INV 2023 S2

Discussion notes on solution to exercise 8.1 in Module 8 (Performance measurement)

Exercise 8.1

You are a director on the board of the trustee company of a public offer superannuation fund that has
millions of members. Most members have their superannuation in the default investment option—a multi-
asset class investment portfolio. The investment objective of the default option is an expected return
exceeding inflation by at least 3% p.a. over rolling five-year periods.

The board of the fund employs an investment consultant and several external investment managers to
manage parts of its investment portfolio. There are three specialist equity investment managers managing
portfolios of Australian equities, three managing international equities and two managing fixed interest
portfolios.

Consider the description of the various measures that relate to the measurement of investment
performance set out in the section above. Please decide on and indicate which of these measures you
would ask the fund’s investment consultant to report on in relation to each of the three groups of
investment managers. To assist your fellow directors as well as the consultant, justify your selection of
the measures chosen and indicate their advantages and disadvantages in a paragraph of no more than 200
words on each measure chosen.

It is important to focus on the questions that are being asked. These are indicated by the command verbs which
are highlighted in bold. These are described in the Command Verbs document. (Indicate means the same as
State). It is also important to focus on teg information that is relevant to formulating the response to the
questions.

The first one and a half paragraphs in the exercise set out background information which is not essential to
formulating a response to the exercise. The information that is essential to responding to the exercise is that
there are eight investment managers operating in three asset classes.

The response to the exercise needs to indicate that the Board requires the consultant to use performance
measures that allow comparisons to be made within and between asset classes.

There are eight potential measures of investment performance which were discussed in the Module section
referred to in the exercise:

Return on the investment

This is usually the total return including both capital gain and income received, assuming income is reinvested.

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When returns of investment managers are being measured and compared with each other, as in a particular asset
class, the return for each manager is usually calculated after investment costs such as investment management
fees.

While the calculation of returns before costs enables comparison with the return on a benchmark, which is also
normally calculated as an accumulation index assuming that income is reinvested but without deduction of
costs, it is often the case that investment manager returns are compared against each other and against a
common benchmark, using the investment manager’s returns after or net of costs. This is consistent with the
practice of reporting returns to investors net of investment management costs i.e. in terms of the benefit that
they receive from the investment process net of the costs of the process.

Return on investment, calculated for a given period, for different investment managers is comparable where the
managers are operating within the same asset class and are being measured against that same benchmark for
that asset class. For example, if one of the international equity managers is managing a portfolio of emerging
market (EM) equites, while the other two are managing portfolios of developed market (DM) equities, then the
EM manager’s returns are not comparable to those of the two DM managers. Even if all three were managing
global portfolios which included both DM and EM equities and were benchmarked against the MSCI All
Country World Index (MSCI ACWI), their returns would not be comparable with those of the three Australian
equity managers or the two fixed interest managers.

In order to use returns as the basis for judgments on performance and skill of the managers, they need to be
operating within the same asset class and be compared against the same benchmark.

Advantages: easy to calculate and relatively easy explain to people, who are not investment specialists.

Disadvantage: Lacks a frame of reference (such as the return of a relevant benchmark)

Standard deviation of the return

The standard deviation of the return is usually calculated as the annualised monthly standard deviation of the
monthly total return. It is also called the volatility and is commonly used as a measure of risk. The comments
relating to comparability of returns also apply to volatility.

Advantage: Easy to calculate.

Disadvantages: Does not necessarily measure risk, does not measure returns, lacks a frame of reference (such as
the volatility of the return of a relevant benchmark)

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Excess return

The excess return is calculated as the total return less the return on the benchmark for the investment manager,
for a given period. It allows a valid comparison to be made between investment managers within an asset class
where they have a common benchmark. If they are operating within the same asset class but are being measured
against different benchmarks, then the validity of the comparison is reduced to an extent depending on the
divergence between the benchmarks.

Advantage: focusses attention on the value added by the investment process being applied.

Disadvantages: a positive excess return may not satisfy the stakeholders or investors if the absolute level of
return is negative, lacks context of the degree of variability in excess returns

Tracking error

Tracking error is the standard deviation of the excess return. Tracking errors are comparable between
investment managers where they operate within the same asset class and where they have a common
benchmark. Tracking error is not a useful means of comparing investment managers in different asset classes.

A low tracking error is an indicator of a more consistent level of excess return, which may be positive or
negative. It is an indicator of good performance if the excess return is positive, but by itself is not a useful
indicator of good performance.

Advantage: shows the degree of variability in excess returns

Disadvantages: Does not necessarily measure the risk that is being tolerated in seeking excess returns and does
not indicate the level of excess returns,

Risk-adjusted return

The form of Risk Adjusted Return most commonly used for comparisons of investment managers against each
other as well as against their relevant benchmarks is the Information Ratio. This is calculated as the Excess
Return divided by the standard deviation of that excess return (the Tracking Error).

The information ratio is useful in comparing the investment performance of portfolios with similar objectives
and/or asset allocations.

It should be noted that both of these measures of ‘risk-adjusted return’ are using measures of volatility as a
means of adjusting for risk, while they are simply measures of variability of returns over time. They could more

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accurately be described as measures of excess return per unit of volatility; however, usage of the term ‘risk-
adjusted return’ is widespread and long-standing among many investment practitioners.

Advantages: Provides context in which excess returns are being achieved and focusses attention on the value
added per unit of variability of excess return, by the investment process being applied.

Disadvantage: More complicated to explain to people who investment specialists are not.

Proportion of time over which the excess return was positive (Batting average)

This is usually calculated as the percentage of months during a period, such as three or five years or more, in
which the return achieved by an investment manager exceeded that of the relevant benchmark return.

Advantages: Relatively easy to calculate and explain to people, who are not investment specialists; allows
comparability of investment managers within and between asset classes.

Disadvantage: does not indicate the size of the excess returns or the cumulative e effect of excess returns over
time and has no context in terms of the variability of returns or excess returns that are being tolerated.

Risk

Risk is defined as the probability of the return being less than the benchmark return set out in the investment
objective (for the investment manager).

Advantages: Explicitly related to the investment objective, therefore clearly related to the purpose of employing
the investment managers; allows comparability of investment managers within and between asset classes.

Disadvantage: Difficult to estimate for future periods (ex-ante risk)

The batting average can be used as a historical or ex-post estimate of risk, but it may not necessarily be a good
estimate of future risk.

The exercise requires the comparison of investment performance of eight investment managers operating across
three asset classes. This requires comparability of the selected measures within and between asset classes. This
justifies the use of the following two measures as indicators of investment performance across all eight
managers for various time periods:

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 • Information ratio

• Batting average