Performance Analysis

Question 1

What is meant by a funds alpha? (4)

Answer 1

• the difference between expected return and actual return
• return not explained by market movements and beta
• risk adjusted return measure
• value added by the fund manager
• amount of return not accounted for by its beta

Question 2

Alpha formula

Answer 2

Alpha = actual return - CAPM

Alpha = actual return - [Rf + Bi(Rm-Rf)]

Rf = risk free return
Rm = market return
Bi = beta of fund

Question 3

What is beta?

Answer 3

• measures the risk of a fund compared to the rest of the market

Question 4

What is meant by value investing and the assumption which underpins the concept (3)

Answer 4

• identifies stock which are undervalued/ trading at less…
• than their intrinsic value

Assumptions:

• the market is inefficient
• but will return to fair value

Question 5

Explain How is technical analysis used to make investment decisions (4)

Answer 5

• based only on share price/ excludes fundamental analysis (company accounts etc)
• uses charts of past share price
• identifies patterns that predict future performance
• assumes these are repeated

Question 6

What does information ratio measure and it’s limitations (6)

Answer 6

• relative performance
• compared to a benchmark
• adjusted for risk

Limitations:

• based on historical data
• needs to be compared to similar funds
• need to look at trends
• need to consider other factors

Question 7

Information ratio formula

Answer 7

(Investment return - index or benchmark return) / tracking error

Measures risk adjusted returns vs benchmark

Question 8

Reasons why funds with same benchmark have different information ratios (3)

Answer 8

• different tracking errors
• different performances
• different portfolio construction

Question 9

What is tracking error?

Answer 9

tracking error or active risk is a measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager.

it indicates how closely a portfolio follows the index to which it is benchmarked.

Question 10

Explain potential causes of an ETF tracking error (7)

Answer 10

• inaccuracy of the method used
• management fees
• other costs
• currency hedging
• cash drag
• dividend reinvestment lag
• tax
• securities lending

Question 11

Purpose of using a benchmark (4)

Answer 11

• sets assets allocation/ starting point
• Independant basis
• to manage risk expectations
• to measure relative performance to benchmark / value added by fund manager

Question 12

Why include an asset in a portfolio which has lost money over the last 5 years (4)

Answer 12

• diversification
• negatively correlated to other assets
• lower volatility (if bonds or cash)
• better expected risk adjusted returns
• past performance no guide to future

Question 13

Money weighted return:

What does it show?

What is the formula?

Answer 13

MWR measures overall return on capital over a specific period

= difference in value + income/capital distributions

R = [D + (V1 - V0)] / V0

V1 = value at end
V0 = value st start
D = income/ capital distributions

Question 14

Sharpe ratio

• what does it show?
• what is the formula?

Answer 14

• measure of risk adjusted returns of an investment
• measures excess returns for every unit of risk taken
• uses to compare investments to see which offers most return for any given level of risk
• allows comparison
• if returns of different funds
• adjusted for risk

SR = (return on investment - Rf return) / SD

Difference between return on investment and Rf = excess return for taking the risk
- risk is measured by SD

If SR = 0.75 then 0.75% extra return for each unit of risk taken

The higher the SR the better the returns for the amount of risk taken

Negative SR shows Rf would have been better

SR is useful to measure if returns are due to fund manager decisions or purely because of extra risk being taken

Question 15

Limitations of the sharper ratio (4)

Answer 15

• returns are not always normally distributed
• assumes that SD is correct measure of risk
• assumes risk free return rate is correct
• simplistic / ignores other factors
• ignores Charges
• ignores tax
• uses historic data
• can be manipulated

Question 16

Explain why MWR is not considered appropriate when evaluating and comparing different portfolio returns and suggest a more suitable alternative measure (4)

Answer 16

• strongly influenced by timing of investments
• outside of the control
  of the manager
• doesn’t identify whether the returns are due to ability of the manager
• TWR

Question 17

6 relative differences between SD and Beta and terms of what they measure and how they measure risk

Answer 17

What they measure:

• beta measures market risk
• SD measures fund risk

How they measure risk:

• beta measures volatility
• SD measures total risk

Benchmark:

• beta is measured against the market
• SD is not/ measured against actual return

Question 18

Explain what is meant if a fund has a beta of more than 1 (3)

Answer 18

• moves in same direction / positive correlation as the market
• more volatile than market
• will our perform in rising market/ under perform in falling market