Investment Performance Measurement

Evaluating and Presenting Results

Philip Lawton, CIPM, Todd Jankowski, CFA

• Publisher: Wiley
• Year: 2009
• Print ISBN: 9780470395028
• eBook ISBN: 9780470473719
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Investment Performance Measurement

Over the past two decades, the importance of measuring, presenting, and evaluating investment performance results has dramatically increased. With the growth of capital market data services, the development of quantitative analytical techniques, and the widespread acceptance of Global Investment Performance Standards (GIPS ® ), this discipline has emerged as a central component of effective asset management and, thanks in part to the Certificate in Investment Performance Measurement (CIPM) program, has become a recognized area of specialization for investment professionals.

That's why Investment Performance Measurement: Evaluating and Presenting Results —the second essential title in the CFA Institute Investment Perspectives series—has been created. CFA Institute has a long tradition of publishing content from industry thought leaders, and now this new collection offers unparalleled guidance to those working in the rapidly evolving field of investment management.

Drawing from the Research Foundation of CFA Institute, the Financial Analysts Journal, CFA Institute Conference Proceedings Quarterly, CFA Magazine, and the CIPM curriculum, this reliable resource taps into the vast store of knowledge of some of today's most prominent thought leaders—from industry professionals to respected academics—who have focused on investment performance evaluation for a majority of their careers.

Divided into five comprehensive parts, this timely volume opens with an extensive overview of performance measurement, attribution, and appraisal. Here, you'll become familiar with everything from the algebra of time-weighted and money-weighted rates of return to the objectives and techniques of performance appraisal.

After this informative introduction, Investment Performance Measurement moves on to:

• Provide a solid understanding of the theoretical grounds for benchmarking and the trade-offs encountered during practice in Part II: Performance Measurement
• Describe the different aspects of attribution analysis as well as the determinants of portfolio performance in Part III: Performance Attribution
• Address everything from hedge fund risks and returns to fund management changes and equity style shifts in Part IV: Performance Appraisal
• Recount the history and explain the provisions of the GIPS standards—with attention paid to the many practical issues that arise in the course of its implementation—in Part V: Global Investment Performance Standards

Filled with invaluable insights from more than fifty experienced contributors, this practical guide will enhance your understanding of investment performance measurement and put you in a better position to present and evaluate results in the most effective way possible.

PART I

OVERVIEW OF PERFORMANCE EVALUATION

CHAPTER 1

EVALUATING PORTFOLIO PERFORMANCE

Jeffery V. Bailey, CFA Thomas M. Richards, CFA David E. Tierney

The ex post analysis of investment performance stands as a prominent and ubiquitous feature of modern investment management practice. Investing involves making decisions that have readily quantifiable consequences and that, at least on the surface, lend themselves to elaborate dissection and review. We broadly refer to the measurement and assessment of the outcomes of these investment management decisions as performance evaluation. At the institutional investor level, and to a lesser (but growing) extent on the individual investor level, a large industry has developed to satisfy the demand for performance evaluation services. Although some observers contend that performance evaluation is misguided, frequently misapplied, or simply unattainable with any reasonable degree of statistical confidence, we believe that analytic techniques representing best practices can lead to valid insights about the sources of past returns, and such insights can be useful inputs for managing an investment program.

The purpose of this chapter is to provide an overview of current performance evaluation concepts and techniques. Our focus will be on how institutional investors—both fund sponsors and investment managers—conduct performance evaluation. Individual investors tend to use variations of the performance evaluation techniques employed by institutional investors. We define fund sponsors to be owners of large pools of investable assets, such as corporate and public pension funds, endowments, and foundations. These organizations typically retain multiple investment management firms deployed across a range of asset categories. Fund sponsors have the challenge of evaluating not only the performance of the individual managers, but also the investment results within the asset categories and for their total investment programs.

Reprinted from Managing Investment Portfolios: A Dynamic Process, 3^rd Edition (John Wiley & Sons, 2007):717-780.

In the section titled The Importance of Performance Evaluation, we distinguish between the perspectives of the fund sponsor and the investment manager. In The Three Components of Performance Evaluation, we divide the broad subject of performance evaluation into three components: performance measurement, performance attribution, and performance appraisal. Under the topic of performance measurement, we discuss several methods of calculating portfolio performance. The next section introduces the concept of performance benchmarks. Turning to performance attribution, we consider the process of analyzing the sources of returns relative to a designated benchmark both from the total fund (fund sponsor) level and from the individual portfolio (investment manager) level. This is followed by performance appraisal, which deals with assessing investment skill. The chapter ends by addressing key issues in the practice of performance evaluation.

THE IMPORTANCE OF PERFORMANCE EVALUATION

Performance evaluation is important from the perspectives of both the fund sponsor and the investment manager.

The Fund Sponsor’s Perspective

A typical fund sponsor would consider its investment program incomplete without a thorough and regular evaluation of the fund’s performance relative to its investment objectives. Applied in a comprehensive manner, performance evaluation is more than a simple exercise in calculating rates of return. Rather, it provides an exhaustive “quality control” check, emphasizing not only the performance of the fund and its constituent parts relative to objectives, but the sources of that relative performance as well.

Performance evaluation is part of the feedback step of the investment management process. As such, it should be an integral part of a fund’s investment policy and documented in its investment policy statement. As discussed in Ambachtsheer (1986) and Ellis (1985), investment policy itself is a combination of philosophy and planning. On the one hand, it expresses the fund sponsor’s attitudes toward a number of important investment management issues, such as the fund’s mission, the fund sponsor’s risk tolerance, the fund’s investment objectives, and so on. On the other hand, investment policy is a form of long-term strategic planning. It defines the specific goals that the fund sponsor expects the fund to accomplish, and it describes how the fund sponsor foresees the realization of those goals.

