Practical Investment Management by Robert.A.Strong slides ch22

8/14/2019 Practical Investment Management by Robert.A.Strong slides ch22

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PERFORMANCE MEASUREMENTAND PRESENTATION

CHAPTER TWENTY-TWO

Practical Investment Management

Robert A. Strong


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South-Western / Thomson Learning 2004 22 - 3

Outline

Performance Presentation Standards Composite Results International Portfolios Leverage and Derivatives


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For most investors, the expected utility of an

investment is a positive function of theexpected return of the investment and anegative function of the variance of thesereturns : E(U) = f[ E(R), - 2]

Other relevant risk measures may includebeta (for a stock portfolio) or duration (for afixed income portfolio).

Risk, Return, and Utility

Proper performance evaluation should

recognize both the return and theriskiness of the investment.


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To get around the problem of negative returns,returns are transformed into return relatives byadding 1.0 to them.

Suppose an initial investment of $100 falls by

50% in one period, and rises by 50% in thefollowing period. What is the average return?

Arithmetic vs. Geometric Averages

The proper measure of average return over

time with investments is the geometric meanreturn : nn

i

iGMRx

1

1

= = where Ri = the return relativein period i


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The Sharpe measure relates return to totalrisk. It can be used effectively with a portfoliowhere unsystematic risk has been diversifiedaway.

Traditional Performance Measures

Sharpe measure= Ri Rf

i

where = arithmetic mean return of security i= risk free rate= standard deviation of returns on security i

Ri

Rf

i


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Insert Table 22-2 here.



The Treynor measure relates return tosystematic risk, as measured by thesecurity (or portfolio) beta. It is anappropriate measure for both single

securities as well as for portfolios.


Treynor measure = Ri Rfi


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The line extending from the riskfree ratethrough the market portfolio on the efficientfrontier is the capital market line.

Securities plotted above the capital marketline show better-than-expected performance,and vice versa.


mean

re

turn

standard deviation

The Sharpe performance

measure can be interpreted asthe slope of a line relating thesecuritys return with its risk.




Insert Figure 22-1 here.



The standard of comparison in this case isthe security market line. This line extendsfrom the riskfree rate through the point

corresponding to the return associated with abeta of 1.0.


mean

return

beta

It is also possible to plot thereturns of securities againsttheir levels of systematic risk,or beta.




Insert Figure 22-2 here.



Compliance with AIMR (Association forInvestment Management and Research)Performance Presentation Standards is rapidlybecoming a nonoptional practice in the money

management business. In order to be compliant with AIMR standards,

certain information mustbe presented. Certain

practices are recommended by AIMR too,though not required.

Performance Measurement


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AIMR-Required Calculations



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Time-weighted rate of return : Returns should

be measured with recognition of both thetiming of the cash flows and their size. Thereare two ways of achieving this.

The daily valuation methodcalculates theexact time-weighted rate of return. Thoughcumbersome, it is the preferred method.

The modified BAI methodapproximates theinternal rate of return for the investment overthe period in question.



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Daily Valuation Method

Rdaily = Sii=1

n

Si =MVEi

MVBiwhere

market value of the portfolio at the end of period ibefore any cash flows in period i but includingaccrued income the period

market value of the portfolio at the beginning of

period i , including any cash flows at the end of theprevious subperiod and including accrued income

MVEi =

MVBi =


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Modified BAI Method

MVE= Fi1+R)Wii=1

nFi =where the sum of the cash flows during the period (with

opposite signs for inflows and outflows)

market value at the end of the period, includingaccrued income

market value at the start of the period

MVE=

Wi =CD Di

CD

F0 =

total number of days in the period

number of days since the beginning of the period inwhich cash flow Fi occurred

=CD=iD


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Using the trade date : AIMR recommends that

all calculations be done on the basis of thetrade date rather than the settlement date.

Prior to fees : AIMR also recommends thatinvestment results be presented before thededuction of management fees unless it wouldviolate SEC advertising rules.

Before taxes : Performance should also

generally be presented on a before-tax basis. Ifnot, the tax rate used in the calculations mustbe disclosed.

Recommended Calculations


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Most investment management firms managemany accounts. A composite measure can bemisleading if calculated inappropriately.

Include all portfolios : All portfolios undermeasurement must be included in at leastone composite.

It is permissable to include a nonfee portfolioin a composite provided that such inclusionis disclosed.

Performance Presentation Standards :Composite Results


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Survivor bias : AIMR standards require that

portfolios no longer under management mustbe included in a composite for the period inwhich they were in operation.

Treatment of convertibles : Convertiblesecurities should be treated as equityinstruments unless there is a clearly statedagreement to treat them differently.

At least a 10-year presentation ofannualreturns is required. A 20-year disclosureis preferred if the data is available.

Composite Results


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Country carve-outs from an internationalcomposite are not permitted unless the carve-out is actually managed as a separateportfolio.

Performance Presentation Standards

International portfolios : AIMR

standards require disclosure onwhether returns are net or gross ofwithholding taxes on dividends,interest, or capital gains.


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S th W t / Th L i 2004 22 28

Review

Performance Presentation Standards Composite Results

International Portfolios

Leverage and Derivatives

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Practical Investment Management by Robert.A.Strong slides ch22

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