Portfolio Performance Measurement and Benchmarking (PROFESSIONAL FINANCE & INVESTM) - Hardcover

CHRISTOPHERSON

Hardcover

ISBN 10: 0071496653 ISBN 13: 9780071496650

Publisher: McGraw Hill, 2009

Synopsis

In order to make sound investment choices,investors must know the projected return oninvestment in relation to the risk of not beingpaid. Benchmarks are excellent evaluators,but the failure to choose the right investingperformance benchmark often leads to baddecisions or inaction, which inevitably resultsin lost profits.

The first book of its kind, Portfolio PerformanceMeasurement and Benchmarking is a completeguide to benchmarks and performace evaluationusing benchmarks. In one inclusivevolume, readers get foundational coverage onbenchmark construction, as well as expert insightinto specific benchmarks for asset classesand investment styles.

Starting with the basics―such as return calculationsand methods of dealing with cashflows―this thorough book covers a widevariety of performance measurement methodologiesand evaluation techniques beforemoving into more technical material that deconstructsboth the creation of indexes andthe components of a desirable benchmark.

Portfolio Performance Measurement and Benchmarkingprovides detailed coverage of benchmarksfor:

• U.S. equities
• Global and international equities
• Fixed income
• Real estate

The team of renowned authors offers illuminatingopinions on the philosophy and developmentof equity indexes, while highlightingnumerous mechanical problems inherent inbuilding benchmarks and the implications ofeach one.

Before you make your next investment, becertain your return will be worth the riskwith Portfolio Performance Measurement andBenchmarking.

About this title

About the Authors

Jon A. Christopherson, Ph.D., is a research fellow for Russell Investments, where he has a solid record of intellectual innovation. He has been a member of the editorial advisory boards of The Journal of Portfolio Management and The Journal of Investment Consulting.

David R. Cariño, Ph.D., is a research fellow for Russell Investments. He was the architect of the Russell-Yasuda Kasai model, which received a Franz Edelman Award by The Institute for Operations Research and the Management Sciences. Cariño serves on the advisory board of The Journal of Performance Measurement.

Wayne E. Ferson, Ph.D., holds the Ivadelle and Theodore Johnson Chair in Banking and Finance at the USC Marshall School of Business and is the former John L. Collins Chair in Finance at the Carroll School of Management at Boston College. He is widely known in academic circles, has been published in the best academic journals, and has served on several prestigious editorial boards.

From the Back Cover

The first comprehensive guide to performance assessment and equity benchmark construction for your portfolio

Portfolio Performance Measurement and Benchmarking helps institutional investors create a smart system for accurate performance evaluation of managed asset portfolios. Striking a useful balance between scholarly groundwork and real-world practicality, this state-of-the-art book gives readers a potent combination of cornerstone knowledge on measuring return and risk with practical guidance on evaluating the performance of a variety of investment strategies.

Packed with applicable examples demonstrating how to correctly calculate performance statistics and properly interpret the results, Portfolio Performance Measurement and Benchmarking features:

• Thorough coverage of a wide variety of performance-measurement methodologies and evaluation techniques
• Expert explanations of the mathematics underlying each method
• Specific calculation and evaluation examples from the real world

From the basics of asset class return expectations and portfolio comparisons to up-to-date information on investment styles and global index construction, this go-to guide provides a useful depth of coverage in easy-to-understand terms.

Whether you're investing in a single equity market or managing a multiple asset class fund, Portfolio Performance Measurement and Benchmarking is a must-have resource for determining which investment strategies offer the most profitable rewards relative to their risk.

Excerpt. © Reprinted by permission. All rights reserved.

Portfolio Performance Measurement and Benchmarking

By JON A. CHRISTOPHERSON, DAVID R. CARI, #209;O, WAYNE E. FERSON

The McGraw-Hill Companies, Inc.

Copyright © 2009 The McGraw-Hill Companies, Inc.
All rights reserved.