Investment policy gives an investment program a sense of direction and discipline. Performance evaluation enhances the effectiveness of a fund’s investment policy by acting as a feedback and control mechanism. It identifies an investment program’s strengths and weaknesses and attributes the fund’s investment results to various key decisions. It assists the fund sponsor in reaffirming a commitment to successful investment strategies, and it helps to focus attention on poorly performing operations. Moreover, it provides evidence to fund trustees, who ultimately bear fiduciary responsibility for the fund’s viability, that the investment program is being conducted in an appropriate and effective manner.

Fund sponsors are venturing into nontraditional asset categories and hiring a larger assortment of managers exhibiting unique investment styles, with the addition of hedge fund managers representing the latest and perhaps most complex example of this trend. Some fund sponsors are taking more investment decisions into their own hands, such as tactical asset allocation and style timing. Others are taking a quite different direction, giving their managers broad discretion to make asset allocation and security selection decisions. As a consequence of these developments, alert trustee boards are demanding more information from their investment staffs. The staffs, in turn, are seeking to better understand the extent of their own contributions and those of the funds’ investment managers to the funds’ investment results. The increased complexity of institutional investment management has brought a correspondingly greater need for sophisticated performance evaluation from the fund sponsor’s perspective.

The Investment Manager’s Perspective

Investment managers have various incentives to evaluate the performance of the portfolios that they manage for their clients. Virtually all fund sponsors insist that their managers offer some type of accounting of portfolio investment results. In many cases, performance evaluation conducted by the investment manager simply takes the form of reporting investment returns, perhaps presented alongside the returns of some designated benchmark. Other clients may insist on more sophisticated analyses, which the managers may produce in-house or acquire from a third party.

Some investment managers may seriously wish to investigate the effectiveness of various elements of their investment processes and examine the relative contributions of those elements. Managing investment portfolios involves a complex set of decision-making procedures. For example, an equity manager must make decisions about which stocks to hold, when to transact in those stocks, how much to allocate to various economic sectors, and how to allocate funds between stocks and cash. Numerous analysts and portfolio managers may be involved in determining a portfolio’s composition. Just as in the case of the fund sponsor, performance evaluation can serve as a feedback and control loop, helping to monitor the proficiency of various aspects of the portfolio construction process.

THE THREE COMPONENTS OF PERFORMANCE EVALUATION

In light of the subject’s importance to fund sponsors and investment managers alike, we want to consider the primary questions that performance evaluation seeks to address. In discussing performance evaluation we shall use the term account to refer generically to one or more portfolios of securities, managed by one or more investment management organizations. Thus, at one end of the spectrum, an account might indicate a single portfolio invested by a single manager. At the other end, an account could mean a fund sponsor’s total fund, which might involve numerous portfolios invested by many different managers across multiple asset categories. In between, it might include all of a fund sponsor’s assets in a particular asset category or the aggregate of all of the portfolios managed by an investment manager according to a particular mandate. The basic performance evaluation concepts are the same, regardless of the account’s composition.

With the definition of an account in mind, three questions naturally arise in examining the investment performance of an account:

1. What was the account’s performance?

2. Why did the account produce the observed performance?

3. Is the account’s performance due to luck or skill?

In somewhat simplistic terms, these questions constitute the three primary issues of performance evaluation. The first issue is addressed by performance measurement, which calculates rates of return based on investment-related changes in an account’s value over specified time periods. Performance attribution deals with the second issue. It extends the results of performance measurement to investigate both the sources of the account’s performance relative to a specific investment benchmark and the importance of those sources. Finally, performance appraisal tackles the third question. It attempts to draw conclusions concerning the quality (that is, the magnitude and consistency) of the account’s relative performance.

PERFORMANCE MEASUREMENT

To many investors, performance measurement and performance evaluation are synonymous. However, according to our classification, performance measurement is a component of performance evaluation. Performance measurement is the relatively simple procedure of calculating returns for an account. Performance evaluation, on the other hand, encompasses the broader and much more complex task of placing those investment results in the context of the account’s investment objectives.

Performance measurement is the first step in the performance evaluation process. Yet it is a critical step, because to be of value, performance evaluation requires accurate and timely rate-of-return information. Therefore, we must fully understand how to compute an account’s returns before advancing to more involved performance evaluation issues.

Performance Measurement without Intraperiod External Cash Flows

The rate of return on an account is the percentage change in the account’s market value over some defined period of time (the evaluation period), after accounting for all external cash flows.¹ (External cash flows refer to contributions and withdrawals made to and from an account, as opposed to internal cash flows such as...

Table of contents

• Praise
• Title Page
• Copyright Page
• Foreword
• Introduction
• PART I - OVERVIEW OF PERFORMANCE EVALUATION
• PART II - PERFORMANCE MEASUREMENT
• PART III - PERFORMANCE ATTRIBUTION
• PART IV - PERFORMANCE APPRAISAL
• PART V - GLOBAL INVESTMENT PERFORMANCE STANDARDS
• APPENDIX A - GLOBAL INVESTMENT PERFORMANCE STANDARDS (GIPS®)
• APPENDIX B - CORRECTIONS TO GIPS STANDARDS 2005
• ABOUT THE CONTRIBUTORS
• INDEX