Chapter 12

Global
Performance
Evaluation

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 Introduction
ƒ In this chapter we look at:
ƒ The three steps of global performance
evaluation.
ƒ Calculate money-weighted and time-weighted
rates of return.
ƒ Decomposition of portfolio return into yield,
capital gains (in local currency) and currency
contribution.
ƒ Performance attribution in multi-currency,
multi-asset portfolios.

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 Introduction
ƒ In this chapter we look at:
ƒ Calculate and interpret Sharpe ratio.
ƒ Performance appraisal to determine whether the
manager has a true ability to add value.
ƒ Discuss different international benchmarks used
in performance evaluation.
ƒ Discuss various biases that may affect
performance appraisal.

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 Global Performance Evaluation
(GPE)
ƒ There are three components:
ƒ Performance measurement:
ƒ Should not be confused with accounting valuation.
ƒ The GPE component by which returns are calculated
over a measurement period for the overall portfolio
and various segments.

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 GPE (continued)
ƒ Performance attribution:
ƒ The GPE component by which the total portfolio
performance is attributed to major investment
decisions taken by the manager.
ƒ Performance appraisal:
ƒ The GPE component by which some judgment is
formulated on the investment manager’s skill.
ƒ Risk-adjusted measures are used.

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 Performance
Measurement

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 Calculating a Rate of Return
ƒ One approach to calculating a rate of return if there are no
cash flows in or out of the portfolio:
V − V
r = 1 0
or
V 0
V
1 + r = 1
V 0

ƒ There are two approaches to calculating a rate of return in

the presence of an interim cash flow.
ƒ The money-weighted return (MWR)
ƒ The time-weighted return (TWR)
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 Example – Simple Portfolio
ƒ Consider a “Simple Portfolio” with a single cash flow
during the measurement period. For simplicity, the
measurement period is supposed to be one year. Using the
formula on the previous slide, what would be the rate of
return? The details on the portfolio are as follows:

ƒ Value at start of the year is V0 = 10,000

ƒ Cash withdrawal on day t is Ct = -650
ƒ The cash outflow takes place 40 days after the start of
the period, or at t = 40/365 = 0.1096 year
ƒ Value on day t, before the cash flow is Vt = 9450
ƒ Final value at end of the year is V1 = 9550
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 Example – Simple Portfolio
ƒ If the formula were applied directly, we would
find:
V1 − V0
r=
V0
9,550 − 10,000
r=
10,000
r = −4.5%, which is clearly incorrect

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 Money Weighted Return (MWR)

ƒ Captures the return on average invested

capital.
ƒ It measures net enrichment of the client.
ƒ Sometimes called the dollar-weighted rate
of return (in the U.S).
ƒ Sometimes called an internal rate of return.

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 MWR (formula)
ƒ The MWR is defined as:
Ct V1
V0 = −∑ +
(1 + r ) (1 + r )1
t

ƒ r = MWR,
ƒ V1 = final value,
ƒ Ct = cash flow at time t
ƒ V0 = initial value.
ƒ The cash flow convention is a “+” if it represents a
contribution by the client, and a “-” if it is a cash flow
withdrawal by a client.
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 MWR - Example
ƒ Consider the “Simple Portfolio” example on
slide 7. Calculate the money weighted return.
ƒ Answer:
650 9550
10,000 = +
(1 + r )
( 40 / 365)
(1 + r )
r ≈ 2.12%

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 MWR - Example
ƒ Another approach (Dietz Method)…
Profit
MWR1 =
Average invested capital
9,550 − 10,000 + 650
MWR1 =
365 − 40
10,000 − × 650
365
MWR1 ≈ 2.12%

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 Time Weighted Return (TWR)
ƒ Is the performance per dollar invested (or
per unit of base currency).
ƒ It measures the performance of the manager
independently of the cash flows to or from
the portfolio.
ƒ Obtained by calculating the rate of return
between each cash flow date and chain
linking these rates over the total
measurement period.

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 Time Weighted Return (TWR)

ƒ This method is necessary for comparing

performance among managers or with a
passive benchmark.
ƒ The TWR must be used for performance
evaluation under GIPS guidelines.

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 TWR (formula)

ƒ The formula over the measurement period is:

Vt V1
(1 + r ) = (1 + rt )(1 + rt +1 ) = ×
V0 (Vt + Ct )

When there is only one cash flow Ct at time t.

