set of beliefs regarding the security pricing mechanism and what it is about that mechanism that sometimes causes securities to be mispriced.
• A set of beliefs regarding the manager’s competitive advantage in• A set of beliefs regarding the manager s competitive advantage in exploiting these mispricings.
• A thesis about how these beliefs can be exploited to generate alpha (anA thesis about how these beliefs can be exploited to generate alpha (an “alpha thesis”).
Source: John R. Minahan, “The Role of Investment Philosophy in Evaluating Investment Managers: A Consultant’s Perspective on Distinguishing Alpha from Noise,” The Journal of Investing, Summer 2006, pp. 6–11.
23 © CFA Institute 2009
The Investment Philosophy Test• What is the thesis (or theses) of how the product generates alpha?
• What is the conceptual basis of the alpha thesis?
• What is the manager’s view about the security pricing mechanism that underlies the thesis?
• What is the relationship of this view to capital market theory?
• What is the manager’s competitive advantage in executing the thesis?
• What is the evidence that alpha has been generated by successful execution of the alpha thesis and not a mismatched benchmark or luck? Ifexecution of the alpha thesis and not a mismatched benchmark or luck? If evidence is lacking, how does the manager convince him‐ or herself that the thesis is sound?
• How does the manager think about the possible need for the alpha thesis g p pto change over time?
Source: John R. Minahan, “The Role of Investment Philosophy in Evaluating Investment Managers: A , p y g gConsultant’s Perspective on Distinguishing Alpha from Noise,” The Journal of Investing, Summer 2006, pp. 6–11.
24 © CFA Institute 2009
Passing the Investment Philosophy Test
“The investment philosophy test is not easy for a manager that doesn’t haveThe investment philosophy test is not easy for a manager that doesn t have answers. Even if a marketer were very creative in reverse engineering a story that seemed to answer the questions, it would be very unlikely for such a story to hold up under cross examination, especially if the evaluator cross‐references the story with analysis of the manager’s holdings.”
Source: John R. Minahan, “The Role of Investment Philosophy in Evaluating Investment Managers: A , p y g gConsultant’s Perspective on Distinguishing Alpha from Noise,” The Journal of Investing, Summer 2006, pp. 10.
25 © CFA Institute 2009
Independent Confirmation
The Asset Manager Code of Conduct (2nd ed., 2009)
D Risk Management Compliance and SupportD. Risk Management, Compliance, and Support
Managers must…
3. Ensure that portfolio information provided to clients by the Manager is accurate and complete and arrange for independent third‐party confirmation or review of such information….p y
26 © CFA Institute 2009
Independent Confirmation
P bli A• Public Accountant
• Custodian
• Global Investment Performance Standards (GIPS®) Verifier
27 © CFA Institute 2009
Independent Confirmation
• GIPS Verification Tests:• Whether the firm has complied with all the composite construction
requirements of the GIPS standards on a firm‐wide basis, and
• Whether the firm’s processes and procedures are designed to calculate and present performance results in compliance with the GIPS standards.
• Verification does not guarantee that investment results are presented fairly, accurately, and completely.
• A Performance Examination of a specific composite performance presentation, conducted by a reputable verifier, gives prospective investors somewhat greater assurance about the reported returns.
28 © CFA Institute 2009
Risk Factors and Controls
The Asset Manager Code of Conduct (2nd ed., 2009)
D. Risk Management, Compliance, and Support
Managers must…
6. Establish a business‐continuity plan to address disaster recovery or periodic disruptions of the financial markets.
7. Establish a firmwide risk management process that identifies, measures, and manages the risk position of the Manager and its investments, including the sources, nature, and degree of , g , , grisk exposure.
