he following is «review of the Performance Evaluation and Attribution principles designed to addres the letning outcome statements set forth by CFA Insttute®. This topic is also covered i EVALUATING PorTFOLIO PERFORMANCE! Study Session 17 Exam Focus ‘This topic review covers current performance evaluation concepts and techniques used by insticutional investors. We will distinguish between the perspectives of the Fund sponsor and the investment manager. We will then splic up performance evaluation into three components: performance measurement, performance attribution and performance appraisal. All of this ‘material has seen coverage on recent Level 3 exams. PERFORMANCE EVALUATION LOS 46.a: Demonstrate the importance of performance evaluation from the perspective of fund sponsors and the perspective of investment managers. ‘The importance of performance evaluation is viewed from the perspectives of fund sponsors and investment managers. A fund sponsor is defined as an owner of large pools of investable assets (e.g., pension funds, endowments, and foundations) using several investment management firms. Fund sponsor's perspective. Performance evaluation improves the effectiveness of a fund's investment policy by acting as a feedback and control mechanism. It: 1. Shows where the policy is effective and where it isn't 2. Directs management to areas of underperformance 3. Indicates the results of active management and other policy decisions. 4, Indicates where others, additional strategies can be successfully applied. 5. Provides feedback on the consistent application of the policies set forth in the IPS. “The increased complexity of institutional investment management has led to a greater need for sophisticated performance evaluation from the fund sponsor's perspective. Investment manager's perspective. As with the fund sponsor's perspective, performance evaluation can serve asa feedback and control mechanism. Some investment managers may simply compare their reported investment returns to a designated benchmark. Others will want to investigate the effectiveness of each component of their investment process. 1. The terminology used throughout chis cop review is industey convention as presented in Reading 46 of the 2010 CEA Level 3 exam curriculum, ©2009 Kaplan, Inc Page 71Study Session 17 Cross-Reference to CFA Institute Assigned Reading #46 ~ Evaluating Portfolio Performance CoMPONENTS OF PERFORMANCE EVALUATION LOS 46.b; Explain the basic components of portfolio evalwation (performance measurement, performance attribution, and performance appraisal) The term “account” will refer to one or more portfolios of securities, managed by one or more investment management organizations. There are three primary concerns to address when assessing the performance of an account: 1. The return performance of the account over the period, This is addressed through performance measurement, wrich involves calculating rates of requrn based on changes in the account's value over specified time periods. 2, How the manager(s) attained che observed performance. ‘This is addressed by performance attribution. This looks into the sources of the account's performance (e., sector or security selection) 3 3. Whether the performance was due to investment decisions. This is addressed by performance appraisal. The objective is to draw conclusions regarding whether the performance was affected primarily by investment decisions, by the overall marker, or by chance. Warm-Up: Return Catcutations WiTH EXTErNaL Casi Frows ‘The rate of retuen on an account is the percentage change in the account's market value over a defined time period (known as the measurement ot evaluation period). An account's rate of return needs to factor in external cash flows. External cash flows refer to contributions and withdrawals made to/from an account, as opposed ro internal cash flows, such as interest or dividends. If chere isan external cash flow at the begintning of the evaluation period, the account's return is calculated as Follows: MY; ~(MVp +CF) MVp +CF If there is an external cash flow at the end of the evaluation period, it should be subtracted from (if a withdrawal, added to) the account’s ending value as it has no impact an the investment-related value of the account: (Mv, —CF)—~MVy MVo Page 72 (©2009 Kaplan, IncStudy Session 17 Cross-Reference to CFA Insticate Assigned Reading #46 ~ Evaluating Portfolio Performance Example: Rate of return calculation ‘The Keane account was valued at $12,000,000 at start of the month (before any contributions). At the month end, its value was $12,260,000. During the month, the account received a contribution of $40,000. Calculate the rate of return if the contribution was received: (1) on the frst day of the month, and (2) on the last day of the month. Answer: If the contribution was received on the first day of the month, the rate of return for the month would be: __ $12,260,000 ($12,000,000 + $40,000) _ FR SEO OO SIR NE) = 0.018272 = 1.8272% . ($12,000,000 + $40,000) If the $40,000 contribution was received on the last day of the month, the rate of return would be: ($12,260,000 — $40,000) —$12,000,000. ‘$12,000,000, = 0.018333 = 1.8333% Note: A contribution on the lat day of the month has no impact on the investment- related value of the account. This is because the contribution is deducted before calculating the return, . ‘We now consider the calculation of rates of return in the context of intraperiod external cash flows. CancuLaTine Time- anp Money-WeicHTEp ReTurns weighted rates of return and discuss how each is affected by cash contributions and withdrawals, For the Exam: The fact that these return calculations also'appear in Study Session 18 (GIPS) tells me you should be ready to perform them on the exam. Time-Weighted Rate of Return The time-weighted rate of return (TWRR) calculates the compounded rate of growth over a stated evaluation period of one unit of money initially invested in the account. Ic requires a set of sub-period returns to be calculated covering each period thac has an external cash flow. The sub-period results are then compounded cogether. (©2009 Kaplan, Inc Page 73