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 TWR - Example

ƒ Consider the example on slide 7. Calculate the

TWR based on the given information.
ƒ Answer:

9, 450 rt = −5.5%
1 + rt =
10, 000
9,550 rt +1 = 8.523%
1 + rt + 1 =
8,80 0
1 + r = 0 .9 4 5 × 1 .0 8 5 2 3 TWR = r = 2.554%

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 MWR versus TWR
ƒ MWR is useful for measuring the return of
invested capital.
ƒ MWR gives an assessment of the client’s
net enrichment over the measurement
period.
ƒ TWR is the preferred method for measuring
and comparing the performance of money
managers.
ƒ TWR should be used for performance
evaluation.
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 Example 12.5. Valuing Stock Selection
Ability on a Japanese Equity Portfolio
Consider a £10 million fund that is restricted to a 10% investment
limitation in Japan. ¥100 million (£1 million) are invested in the
Japanese stock market and managed by a local money manager. The
British fund’s trustee wants to evaluate the manager’s security selection
skill in this market. Assuming a fixed exchange rate (i.e., 100¥ per £
rate), we will consider the following scenario. The Japanese manager
invests ¥100 million in the Japanese stock index, via an index fund,
thereby exactly tracking the index. After two weeks, the index rises
from 100 to 130, and the fund’s trustee ask the manager to transfer ¥30
million to a falling market (such as the U.K. market) to keep within the
10% limitation on Japanese investment and rebalance the asset
allocation to its desired target. Over the next two weeks, the Japanese
index loses 30% of its value (falling to 91), so that by the end of the
month, the Japanese portfolio is down to ¥70 million. The calculations
for the MWR, using the Dietz method, and the TWR are indicated
below. The fund uses a consultant that performs a GPE with monthly
MWR to estimate performance. What would be the conclusions
regarding the security selection ability of the manager in Japan?
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 Exhibit 12.1: TWR and Dietz
Approximation to MWR for a Hypothetical
Japanese Portfolio

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 Solution

The TWR on the Japanese portfolio is -9%; that is the

performance of the Japanese index, which was perfectly
tracked and fell from 100 to 91.
The MWR computed by the consultant will be 0% (a net
profit equal to 0, divided by some average capital),
wrongly implying that the manager outperformed the
Japanese market and has great skills in Japanese stock
selection. In fact, the manager precisely tracked the
Japanese market and no more.

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 Performance Attribution in Global
Performance Evaluation
ƒ To conduct a detailed GPE, one should
calculate the return for various segments of
the portfolio.
ƒ Return in local currency:
ƒ rj = pj + dj
ƒ where pj = capital gain
ƒ dj = yield in percent

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 Exhibit 12.2: International Portfolio:
Composition and Market Data

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 Currency Contribution
ƒ The currency contribution for a portfolio is the
difference between the portfolio return measured
in base currency and the portfolio return measured
in local currency (i.e. assuming no change in
exchange rates over the measurement period).

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 Exhibit 12.3: Market and Currency Gains

Example: British market goes up 10% and £ goes up 5%

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 Total Return Decomposition
ƒ The portfolio’s total return, measured in base
currency, can be decomposed as:
ƒ Capital gain (in local currency)
ƒ Yield
ƒ Currency
ƒ To perform the calculation it is useful to break
down the portfolio into homogenous segments by
asset type and currency
(e.g., one segment is foreign stocks).

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 Total Return Decomposition
(formula)
ƒ Let’s denote:
ƒ pj — the percentage capital gain on segment j
ƒ dj — the percentage yield on segment j
ƒ cj — the percentage currency contribution on segment j
ƒ wj — the percentage of segment j in the total portfolio
at the start of the period

r=∑w p +∑w d +∑w c

j j j j j j j j j

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 Exhibit 12.4: International Portfolio:
Total Return Decomposition

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 Exhibit 12.5: International Benchmark:
Total-Return Decomposition

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 Performance
Attribution

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 Performance Attribution

ƒ Superior performance can result from any of

the following major investment decisions:
ƒ Asset allocation
ƒ Currency allocation
ƒ Market timing (time variation in the weights)
ƒ Security selection on each market.

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 Security Selection

ƒ Ability is determined by isolating the local

market return of the various segments.
ƒ Part of the return measures the performance
that would have been achieved had the
manager invested in a local market index
instead of individual securities.