ISBN: 978-0-07-149665-0

Contents

Preface
Chapter 1 What Is Performance and Benchmarking?
Chapter 2 Asset Class Return Expectations
Chapter 3 Returns Without Cash Flows
Chapter 4 Average Returns
Chapter 5 Returns in the Presence of Cash Flows
Chapter 6 Comparing Two Portfolio Returns
Chapter 7 Some Foundations
Chapter 8 Estimating the Elements of the CAPM
Chapter 9 What Is Risk?
Chapter 10 Risk-Adjusted Return Measures
Chapter 11 Fixed-Income Risk
Chapter 12 Conditional Performance Evaluation
Chapter 13 Market Timing
Chapter 14 Factor Models
Chapter 15 Factors of Equity Returns in the United States
Chapter 16 Factor Model (Barra) Performance Attribution
Chapter 17 Contributions to Return
Chapter 18 Performance Attribution
Chapter 19 Linking Attribution Effects
Chapter 20 Benchmarks and Knowledge
Chapter 21 Elements of a Desirable Benchmark
Chapter 22 Index Weighting
Chapter 23 Practical Issues with Building Indexes
Chapter 24 Styles, Factors, and Equity Benchmarks
Chapter 25 Equity Style Indexes: Tools for Better Performance Evaluation 
and Plan Management
Chapter 26 Russell Style Index Methodology
Chapter 27 U.S. Equity Benchmarks
Chapter 28 Global and International Equity Benchmarks
Chapter 29 Fixed-Income Benchmarks
Chapter 30 Real Estate Benchmarks
Chapter 31 Hedge Fund Universes
Chapter 32 Determining Investment Style
Chapter 33 GIPS: Global Investment Performance Standards
Index

Excerpt

CHAPTER 1

What Is Performance and Benchmarking?

THE BASIC ISSUE: HAS YOUR WEALTH INCREASED?

If we receive a $5,000 bonus check because we sold more widgets than ourcompetitors did, we can either spend the money now or we can defer spending itnow and let it grow in an investment. Say we had invested our $5,000 in acertificate of deposit (CD) and our account grew to $5,050 over a period ofthree months. We earned $50 on a $5,000 investment or 1 percent over threemonths, or about 4 percent per year on our investment. If we think that the $50earned on a $5,000 investment is not a reasonable return, then we might beinclined to spend $5,000 and not invest it or look for an alternative higher-payinginvestment.

To make investment choices we must have the proper data and information aboutthe return on investments and the risk of not being paid. This relatively simplenotion of performance measurement and evaluation is basic to all investments.The decision to consume today or defer consumption by investing for tomorrow isabsolutely fundamental to all economic activity. Economic growth depends oninvestors deferring consumption so that the money can be invested for thefuture. No factory is built, no new company is capitalized, and no economicgrowth is possible without this deferred consumption.

The confidence that people have that their investments will earn sufficientcompensation in the future is critical to justifying their deferring consumptiontoday. Hence, it is fundamental to any economic system.

Instances of hyperinflation such as in Zimbabwe in 2007, Argentina in the 1990s,or Germany in the early 1930s create very challenging environments for economicactivity. Investors ask themselves why anyone would put money in a bank, buy astock, buy a bond, or invest in anything if the payoff cannot be expected toexceed the very rapid rise in prices. Being able to reasonably anticipate thepayoff we will receive for investing is absolutely critical.

The institutions that gather money from investors and distribute it to users ofcapital make up the financial system. The more efficient and effective thecollection and distribution of capital, the more efficient the economy will be.Essential to this operation is the ability to correctly assess the performanceof various investment alternatives. New companies or companies seeking to expandattempt to raise capital by persuading potential investors that their investmentwill be rewarded. If investors are unable to calculate before or after the factwhether the promises or expectations of an investment were met, they will notinvest. This flow of information is fundamental to the efficient allocation ofcapital within an economy toward productive activities and enterprises thatincrease wealth and away from activities and enterprises that are lessproductive. In this sense, anything investors can do to improve the performanceevaluation techniques and methods that they use makes a positive contribution byhelping the economic system to more efficiently allocate their savings (i.e.,capital) and thereby maximizing economic growth.

