Practical Portfolio Performance Measurement and Attribution

A practitioner's guide to the role and implications of performance measurement and attribution analysis in asset management firms

Practical Portfolio Performance Measurement and Attribution is a comprehensive reference and guide to the use and calculation of performance returns in the investment decision process. Focusing on real-world application rather than academic theory, this highly practical book helps asset managers and investors determine return on assets, analyse portfolio behaviour and improve performance. Author Carl R. Bacon clearly describes each of the methodologies used by performance analysts in today's financial environment whilst sharing valuable insights drawn from his experience as a Director of Performance Measurement & Risk Control.

The third edition is revised to reflect recent developments in performance attribution and presentation standards. Fully up-to-date chapters cover the entire performance measurement process, including return calculations, attribution methodologies, risk measures, manager selection and presentation of performance information.

• Written by an acknowledged leader in global investment performance standards, performance attribution technique and risk measurement
• Aligns with the publication of the 2020 Global Investment Performance Standards (GIPS®)
• Explains the mathematical aspects of performance measurement and attribution in a clear, easy-to-understand manner
• Provides numerous practical and worked examples of attribution analysis and risk calculations supported by Excel spreadsheets
• Includes signposts for the future development of performance measurement

Practical Portfolio Performance Measurement and Attribution, Third Edition, remains a must-have for performance analysts and risk controllers, portfolio managers, compliance professionals and all asset managers, owners, consultants and servicing firms.

CARL R. BACON, CIPM, is Chief Advisor to Confluence. He is a member of the Advisory Board of the Journal of Performance Measurement and Founder of The Freedom Index Company. He is the former Chairman of StatPro plc, Director of Risk Control and Performance at Foreign & Colonial Management Ltd and Vice President Head of Performance (Europe) for JP Morgan Investment Management Inc.

Contents

Acknowledgements

Contents

Chapter 1 Introduction

The Performance Measurement Process

Role of performance analysts

Book Structure

Chapter 2 The Asset Management Industry

Asset Classes

Public Equities

Bonds (or Fixed Income)

Cash (and near cash)

Private Assets

Real Estate

Private Equity

Private Debt

Infrastructure

Natural Resources

Commodities

Derivatives

Futures

Forwards

Swaps

Contracts for Difference (CFD)

Options

Overlay Strategies

Currency

Hedge Funds

Asset Allocation

Strategic asset allocation

Tactical asset allocation.

Chapter 3 The Mathematics of Portfolio Return

Simple Return

Continuously Compounded (or logarithmic) Returns

Money-weighted Returns (MWR)

Internal Rate of Return (IRR)

Ex-ante Internal Rate of Return

Simple Internal Rate of Return

Ex-post Internal Rate of Return

Simple Dietz

ICAA Method

Modified Dietz

Time-Weighted Returns (TWR)

True Time-Weighted

Unit Price Method

Unit Price Method with Distributions

Time-weighted versus Money-weighted Rates of Return

Approximations to the Time Weighted Return

Index Substitution

Regression Method (or b method)

Analyst’s Test

Hybrid Methodologies

Linked Modified Dietz

BAI Method (or linked IRR)

Which method to use?

Late Trading and Market Timing

Self-selection

Large Cash Flow

Self-selection of methodologies

Annualised Returns

Since Inception Internal Rate of Return (SI-IRR)

Modified IRR (MIRR)

Return Hiatus

Gross and net of fee calculations

Estimating gross and net of fee returns

Initial Fees

Performance Fees

Asymmetric or Symmetric

Crystallisation

Performance Fees in Practice

Equalization

Reporting Hierarchy

Overlay Strategies

Overlay performance return calculations:

Base currency and local returns

Currency conversions

Hedged Returns

Currency Overlay Returns

Perfectly Hedged Returns

Portfolio Component Returns

Money-weighted Component Returns

End of day

Beginning of day

Intra-day weighted

Differentiated

Actual Time

Rule-based

Extremely large cash flows

Which timing assumption to use for time-weighted returns?

Carve Outs

Sub-portfolios

Cash Sectors

Individual security returns

Multi-period component returns

Abnormal Returns

Short Positions

Contribution to return

Composite returns

Chapter 4 Benchmarks

Benchmarks

Benchmark attributes

The Role of Benchmarks

Types of Benchmarks

Commercial Indexes

Calculation methodologies

Aggregate Price Index (Price-weighted Index or Carli type)

Geometric (or Jevons type) Index

Market Capitalisation Index

Laspeyres Index

Paasche Index

Marshall – Edgeworth Index

Fisher Index

Equal weighted Indexes

Fundamental Indexes

Optimised Indexes (efficient or minimum variance indexes)

Fixed Income Indexes

Index Providers

Choice of Index Provider

Benchmark Regulation

Choice of Index

Currency Effects in Benchmark

Hedged Indexes

Customised Indexes

Capped Indexes

Peer Groups and Universes

Percentile Rank

Random Portfolios

Exchange Traded Funds (ETFs)