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 Example of Security Selection
ƒ The return attributed to security selection can be
determined by comparing to market index returns
ƒ Let’s denote
Ij The local-currency return on the market index
of segment j.
Then:
⎛ ⎞
r = ∑w I + ∑w p −I + ∑w d + ∑w c ⎜
⎜
⎟
⎟
jj j j j j j j j ⎜
⎝
⎟
⎠

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 Asset Allocation
ƒ The word “contribution” in this context
indicates performance relative to a selected
benchmark.
ƒ A manager’s relative performance, r – I*,
can be attributed to:
ƒ A market allocation different from that of the
index.
ƒ A currency allocation different from that of the
index
ƒ Superior security selection
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 Exhibit 12.6: Summary of Previous
Results

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 Market Timing

ƒ Market timing makes a contribution due to

time variation in weights, wj.

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 More on Currency Management
ƒ In general, there are two major ways to take
active currency exposure relative to a benchmark.
ƒ Deviations from benchmark currency weights
ƒ Using derivatives
ƒ The overall currency component of the portfolio
return can be viewed as the sum of:
1) The currency component of the passive benchmark
2) The currency allocation contribution
3) Return on currency hedges.

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 Exhibit 12.7: Data on Portfolio and
Benchmark

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 Exhibit 12.8: Multiperiod Performance
Attribution

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 Exhibit 12.9:

Analysis of
Performance:
Non-North
American
Equity Return
in U.S. Dollars:
One year
(in percent)
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 Performance
Appraisal

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 Risk

ƒ The most common approach to global

investment involves two steps:
ƒ The investor decides on an asset allocation
across various asset classes based on expected
returns and risks for the various asset classes.
ƒ An actively managed portfolio is constructed
for each asset class, and a benchmark is
assigned.

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 Risk Measures - Total, or Absolute Risk
(Standard Deviation)
ƒ Usually annualized and expressed in percent per
year.
ƒ If a global benchmark is assigned to the total
portfolio, the standard deviation of the total
portfolio and the global benchmark can be
compared.
T 2
ƒ The formula is: σTOT =
1
(
× ∑ rt − r
T − 1 t =1
)

Where T is the number of observations (e.g., 12 months)

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 Risk Measures (Continued)
ƒ Relative Risk (Tracking Error):
ƒ Usually annualized, expressed in percent per year.
ƒ Tracking error is sometimes called active risk.
ƒ Measures how closely the portfolio, or segment of a
portfolio, tracks a benchmark.

T 2
σ er =
1
× ∑ ert − er
T − 1 t=1
( )
where ert = rt − I t

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 Exhibit 12.10: Tracking Error and Total
Risk of International Portfolio

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 Risk-Adjusted Performance
ƒ The Sharpe ratio measures reward to variability.
ƒ The Sharpe ratio should be used only for the
investor’s global portfolio.
ƒ The Sharpe ratio is defined as:

Sharpe ratio = rs - R0
tot

Where R0 is the risk-free rate.

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 Risk-Adjusted Performance

ƒ Other measures include Treynor ratio which

uses market risk (beta) and Jensen’s
measure.
ƒ The pertinent measure of risk of a portfolio
of foreign assets should be its
“contribution” to the risk of the global
portfolio of the client.

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 Information Ratio
ƒ Defined as the ratio of the excess return from the
benchmark divided by the tracking error relative to the
benchmark.
ƒ Measures whether the excess return generated is large
relative to the tracking error incurred.
ƒ Grinold and Kahn (1995) assert that an IR of 0.50 is
“good” and that an IR of 1.0 is “exceptional”.
ƒ The formula is:
er
IR =
σer

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 Examples - Question
ƒ You are provided with annual return, standard deviation of
returns, and tracking error to the relevant benchmark for
three portfolios. Calculate the Sharpe ratio and information
ratio for the three portfolios and rank them according to
each measure.

