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LM3 Portfolio Performance Evaluation 2024 Level III Notes © IFT. All rights reserved 1 LM3 Portfolio Performance Evaluation 1. Introduction .......................................................................................................................................................2 2. Performance Evaluation and Attribution................................................................................................2 Performance Attribution..............................................................................................................................3 3. Equity Return Attribution.............................................................................................................................5 4. Fixed-Income Return Attribution ........................................................................................................... 14 5. Risk Attribution.............................................................................................................................................. 19 6. Return Attribution Analysis at Multiple Levels ................................................................................. 21 7. Asset- and Liability-Based Benchmarks............................................................................................... 25 Asset-Based Benchmarks .......................................................................................................................... 27 8. Benchmarks..................................................................................................................................................... 28 Evaluating Benchmark Quality: Analysis Based on a Decomposition of Portfolio Holdings and Returns .................................................................................................................................................... 30 Importance of Choosing the Correct Benchmark............................................................................. 33 9. Benchmarking Alternative Investments .............................................................................................. 33 10. Performance Appraisal: Risk-Based Measures ............................................................................... 35 Distinguishing Investment Skill from Luck ........................................................................................ 36 Appraisal Measures ..................................................................................................................................... 36 11. Performance Appraisal: Capture Ratios and Drawdowns .......................................................... 40 12. Evaluation of Investment Manager Skill............................................................................................ 47 Summary ............................................................................................................................................................... 50 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM3 Portfolio Performance Evaluation 2024 Level III Notes © IFT. All rights reserved 2 1. Introduction Performance evaluation helps to understand the quality of the investment process. Three broad components of performance evaluation are performance measurement, performance attribution, and performance appraisal. We will understand the differences between these components and their interrelationships. We will also discuss how to select an appropriate benchmark and the difference between a benchmark and a market index. Finally, we will consider the tools used to evaluate the skill of investment managers. 2. Performance Evaluation and Attribution The three components of performance evaluation address the following questions: • Performance measurement—What was the portfolio’s performance? • Performance attribution—How was the performance achieved? • Performance appraisal—Was the performance achieved through manager skill or luck? Performance measurement provides an overall indication of the portfolio’s performance compared to a benchmark. This involves calculating both the portfolio’s absolute return and its benchmark return. For example, for a given period, if the portfolio generated a return of 6% and its benchmark generated a return of 4%. The portfolio’s absolute return is 6% and the excess return relative to its benchmark is 6% - 4% = 2%. In addition, to return, performance measurement also considers the risk that was taken to achieve the return. Risk measurement includes both ex ante (looking forward in time) and ex post (looking back in time) techniques. Performance attribution builds on performance measurement to explain how the performance was achieved. Return attribution involves decomposing the excess return into its component sources. This helps understand why the manager over- or underperformed the target benchmark. Likewise, risk attribution is used to decompose the risk incurred into its component sources. Performance appraisal leverages returns and attribution to infer the quality of the investment performance. This component attempts to distinguish manager skill from luck and helps evaluate if the superior performance of the manager will likely continue in the future. Example: Performance Evaluation (This is Example 1 from the curriculum.) 1. Performance attribution: A. measures the excess performance of a portfolio. B. explains the proportion of returns due to manager skill. C. explains how the excess performance or risk was achieved. 2. Performance appraisal:
LM3 Portfolio Performance Evaluation 2024 Level III Notes © IFT. All rights reserved 3 A. identifies the sources of under- or outperformance. B. decomposes a portfolio’s risk and return into their constituent parts. C. uses the results of risk, return, and attribution analyses to assess the quality of a portfolio's performance. Solution to 1: C is correct. Performance attribution identifies the drivers of investment returns. A is not correct because measuring the excess performance of a portfolio is the subject of performance measurement. B is not correct because it is performance appraisal that distinguishes skill from luck. Solution to 2: C is correct. Performance appraisal combines all the techniques of performance measurement and attribution to assess the quality of performance. Both A and B describe performance attribution. Performance Attribution An effective performance attribution process must: 1. account for all of the portfolio’s return or risk exposure, 2. reflect the investment decision-making process, 3. quantify the active decisions of the portfolio manager, and 4. provide a complete understanding of the excess return/risk of the portfolio. Instructor’s tip: You can use the acronym ‘ARQP’ to remember the list. This process is explained in more detail below: 1. The total portfolio risk and return should be reconciled. For example, if a portfolio’s return was 6%, but the attribution process only explains 4%, then the attribution is incomplete or incorrect. 2. Consider a portfolio manager who uses a top-down approach. He first identifies which sectors to under or overweight and then selects specific stocks within these sectors. This investment process includes sector allocation and security selection decisions. The attribution process should consider both of these choices. If the attribution process focuses on security selection alone and ignores sector allocation decisions, then it is incorrect. 3. In the above scenario, the attribution process should be able to quantify the percentage of returns that came from sector allocation, and the proportion of returns from security selection. 4. The portfolio return is compared with a benchmark to provide an understanding of the sources of excess return. Performance attribution includes both return attribution and risk attribution. • Return attribution analyzes the impact of investment decisions on the returns. • Risk attribution analyzes the risk consequences of investment decisions.
LM3 Portfolio Performance Evaluation 2024 Level III Notes © IFT. All rights reserved 4 Performance attribution can be conducted at distinct levels. • Macro attribution considers the decisions of the fund sponsor (asset owner). Consider a defined benefit pension plan that decides how much to allocate to each asset class, which managers to hire for each asset class, and whether to deviate from the SAA. Macro attribution measures the impact of these decisions on investment performance. • Micro attribution considers the decisions of the individual portfolio manager. Consider an equity portfolio manager selected by the DB plan to manage the equity portion of its portfolio. The manager makes sector allocation and security selection decisions. Micro attribution measures the impact of these decisions on investment performance. Performance attribution can be returns-based, holdings-based, or transactions-based. • Returns-based attribution uses total portfolio returns over a period to identify the components that have generated those returns. It is used when information about the underlying holdings is not available. For example, this approach is frequently used to evaluate hedge funds. This approach is the easiest to implement, but it is also the least accurate and most vulnerable to data manipulation. • Holdings-based attribution considers the actual portfolio holdings at the beginning of the measurement period and is more accurate when using data with shorter intervals. Reducing the measurement period, for example, from one quarter to one month, will improve the accuracy of the attribution process. This approach works well for passive strategies with low turnovers. For longer evaluation periods, the attribution results for the shorter measurement periods can be linked together. • Transactions-based attribution uses both the holdings of the portfolio and the transactions that occurred during the evaluation period. Out of the three approaches, this is the most accurate but also the most difficult to implement. To obtain meaningful results, the underlying data must be complete, accurate, and reconciled from period to period. The choice of the attribution approach depends on: • Availability and quality of the underlying data, • reporting requirements for the client, and • the complexity of the investment decision-making process. Example: Performance Attribution (This is Example 2 from the curriculum.) 1. Effective attribution analysis must: A. use intraday transaction data. B. reconcile to the total portfolio return or risk exposure. C. measure the contribution of security and sector selection decisions. 2. Which of the following most accurately describes macro attribution?