Target Returns

Blended Benchmarks (or balanced benchmarks)

Fixed Weight & Dynamised Benchmarks

Spliced Indexes

Money-weighted Benchmarks (or public market equivalents)

Normal Portfolio

Benchmark Statistics

Index Turnover

Up-capture Indicator

Down-capture Indicator

Up-number Ratio

Down-number Ratio

Up-percentage Ratio

Down-percentage Ratio

Percentage Gain Ratio

Excess return

Arithmetic Excess Return

Geometric Excess Return

Chapter 5 Risk

Definition of Risk

Risk types

Risk management v Risk control

Risk aversion

Ex-post and ex-ante

Descriptive Statistics

Mean (or arithmetic mean)

Mean absolute deviation (or mean deviation)

Variance

Bessel’s correction (population or sample, n or n-1)

Sample variance

Standard deviation (variability or volatility)

Annualised risk (or time aggregation)

The Central Limit Theorem

Frequency and number of data points

Normal (or Gaussian) distribution

Histograms

Skewness (Fisher’s or moment skewness)

Sample skewness

Kurtosis (Pearson’s kurtosis)

Excess kurtosis (or Fisher’s kurtosis)

Sample kurtosis

Bera-Jarque statistic (or Jarque-Bera)

Covariance

Sample covariance

Correlation (r)

Sample correlation

Performance appraisal

Sharpe ratio (reward to variability, Sharpe index)

Roy ratio

Risk-free rate

Alternative Sharpe ratio

Revised Sharpe ratio

Adjusted Sharpe Ratio

Skew-adjusted Sharpe Ratio

Relative risk

Tracking error (or tracking risk, relative risk, active risk)

Information ratio

Geometric information ratio

Modified information ratio

Regression analysis

Regression equation

Regression alpha

Regression beta

Regression epsilon

Capital Asset Pricing Model (CAPM)

Beta (b) (systematic risk or volatility)

Jensen’s alpha (Jensen’s measure or Jensen’s differential return or ex-post alpha)

Annualised alpha

Bull beta (b⁺)

Bear beta (b^-)

Beta timing ratio

Market timing

Systematic risk

Correlation

R²(or coefficient of determination)

Specific (or residual) risk

Treynor ratio  (Reward to volatility)

Appraisal ratio (or Treynor-Black ratio)

Factor Models

Fama decomposition

Selectivity

Diversification

Net selectivity

Fama-French three factor model

Three factor alpha (or Fama-French alpha)

Carhart four factor model

Four factor alpha (or Carhart’s alpha)

Multi-factor Models

Drawdown

Average drawdown

Maximum drawdown

Largest individual drawdown

Recovery time (or drawdown duration)

Drawdown deviation

Ulcer index

Pain index

Calmar ratio (or Drawdown ratio)

MAR ratio

Sterling ratio

Sterling-Calmar ratio

Burke ratio

Modified Burke ratio

Martin ratio (or Ulcer performance index)

Pain ratio

Partial Moments

Downside risk (or semi-standard deviation)

Downside potential

Pure downside risk

Half variance (or semi-variance)

Upside risk (or upside uncertainty)

Mean absolute moment

Omega ratio (W)

Bernardo & Ledoit (or gain–loss) ratio

d ratio

Omega-Sharpe ratio

Sortino ratio

Reward to half-variance

Downside risk Sharpe ratio

Sortino-Satchell ratio

Kappa ratio

Upside potential ratio

Volatility skewness

Variability skewness

Farinelli-Tibiletti Ratio

Prospect ratio

Fixed Income Risk

Pricing fixed income instruments

Redemption yield (yield to maturity)

Weighted average cash flow

Duration (effective mean term, discounted mean term or volatility)

Macaulay duration

Macaulay-Weil duration

Modified duration

Portfolio duration

Effective duration (or option-adjusted duration)

Duration to worst

Convexity

Modified convexity

Effective convexity

Portfolio convexity

Bond returns

Duration beta

Reward to duration

Miscellaneous Risk Measures

Hurst index (or Hurst exponent)

Bias ratio

Active Share

Value at Risk (VaR)

Risk-adjusted return

M²

M² excess return

Differential return

Adjusted M²

Skew-adjusted M²

Types of Excess Return (or Alpha)

A Periodic Table of Risk Measures

Periodic Table Design

Why measure ex-post risk?

Which risk measures to use?

Hedge funds

Smoothing

Outliers

Data mining

Time Period

Chapter 6 Return Attribution  280

What is Attribution?

