Kaarten: Asset management lecture 3: performance management | Quizlet

What is raw return?

Raw return = net return = the relative change in NAV per share (adjusted to distributions)

What is the problem with the net asset value?

While expenses are deducted on a daily basis from the net asset value of the fund, the net asset value does not take into account loads.

What are the advantages of raw return?

− Easy to compute

− Intuitive economic interpretation

− Often used in practice

What are the disadvantages of raw return?

No risk-adjustment

What is a fund's excess return?

The raw return minus the return of the benchmark

What is the goal of the benchmark for the fund?

The benchmark should reflect the return to an investment with similar risk.

What is the fund's market-adjusted performance and how is it calculated?

Outperformance (underperformance) of the fund relative to the market.

The fund's market-adjusted return is the raw return minus the market return.

What are the advantages of market-adjusted return?

− Easy to compute

− Intuitive economic interpretation

− Often used in practice

− Takes the market risk into account

What is the disadvantage of market-adjusted return?

It does not take the fund's risk into account

What is strategic benchmark selection?

Investment management companies have an incentive to strategically select the benchmark, fund managers want to outperform their benchmark. Thus, they will try to select a less risky benchmark that is likely to yield lower returns compared to the fund. The fund will likely outperform the benchmark, indicating that it generates an excess return ("alpha"), even though the outperformance is merely a compensation for risk.

What is the danger of strategic benchmark selection for investors?

Benchmarks selected by investment management companies often do not adequately control for the riskiness of funds.

What is a real-life example of strategic benchmark selection?

Fidelity Magellan Fund benchmarks S&P 500 but Fidelity Magellan Fund also invests in foreign issuers -> is it fair to compare it to a domestic benchmark?

What is the Sharpe ratio and how is it calculated?

The fund's Sharpe ratio shows the return per unit of risk. It is the excess return minus the risk-free rate divided by the standard deviation of the fund's returns.

What are the advantages of the Sharpe ratio?

− Easy to compute

− Intuitive economic interpretation

− Often used in practice

− Takes the fund's risk into account

What is the disadvantage of the Sharpe ratio?

It is based on the fund's total risk -> total risk=systematic risk (rewarded) + idiosycratic (not rewarded but can be diversified)

What is the Treynor ratio?

The fund's Treynor ratio shows the return per unit of systematic risk. It is the excess return over the risk-free rate divided by the fund's beta relative to the market.

What are the advantages of the Treynor ratio?

- Solid measure of risk-adjusted performance

− Relatively easy economic interpretation

What are the disadvantages of the Treynor ratio?

- More difficult to compute (beta estimation)

− Does not take additional risk factors into account (e.g. size, value)

What is the Jensen's alpha / CAPM alpha and how is it calculated?

The fund's Jensen's alpha / CAPM alpha shows the excess return relative to an alternative investment with the same systematic risk as the mutual fund. It is the excess return over the risk-free rate that cannot be explained by the market factor.

What are the advantages of Jensen's alpha / CAPM alpha?

- Theoretical basis (CAPM)

− Prominent measure of risk-adjusted performance

What are the disadvantages of Jensen's alpha / CAPM alpha?

− More difficult to compute (beta estimation)

− Does not take additional risk factors into account (e.g. size, value)

What is the problem of CAPM?

CAPM doesn't work that well since it says that funds with a high beta should have a bigger return than firms with a low beta, but in reality it's the opposite

According to Fama and French (1992,1993), what causes the size premium and the value premium?

the size premium and the value premium are not due to market inefficiency, but they claim that size and value are systematic risk factors.

What are, according Fama and French, strong determinants of stock returns?

Company size and the book-to-market ratio

What is the fund's Fama-French 3-factor alpha?

The fund's Fama-French 3-factor alpha is the excess return over the risk-free rate that cannot be explained by the market factor, the size factor, and the value factor.

Do you allow the fund manager to generate alpha by investing in small stocks or value stocks?

