Evaluating Portfolio Performance
1. Explain the following components of portfolio evaluation: Performance measurement, performance attribution and performance appraisal
– The return performance of the account over the period: This is addressed through performance measurement, which involves calculating rates of return based on changes in the account’s value over specified time periods.
– How the manages attained the observed performance: This is addressed by performance attribution. This looks into the sources of the account’s performance and the importance of those sources.
– 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 market or by chance.
2. Calculate, interpret and contrast time-weighted and money weighted rates of return and discuss how each is affected by cash contributions and withdrawals.
– 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. It requires a set of subperiod results are then compounded together:
Rp = (1+Rs1) (1+Rs2) (1+Rs3)…….(1+Rsk) -1
– The money-weighted rate of return is the internal rate of return (IRR) on all funds invested during the evaluation period, including the beginning value of the portfolio.
MV1 = MV0 (1+R) m +Σ CF i ( 1+R) L(i) ( i= 1 …n)
– The MWRR, unlike the TWRR is heavily influenced by the size and timing of cash flows. The TWRR is the preferred method inless the manger has control over the size and timing of the cash flows.
– The MWRR will be higher (lower) than the TWRR if funds are added prior to a period of strong ( weak) performance.
3. Demonstrate the composition of portfolio returns into components attributable to the market, to style and to active management.
– Portfolio return, P, can be broken into returns due to market, style, and active management.
P = M + S + A
P: portfolio return.
M: market index return.
S: return to style
A: return due to active management.
S = B – M
B: portfolio benchmark return
A = P – B