Portfolio Return Standard Deviation Tracking error

1 14.50% 19.50% 7.50%
2 17.25% 25.00% 8.00%
3 18.00% 24.00% 7.50%
Benchmark 14.00% 21.00%
Risk-free rate 6.00%

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 Examples
ƒ Sharpe Ratio calculations

0.145 − 0.06
Portfolio 1 = = 43.59% Rank 3
0.195
0.1725 − 0.06
Portfolio 2 = = 45.0% Rank 2
0.25
0.18 − 0.06
Portfolio 3 = = 50.0% Rank 1
0.24

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 Example
ƒ Information ratio calculations:

0.145 − 0.14
Portfolio 1 = = 0.067 Rank 3
0.075
0.1725 − 0.14
Portfolio 2 = = 0.4063 Rank 2
0.08
0.18 − 0.14
Portfolio 3 = = 0.533 Rank 1
0.075

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 Exhibit 12.11: Risk-Return Performance
Comparisons: World Equity Portfolios
(U.S. dollars) Four years

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 Risk Allocation and Budgeting
ƒ Performance appraisal requires that both return
and risk measures be unbiased.
ƒ The total risk (standard deviation) of a portfolio is
the result of decisions at two levels:
ƒ The absolute risk allocation to each asset class.
ƒ The active risk allocation of managers in each
asset class.

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 Implementation
ƒ Important issues in constructing customized
international benchmarks are:
ƒ Individual country/market weights
ƒ Countries, industries, and styles
ƒ Currency hedging
ƒ Standard international equity indexes are weighted
by market capitalization.
ƒ Some prefer weights based on relative national
GDP.

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 Biases in Performance
Evaluation

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 Some Potential Biases in Return and
Risk
ƒ Infrequently traded assets
ƒ Option-like investment strategies
ƒ Survivorship bias: return
ƒ Survivorship bias: risk
ƒ Tricks sometimes used

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 Infrequently Traded Assets

Smoothed pricing: Infrequently traded

assets: Some assets trade infrequently. This is
the case for many alternative assets that are
not exchange-traded, such as real estate or
private equity. This is also the case for
illiquid exchange-traded securities or OTC
instruments often used by hedge funds.

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 Infrequently Traded Assets (cont’d)

Because prices used are often not up-to-

date market prices, but estimates of fair value,
their volatility is reduced (smoothing effect).
It introduces serial correlation of returns and
a downward bias to the measured risk of the
assets. In addition, it reduces the apparent
correlation with conventional (liquid) equity
and fixed income assets.

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 Infrequently Traded Assets (2)
The bias can be large, so the true risk is much larger
than the reported estimates. As suggested by Asness,
Krail, and Liew (2001), Lo (2002) and Getmansky,
Lo, and Makarov (2004), the correction requires
taking serial correlation of return into account. This
will lead to an increase in the estimated standard
deviation and a decrease in the Sharpe ratio
commonly used to measure risk-adjusted
performance. After adjusting for serial correlation,
Lo (2002) finds estimates that differ from the naive
Sharpe ratio estimator by as much as 70 percent.
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 Infrequently Traded Assets (2)

Some hedge funds purport to be market

neutral (i.e., funds with relatively small
market betas), but Asness, Krail, and Liew
(2001) show that including both
contemporaneous and lagged market returns
as regressors and summing the coefficients
yields significantly higher market exposure.

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 Option-like investment strategies
ƒ Risk measures used in performance appraisal
assume that portfolio returns are normally
distributed.
ƒ Many investment strategies followed by hedge
funds have some option-like features that violate
the normality assumption. For example, hedge
funds following so-called arbitrage strategies will
generally make a “small” profit when asset prices
converge to their arbitrage value, but they run the
risk of a huge loss if their arbitrage model fails.
Standard deviation or traditional VaR measures
understate the true risk of losses.
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 Biases in Returns
ƒ Self-selection bias: Hedge fund managers
decide themselves whether they want to be
included in a database. Managers that have
funds with an unimpressive track record will
not wish to have that information exposed.
Some managers only include the best-
performing funds.

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 Biases in Returns (cont’d)
ƒ Backfilling bias: When a hedge fund enters a
database, it brings with it its track record. Because
only hedge funds with good track records enter the
database, this creates a positive bias in past
performance in the database. Ibbotson and Chen
(2006) studied the TASS database from 1995 to
2006 and estimate that excluding backfilled data
reduces the average annual return by some 350 basis
points. Reliable index providers have recently taken
steps to minimize backfill bias.

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 Biases in Return (2)
ƒ Survivorship bias: In the investment
industry, unsuccessful funds and managers
tend to disappear over time. Only successful
ones search for new clients and present their
track records. This creates a survivor bias.