WAS THE CHANGE IN WEALTH WORTH THE RISK?

If investors want their investments to grow more than in a savings account, thenthey are going to have to invest in enterprises whose outcomes are uncertain.Most investors comparing alternatives that provide the same return, the samepromised payoff, will choose the alternative that is less risky. If a company'smanagement wants investors to invest in its enterprise but the outcome of theenterprise is not certain, the company has to offer a higher return potentialthan comparable less risky investments.

This leads to the second dimension of the investment problem—risk. When wecalculate our growth in wealth, we want to balance that knowledge with anassessment of the risk we undertook to achieve that wealth. The problem with theterm risk is that it's not easy to measure in a way that satisfies allinvestors. In this book we will examine various definitions and measures ofrisk.

The preceding considerations lead us to this definition of performancemeasurement:

Performance is the return or the increase in wealth over time of an investmentrelative to the amount of risk the investor is taking; that is, performancemeasurement provides a risk-adjusted return assessment.

So the first central problem in performance measurement is to assess theincrease in wealth over a given time frame. Then we must view this return interms of some measure of the risk we took to obtain it. If we have more than oneinvestment opportunity, we will want to compare these investments in terms oftheir reward relative to their risk. In the first part of this book we focus oncalculating different measures of wealth growth and different measures of riskcalculation. The objective is to provide tools for calculating risk-adjustedreturn.

COMPARING RETURN WITH ALTERNATIVE INVESTMENT RETURNS

After we have calculated our growth in wealth and have assessed the risk we tookto gain that wealth, the next logical question is, How large was the risk-adjustedreturn compared with the risk-adjusted return achieved with alternativeinvestments? We ask ourselves whether we could have obtained the same return atless risk by following an alternative strategy.

This leads to the discussion of benchmarking. Benchmarking is theprocess of finding a quantifiable standard against which to measure one'sperformance. Benchmarking seeks to determine whether the performance of ourinvestment is better than what we could have obtained using a simpler or lesscostly investment plan. The subject consumes a large portion of the latter halfof this book.

The notion of benchmarking the performance of investment strategies is arelatively new phenomenon. As recently as the 1960s, large sophisticatedinvestors were comparing their growth of wealth to T-bills or government bondson an absolute basis. Investors thought the comparison that mattered wasabsolute return relative to zero—loss was all that mattered. Zero returnis still the first fundamental level of performance evaluation. However,managers of complex funds also wanted to know how various segments of theirplans, such as stocks, performed relative to some alternative.

Until about the 1980s, if investors wanted to know how well their stocksperformed relative to other stocks, the primary equity indexes available in theUnited States were the Dow Jones Industrial Average and the S&P 500. This wasthe extent of equity benchmarking. Much has changed since then. A wide varietyof equity benchmarks have been created. A hierarchy of comparisons has beendeveloped to allow investors to understand how well their equity investments aredoing. Analysts also noted that if the benchmark selected was inappropriate,then the analyst would obtain a useless or even perverse result and makeerroneous evaluations and decisions. For example, if you hold a selection ofsmall company stocks in your portfolio during a period when most small stockswent down while large company stocks went up, it makes little sense to benchmarkyour selection of small stocks by comparing your returns to those of largestocks in the S&P 500. It would be better to compare your returns to a portfolioof all the small stocks that you might have reasonably chosen among.

ACTIVE INVESTING VERSUS PASSIVE INVESTING

During the 1970s and 1980s, portfolios based on the list of securities in anindex led to the creation of index funds, which in turn led to the growth of ahuge industry that provides passive alternative investment vehicles based on allsorts of benchmarks. These inexpensive to manage passive index funds provideinvestment vehicles for investors who want exposure to the average risk andreturns of an asset class without having to select individual securities.