Yes: CAPM alpha

No: Fama-French 3-factor alpha

According to Carhart (1997), what is the main driver behind the persistent outperformance of the "best" mutual funds? And what is his suggestion?

Carhart finds that the persistent outperformance of the "best" mutual funds is largely driven by these mutual funds exploiting the momentum effect. Therefore, he suggests to include a momentum factor as an additional factor in the model when measuring the performance of mutual funds.

Do you allow the fund manager to generate alpha by investing in past winners?

Yes: CAPM alpha and FF alpha

No: Carhart alpha

What is the problem with domestic mutual funds including foreign stocks as part of their portfolio?

Investments in foreign stocks have characteristics that are not fully captured by a model including only domestic equity factors. => Failure to control for foreign investments might result in alphas that are falsely attributed to fund manager skills rather than to the foreign investments.

What are the various approaches to control for foreign investments with the Jensen's alpha / CAPM alpha?

− International factors (e.g., MSCI World)

− Domestic factors and foreign factors

− Blended factors (e.g., blended factor = 80% domestic factor + 20% foreign factor)

What is the problem with mutual funds holding securities other than stocks in their portfolio? (e.g., mixed / balanced mutual funds invested in stocks and bonds) And what is the solution?

Problem: These other asset classes have characteristics that are not fully captured by equity factors. Failure to include factors for other asset classes might result in wrong alpha estimates

Solution: the multifactor model (should include at least one factor for each asset class the fund invested in)

How to know if the t-statistic (number shown in brackets) is significant?

>= 1,645 significant at 10% level

>= 1,960 significant at 5% level

>= 2,576 significant at 1% level

What are the advantages of the multifactor alpha?

− Most comprehensive measure of risk-adjusted performance

− By adding additional factors to the model (e.g., a strategy exploiting the post-earnings announcement drift), one can analyze which strategies a fund manager is pursuing

What are the disadvantages of the multifactor alpha?

− No theoretical basis

− More difficult to compute (beta estimation)

− More difficult economic interpretation

− Not clear what the relevant risk factors are (e.g., do investors perceive the size factor as a risk factor?)

What is the joint hypotheses problem?

The joint hypotheses problem states that tests of market efficiency always jointly test the validity of the underlying asset pricing model. Therefore, whenever someone concludes that a finding seems to indicate market inefficiency, one may also want to question the underlying asset pricing model (e.g., is the size effect evidence for the market not being semi-strong form efficient or is the size effect a compensation for risk?).

Which performance measure should be used?

− Risk-adjusted performance measures are superior to performance measures not controlling for risk.

− Investors need to be conscious of the types of securities a fund holds (i.e., the trading strategy a fund pursues) and they should not simply rely on the self-selected benchmark of the fund (e.g., DAX) or the overall fund classification (e.g., domestic stocks).

− Investors should use different performance measures. If results are consistent across different performance measures, investors likely uncovered the "true" performance of the fund.

Why should you calculate the performance before fees (gross)?

relevant measure to determine whether fund manager has skills

Why should you calculate the performance after fees (net)?

relevant measure to determine whether fund adds value for investors

Do mutual funds on average over or underperform common benchmarks net of fees?

On average, mutual funds underperform common benchmarks net of fees. However, in the cross-section of mutual funds, there might be some funds that perform better than the average.

What is one of the determinants of fund performance?

Past fund performance (performance persistence)

According to Carhart (1997), are past fund returns predictive for future returns?

1) Methodology: On January 1 of each year, the author sorts mutual funds into deciles based on their past 1-year returns (3-year alphas) and tracks their alphas over the following year. −

2) Results:

− When funds are ranked by past raw returns, the top-ranked group has a positive subsequent Jensen's alpha / CAPM alpha.

− The alpha of the top-ranked group turns negative when switching to a Carhart 4-factor alpha.

− Carhart (1997) argues that much of the persistence documented using the Jensen's alpha / CAPM alpha can be attributed to the momentum effect in stock returns.

Why is the performance persistance in the negative so strong (high)? see slide 33

The lowest ones are charging very high fees