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 Biases in Return (2) (cont’d)
This problem is acute with hedge funds because they
often do not have to comply with performance
presentation standards. It is not uncommon to see hedge
fund managers present the track records of only their
successful funds, omitting those that have been closed. If
a fund begins to perform poorly, perhaps even starting to
go out of business, it may stop reporting its performance
entirely, thus inflating the reported average performance
of hedge funds. Hedge fund indexes and databases may
only include funds that have survived. Funds with bad
performance disappear and are removed from the
database that is used by investors to select among
existing funds.
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 Survivorship Bias
Most academic studies suggest that survivorship
bias overstates return by 200-400 basis points per
year. Malkiel and Saha (2005) studied the TASS
database from 1996 to 2003 and estimated the
average annual bias in performance to be 442 basis
points. A similar survivorship bias exists for equity
mutual funds, but it is smaller because the attrition
rate of mutual funds is much smaller that the hedge
fund attrition rate (of the order of 8 to 15 percent
per year on average).

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 Survivorship Bias (cont’d)
Reliable hedge fund indexes are now be much
less susceptible to survivorship bias as defunct
hedge funds are kept in the database; however,
funds that simply stop reporting still pose a
problem.

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 Tricks sometimes played
A manager without any expertise has decided to launch five long/short hedge
funds with some seed money. The investment strategies of the five funds are
quite different. Actually, the investment strategy of fund A is just the opposite of
that of fund E. After a couple of years, some have performed well and some
badly, as could be expected by pure chance. The manager decides to close funds
A, B, and C and to enter funds D and E in a well-known hedge fund database.
The marketing pitch of the manager is that the funds have superior performance
(Sharpe ratio of 1.7 and 2.7). What do you think?

Fund Name Mean Annual Standard Sharpe

Return Deviation Ratio
Fund A –30% 10% –3.3
Fund B –20% 10% –2.3
Fund C 0% 10% –0.3
Fund D +20% 10% 1.7
Fund E +30% 10% 2.7

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 Answer
The performance on the funds is purely
random. But only the good-performing
funds are included in the hedge fund
database. The performance reported for a
selection of funds is misleading. There is
obvious survivorship and self-selection bias.
Similarly, the performance of the hedge
fund index is biased upward and misleading.

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 Tricks sometimes played (2)

An investment company decides to merge two of

its international equity mutual funds:
ƒ Fund A has 100 million of AUM, with a
mediocre track record. The manager is fired.
ƒ Fund B has 1 million of AUM, with a great track
record. The manager will takeover the merged
funds.
What will be the name and published track
record of the new Fund?

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 Answer (2)

ƒ The temptation for the investment company

is to give the name of Fund B and use solely
its track record, as the same manager takes
over the merged fund.
ƒ Ethical performance standards should not
allow this track-record game.

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 Tricks sometimes played (3)
A manager leaves investment company X
and joins investment company Y. He has a
bad track record.
Should the accounts he/she managed be removed
from the universe (composite) of his/her former
investment company X when it reports its track
record?
Should it be added to the universe (composite) of
investment company Y newly-joined by the manager?

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 Answer (3)
ƒ The temptation for Investment company X is to remove the
past record of the accounts managed by the former manager
from the reported track record of its composites, because the
bad performance was due to a guy who is no longer with the
firm. Hence including his/her bad performance would not be
representative of the current firm.
ƒ Investment company Y does not include the bad performance
of the new manager. Anyway, they never had the accounts
under management and the bad performance was caused by the
old firm, not by the manager.

Ethical performance standards should not allow Investment

company X to adjust its reported past performance.
A similar question arises when a client leaves the investment
company because of the bad performance of her account.
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 Global Investment Performance
Standards (GIPS®)
Designed by the CFA Institute
ƒ Allow investors to compare investment firms on a global
level and allows investment managers to compete globally.
ƒ Also ensure uniformity in reporting so that results are
directly comparable among investment managers.
ƒ TWR is required.
ƒ The concept of composites is central to AIMR presentation
standards.
ƒ A composite is an aggregation of a number of portfolios
into a single group that is representative of a particular
objective or strategy.

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 Global Investment Performance
Standards (GIPS®)
ƒ In 2005, a new version of GIPS was
published to be used worldwide.
ƒ As of 2006, GIPS replaced the AIMR-PPS
standards and are being adopted by many
countries.

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 Exhibit 12.A: Account Valuation
Reports (explanation)

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 Exhibit 12.A: Account Valuation
Reports (explanation) (cont’d)

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