One of the first questions modern investors face is that of whether they shouldundertake "active management of assets" or invest in an index fund, that is,engage in "the passive management of assets." When investors purchase a stock ora bond and do not purchase others in the same class, they presumably do sobecause they have some information that persuades them that the stock or bondthey purchased will provide higher payoffs than the other stocks and bondsavailable. This is active management. Passive management refers to thepurchase of a share in an index fund or a group of assets chosen with noinformation about their prospective payoffs other than the asset type to whichthey belong. Passive investing is a "no information" or "naïve investment"strategy because no specialized knowledge is needed to execute the investmentstrategy. For example, "buy all stocks in the market and weight each by itsfloat-adjusted capitalization weight" is a strategy that anyone who knows thebasics of investments can do.

Unfortunately for active management, passive strategies can perform quite well.Investors, who have been in the markets for many years and have seen up marketsand down markets, know that it is difficult for most active investors tooutperform the return of a naïve passive index. In fact there are some who wouldargue that passive investing is the only sensible way for the majority of peopleto invest.

PERFORMANCE ATTRIBUTION

Once the investor has calculated return on a risk-adjusted basis and compared itto an appropriate benchmark, the next natural question is, Where did the returncome from, or to what "market forces or factors" can we attribute the return?The investigation of the sources of return leads to the field calledperformance attribution. The objective of attribution analysis is tobreak out the performance that emerged among various factors in the marketplaceand the decisions the investor made.

Our objective in this book is to provide the reader with fundamental knowledgeabout measuring return and risk and how to use this fundamental information toaccurately evaluate the performance of investment strategies. As we cover themathematics underlying each of the methods, we also try to explain what theymean in simple terms.

CHAPTER 2

Asset Class Return Expectations

To understand performance measurement it is useful to begin with some knowledgeof what investors can expect when they invest. The objective of this review isto provide a background for the performance measurement discussion. The firstobservation is that there is a variety of opportunities for investing.

THE EXPECTED RANGE OF RETURNS FROM DIFFERENT KINDS OF INVESTMENTS

Intuitively we know that different kinds of investments have different kinds ofrisks and potential payoffs. The payoff for buying a winning lottery ticket ismuch greater than the interest received on a savings account; however, theprobability of payoff is quite a bit smaller—usually close to zero.Choosing among different asset class investment alternatives is always a choiceamong return expectations, each of which is associated with a risk of payoff.

Understanding the range of values you are likely to encounter for differentasset classes is useful for practical reasons. It has been said that there are"good data," "bad data," "funny looking numbers," and "ugly data." Good data aredata in which you have confidence. Bad data are data that are obviously wrongand in which you cannot have confidence. Funny looking numbers are data thatintuitively just do not look correct but might be. Ugly data are data that youbelieve are accurate but do not meet your expectations. To avoid errors inperformance evaluation it is useful to be able to intuitively identify each ofthese kinds of data.

For analytical purposes professionals in the investment community classifydifferent investment opportunities into groups called asset classes. Thesavings account or CD we have mentioned previously is classified as a member ofthe fixed-income asset class. Common stocks are grouped into the assetclass called equity. In performance evaluation, the best way to guardagainst errors in calculation and interpretation is to recognize "funny looking"numbers when you see them. To accomplish this you must have an expectation ofwhat the numbers should be.

WHAT RANGE OF VALUES IS LIKELY TO BE ENCOUNTERED?

Generally speaking, the expectation for each asset class tends to change withrecent experience. During the 1970s a leading business magazine asked whetherequities were dead as an investment class because the deep recession of1972–1976 had caused stocks to decline so much that no one could seestocks ever returning 20 percent a year again—but they did in the 1990s.Conversely, when stocks did so well in the 1990s, there were those who claimed anew model of economic development had occurred and stocks would continue toperform well indefinitely. They asked why anyone would ever invest in bondsagain—then there was a 20 percent correction in stock prices in 2000.