Definition

Attribution as an asset management tool

Early Development

Types of Return Attribution

Returns-based (regression or factor) Attribution

Holdings-based (or buy/hold) Attribution

Transaction-based Attribution

Arithmetic Attribution

Brinson, Hood & Beebower

Asset Allocation

Security (or Stock) Selection

Interaction

Brinson & Fachler

Interaction

Geometric Excess Return Attribution

Asset allocation

Stock selection

Sector Weights

Frequency of Analysis

Security Level Attribution

Transaction costs

Off-benchmark (or zero weight sector) attribution

Attribution consistent with the Investment Decision Process

Market Neutral Attribution

Attribution for 130/30 funds (or extended short funds)

Leverage (or gearing)

Attribution including derivatives

Attribution including Equity Index Futures

Attribution Analysis using options

Multi-currency attribution

Ankrim & Hensel

Karnosky & Singer

Geometric Multi-Currency Attribution

Naïve Currency Attribution

Compounding effects

Geometric Currency Allocation

Currency Timing

Interest Rate Differentials

Revised Currency Allocation

Revised Country Allocation

Incorporating Forward Currency Contracts

Summarising

Other Currency Issues

Fixed Income Attribution

The Yield Curve

Yield curve analysis

Shift

Twist (or slope)

Curvature (or butterfly)

Carry

Credit (or spread)

Yield Curve Decomposition

Wagner & Tito

Weighted Duration Attribution

Geometric Fixed Income Attribution

Campisi Framework

Yield Curve Decomposition

Multi-period attribution

Smoothing Algorithms

Carino

Menchero

Linking Algorithms

GRAP Method

Frongello

Davies & Laker

Multi-period Geometric Attribution

Annualisation of Excess Return

Attribution Annualisation

Contribution Analysis (or absolute return attribution)

Risk-adjusted Attribution

Selectivity

Multi-level Attribution

Balanced attribution

Evolution of performance attribution methodologies

Chapter 7 Performance Presentation Standards

Why do we need performance presentation standards?

Global Investment Performance Standards (GIPS^®) – A history

Advantages for Asset Managers

The GIPS Standards

Fundamentals of Compliance

Definition of the Firm

Maintaining Policies and Procedures

Providing GIPS Reports

Benchmark Selection

Correcting Errors in GIPS Reports

Composite Descriptions

Recordkeeping

Linking of theoretical and actual performance

Portability

Use of time-weighted or money-weighted returns

Claiming Compliance with the GIPS standards.

Input Data and Calculation Methodology

Firm Assets, Composite Assets and Pooled Fund Assets

Overlay Exposure

Returns

Valuation

Time-Weighted Returns

Money-weighted Returns

Net Returns

Composite Returns

Private Market Investments

Real Estate

Net-of-fee Carve-outs returns

Wrap fee, side pockets and subscription lines of credit

Composite and Pooled Fund Maintenance

Composite Maintenance

Carve-Outs

Presentation and Reporting

Composite Time-weighted Return Report

Returns, Dispersion & Risk

Unobservable inputs, gross or net-of-fees, multiple benchmarks, breaks in performance, carve-outs and non-fee-paying portfolios

Committed Capital and Advisory Assets

Reporting currency, carve-outs, overlay strategies, wrap fees and supplemental information

Composite Money-weighted Reports

Composite Cumulative Committed Capital

Total Value to Since-inception Paid in Capital (TVPI or Multiple of Investment Capital (MOIC) or Investment Multiple)

Since-inception Distributions to Since-inception Paid-in Capital (Realisation multiple or DPI)

Since-inception Paid-in Capital to cumulative Committed Capital (PIC Multiple)

Residual Value to since-Inception Paid-in Capital (Unrealised Multiple or RVPI)

Disclosures

Claim of Compliance

Firm, composite and benchmark definitions

Fee disclosures

Inception date, creation date, composite lists availability of policies and procedures, leverage and estimated transaction costs.

Significant events, redefinition, minimum asset levels and withholding tax

Conflicts with regulation, carve-out disclosures & sub-advisors.

Benchmark Disclosures

Significant cash flow disclosure and material errors.

Risk measures, overlay strategy, real estate valuation and theoretical performance disclosures.

Sample GIPS Composite Report

GIPS Advertising Guidelines

Fundamental requirements of the GIPS Advertising Guidelines

GIPS Advertisements that do not include performance.

GIPS advertisements for composites

GIPS Advertisements for a Broad Distribution Pooled Fund

Verification

Performance Examination

Achieving Compliance

Maintaining Compliance

GIPS Standards for Asset Owners

Chapter 8 Bringing it all together

Effective dashboards

Data visualisation tools

Manager Selection

Asset Manager Selection

Manager Evaluation

Portfolio Evaluation

Monitoring and Control

The Four Dimensions of Performance

Ex-post Return (The traditional dimension)

Ex-post Risk (The neglected dimension)

Ex-ante Return (The unknown dimension)

Ex-ante Risk (The “sexy” dimension)

Risk efficiency ratio

Performance efficiency

Risk control structure

Risk management

Glossary of Key Terms

Appendix A - Simple Attribution

Appendix B - Multi-Currency Attribution Methodology

Bibliography

Index

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