29 © CFA Institute 2009
Monitoring and Review Process
YES
30
Source: Bailey, Richards, and Tierney, “Evaluating Portfolio Performance” (CFA Institute, 2009)
© CFA Institute 2009
Performance Monitoring Case
Discriminant Asset Management manages an equity portfolio for a high‐net‐worth client. The portfolio is p g pbenchmarked 90% to a broad capital market index and 10% to cash. Discriminant uses equity futures contracts to adjust the portfolio’s overall market exposure inadjust the portfolio s overall market exposure in accordance with the firm’s near‐term asset class forecast. In the month of July 2009, the portfolio outperformed its b h k b 6 b i ibenchmark by 67 basis points:
Return
f lPortfolio 7.07%
Benchmark 6.40%
Value‐Added 0.67%
31 © CFA Institute 2009
Equity Portfolio Characteristics Analysis
Physical Asset Class Portfolio Benchmark
Average Market Capitalization (Millions) 9,473.5 19,348.9
P/E Ratio* 22.3 31.4
P/B Ratio 1.1 1.8
Dividend Yield 4 17 3 42Dividend Yield 4.17 3.42
*Excludes negative earnings
32 © CFA Institute 2009
Attribution AnalysisDiscriminant Asset Management—Month of July 2009
Portfolio Weight
%
Portfolio Return
%
Benchmark Weight
%
Benchmark Return
%Allocation Effect
Selection Effect% % % % Effect Effect
Physical Portfolio:Energy 9.72 3.48 11.29 4.55 0.03 ‐0.10Materials 3.35 14.08 3.31 13.10 0.00 0.03Industrials 8.14 10.78 9.06 9.43 ‐0.03 0.11Consumer Discretionary 14.42 6.29 8.39 9.85 0.21 ‐0.51Consumer Staples 15.43 7.81 9.77 5.78 ‐0.04 0.31Health Care 8.29 6.63 12.59 6.24 0.01 0.03Financials 10.02 9.47 11.89 7.82 ‐0.03 0.17Information Technology 18 42 11 24 17 42 7 14 0 01 0 76Information Technology 18.42 11.24 17.42 7.14 0.01 0.76Telecommunications 2.88 4.50 2.93 3.57 0.00 0.03Utilities 1.43 3.10 3.36 4.12 0.04 ‐0.01Total Stocks 92.11 8.19 90.00 7.11 0.21 0.80Cash 7.90 0.10 10.00 0.10 0.13 0.00Total Physical Portfolio 100.00 7.55 100.00 6.40 0.34 0.80Equity Futures Impact ‐5.92 8.19 0.00 7.11 ‐0.04 ‐0.06Cash Futures Impact 5.92 0.10 0.00 0.10 ‐0.37 0.00Total Portfolio 100.00 7.07 100.00 6.40 ‐0.07 0.74
33 © CFA Institute 2009
*Totals may not add due to rounding.
Things to Watch
• Investment Policy Violations• Investment Policy Violations
• Organizational Changes
• Regulatory Actions
• Reconciliations
• Custodial Statements and Manager’s Holdings
• Returns Calculated by Manager and by Custodian or Consultant
• Portfolio Return vs. GIPS Composite Performance
34 © CFA Institute 2009
Resources
• CFA Institute Centre Publications:
Asset Manager Code of Conduct, 2nd ed.g ,
CFA Institute Code of Ethics and Standards of Professional Conduct
Model Requests for Proposal: Templates for Small Institutional Investors—Equity; Fixed Income; Real EstateInvestors Equity; Fixed Income; Real Estate
U.S. Financial Regulatory Reform: The Investors’ Perspective; A Report by the Investors’ Working Group, An Independent Taskforce Sponsored by CFA Institute Centre for Financial Market Integrity and Council ofby CFA Institute Centre for Financial Market Integrity and Council of Institutional Investors (July 2009)
• “CFA Institute Offers 10 Tips on Avoiding Investment Fraud,” 21 January 2009 (press release)2009 (press release)
• Global Investment Performance Standards (GIPS®): Please visit www.gipsstandards.org
35 © CFA Institute 2009
Certificate in Investment Performance Measurement
Learn about the CIPM® study and exam program at www.cfainstitute.org/cipm
Philip Lawton, PhD, CFA, CMA, CIPMHead, CIPM ProgramE il hili l t @ f i tit t
36 © CFA Institute 2009
E‐mail: [email protected]