LO 69.9: Describe the use of alpha, benchmark, and peer group as inputs in performance measurement tools.
One could use linear regression analysis to regress the excess returns of the investment against the excess returns of the benchmark. One of the outputs from this regression is alpha, and it could be tested for statistical significance to determine whether the excess returns are attributable to manager skill or just pure luck. The other output is beta, and it relates to the amount of leverage used or underweigh ting/overweighting in the market compared to the benchmark.
The regression also allows a comparison of the absolute amount of excess returns compared to the benchmark. Furthermore, there is the ability to separate excess returns due to leverage and excess returns due to skill. One limitation to consider is that there may not be enough data available to make a reasonable conclusion as to the managers skill.
One could also regress the excess returns of the manager against the excess returns of the managers peer group. The features of this regression are generally similar to that for the benchmark, except that the returns of the peer group suffer from survivorship bias, and there is usually a wide range of funds under management amongst the peers (that reduces the comparability).
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Topic 69 Cross Reference to GARP Assigned Reading – Litterman, Chapter 17
Ke y Co n c e pt s
LO 69.1 VaR and tracking error are both measures of risk. VaR is defined to be the largest loss possible for a certain level of confidence over a specific period of time. Tracking error is defined as the standard deviation of excess returns.
LO 69.2 There are five risk planning objectives to consider.
Setting expected return and expected volatility goals. Defining quantitative measures of success or failure. Generalizing how risk capital will be utilized to meet the entitys objectives. Defining the difference between events that cause ordinary damage versus serious
damage. Identifying mission critical resources inside and outside the entity and discussing what should be done in case those resources are jeopardized.
The risk planning process frequently requires the input and approval of the entitys owners and its management team.
LO 69.3 The risk budget quantifies the risk plan. There needs to be a structured budgeting process to allocate risk capital to meet the corporate objectives and minimize deviations from plan.
Quantitative methods may be used in risk budgeting. Activities include: setting the minimum acceptable levels of RORC and ROE, applying mean-variance optimization, simulating portfolio performance, and applying sensitivity analysis.
LO 69.4 Within an entitys internal control environment, risk monitoring attempts to seek and investigate any significant variances from budget.
LO 69.3 Sources of risk consciousness include: (1) banks, (2) boards of investment clients, senior management, and plan sponsors, and (3) investors.
LO 69.6 A risk management unit (RMU) monitors an investment management entitys portfolio risk exposure and ascertains that the exposures are authorized and consistent with the risk budgets previously set. To ensure proper segregation of duties, it is crucial that the risk management function be independent and not report to senior management.
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Topic 69 Cross Reference to GARP Assigned Reading – Litterman, Chapter 17
LO 69.7 The risk monitoring process attempts to confirm that investment activities are consistent with expectations. Specifically, is the manager generating a forecasted level of tracking error that is consistent with the target? And is risk capital allocated to the expected areas?
LO 69.8 Liquidity considerations are important because a portfolios liquidity profile could change significantly in the midst of a volatile market environment or an economic downturn, for instance.
LO 69.9 The excess returns of an investment can be regressed against the excess returns of its benchmark (e.g., S&P 500 Index). An output from this regression is alpha, which determines whether the investments excess returns are due to skill or luck.
The excess returns of a manager can be regressed against the excess returns of the managers peer group. This is similar to the liner regression with a benchmark portfolio, but differs since it suffers from survivorship bias.
LO 69.10 Performance measurement looks at a portfolio managers actual results and compares them to relevant comparables such as benchmarks and peer groups.
A performance measurement framework includes: (1) comparison of performance with expectations, (2) return attribution, (3) calculation of metrics such as the Sharpe ratio and the information ratio, and (4) comparisons with benchmark portfolios and peer groups.
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Topic 69 Cross Reference to GARP Assigned Reading – Litterman, Chapter 17
Co n c e pt Ch e c k e r s
1.
2.
3.
4.
3.
Which of the following statements about tracking error and value at risk (VaR) is least accurate? A. Tracking error and VaR are complementary measures of risk. B. Both tracking error and VaR may assume a normal distribution of returns. C. Tracking error is the standard deviation of the excess of portfolio returns over
the return of the peer group.
D. VaR can be defined as the maximum loss over a given time period.
Which of the following statements about the use of quantitative methods in risk budgeting is least accurate? They may be used: to simulate the performance of portfolios. A. to set levels of return on equity (ROE) and return on risk capital (RORC). B. C. in a scenario analysis context to determine the weights for each asset class. D. in a sensitivity analysis context to consider changes in estimates of returns and
covariances.
A risk management unit (RMU) is most likely to be active in which of the following contexts? A. Risk monitoring. B. Risk measurement. C. Risk budgeting. D. Risk planning.
Which of the following statements does not help explain the purpose of risk decomposition? A. To ensure that there is no style drift. B. To detect large concentrations of risk. C. To detect excessive amounts of tracking risk. D. To ensure that investment activities are consistent with expectations.
Which of the following statements regarding alphas and betas is incorrect? A. Alpha is the excess return attributable to pure luck. B. Alpha is the excess return attributable to managerial skill. C. Beta suggests the relative amount of leverage used. D. Beta suggests whether some of the returns are attributable to over or under
weighting the market.
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Topic 69 Cross Reference to GARP Assigned Reading – Litterman, Chapter 17
Co n c e pt Ch e c k e r An s w e r s
1. C All of the statements are accurate with the exception of the one relating to the peer group.
Tracking error is the standard deviation of the excess of portfolio returns over the return of an appropriate benchmark, not peer group.
2. C All of the statements are accurate with the exception of the one relating to scenario analysis. One should apply mean-variance optimization (and not scenario analysis) to determine the weights for each asset class.
3. A A RMU monitors an investment management firms portfolio risk exposure and ascertains
that the exposures are authorized and consistent with the risk budgets previously set.
4. C Risk decomposition is not designed to detect excessive amounts of tracking risk. In fact, it is the forecasted tracking error amount that should be compared to budget to ensure that there is not excessive tracking risk. All the other reasons are consistent with the purpose of risk decomposition.
5. A Alpha is a measure of the excess return of a manager over the peer group/benchmark that relates to skill as opposed to pure luck. Beta is a measure of the amount of leverage used compared to the peer group or a measure of the underweighting or overweighting of the market compared to the benchmark.
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The following is a review of the Risk Management and Investment Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Po r t f o l i o Pe r f o r m a n c e Ev a l u a t io n
Topic 70
Ex a m Fo c u s
Professional money managers are routinely evaluated using a wide array of metrics. In this topic, alternative methods of computing portfolio returns will be presented, and contrasts will be made between time-weighted and dollar-weighted returns for portfolios experiencing cash redemptions and contributions. For the exam, be sure to understand differences in the risk-adjusted performance measures, including the Sharpe ratio, Treynor ratio, Jensens alpha, information ratio, and M2, and how the trading practices of hedge funds complicates the evaluation process. Be able to apply Sharpes regression-based style analysis to conduct performance attributions.
Tim e -We ig h t e d a n d D o l l a r -We ig h t e d Re t u r n s