Any assumptions made about the performance of asset classes should have a long-runperspective—for example, that true values are not known for the nextquarter, next year, or even five years. Return expectations, whenever made,often seem quite heroic. Recent history has been hard on equities and favorablefor most bonds. However, no matter when such expectations are written down,recent historical events will color investors' expectations.

Return expectations should be based on the long-term analysis of these assetclass returns, and the investor should bear in mind that optimizers aregenerally very sensitive to the forecast value of the spreads between all assetreturns. For the spread between U.S. equities and bonds a forecast of between 2and 6 percent is reasonable. This level of forecast spread is in line withpostwar capital market history and within the range shown as reasonable inacademic studies.

Generally, the more risky the asset, the higher the expected return, so equitiesreturn more than fixed income. This raises the issue of the expectation forhedge funds, which seem to have far greater return prospects than their claimedrisk attributes would suggest. However, recent academic work suggests the risksof hedge funds are probably higher than many have believed.

Obviously, short-term forecasts of the asset class returns will be differentthan longer-term forecasts because analysts can see what is going to happen inthe next six months much more clearly than what is going to happen in the nextfive years.

Expectations are always debatable, and different investment analysts will surelyadvocate different return and risk expectations, but these numbers andprinciples are a place to begin.

The efficient markets hypothesis argues that all relevant information ispublicly available, is widely disseminated among all market participants, and isreflected in current security prices. Yet a casual observer can see that thereis considerable variability in interest rates and security market performancearound the world due to different economic systems, different economicprospects, and different levels of inflation. These differences are alsoaffected, if not controlled, by the differences in the political systemsgoverning these different market environments. Since the U.S. economy is one ofthe strongest in the history of the world and U.S. equities are one of thelargest asset classes in the world, we will spend a little time looking at theexpected returns to U.S. stocks over time.

Equities: Stocks in the long Run

Jeremy Siegel examines U.S. stock behavior over nearly two centuries and findsthat while stocks are certainly riskier than bonds on a day-to-day basis or inthe short run, over long windows (5-, 10-, and 20-year periods) stock returnsare so stable that stocks are actually less volatile over 20 years than eithergovernment bonds or Treasury bills. This is a quite astounding statement, butSiegel backs it up with a thorough statistical analysis.

The consistency of stock returns, after inflation, is exceptional. Siegelbelieves that fixed-income assets pose higher risks for the long-term investorbecause investors holding bonds can never be compensated for unexpectedinflation while those holding stocks can. He maintains that stocks performbetter than bonds and cash because it is more rewarding to own a profitablebusiness (own stock) than to lend money (own bonds or be a cash investor).

Since 1871, stock returns have been higher than cash and bond returns in everyrolling 30-year period. The overall span of Siegel's study was 190 years. Theworld and U.S. economies have undergone massive changes over this time. To findsuch consistency suggests that the return comes from the fundamental structureof the economy rather than accidentally.

Siegel found that stocks provided returns at least 5 percent higher thaninflation and higher than cash or bonds in 99.4 percent of the rolling 30-yearperiods from 1802 through 1992. For Siegel, the term stocks refers tothose in the S&P 500, or the nearest equivalent proxy for the overall stockmarket for the years prior to the inception of the S&P 500, while bondsmeans long-term investment-grade bonds. For cash he used U.S. Treasurybills.

Siegel also found that even if a person invested in stocks at the worst possibletime, investing just before the 1929 crash, stocks still outperformed cash orbonds by the end of 1950. For the 30 years 1929–1958, the average returnson stocks were 6.8 percent per year more than inflation, 5.1 percent per yearmore than bonds, and 7.5 percent per year more than cash.

The world today is much different from what it was in the time period covered bySiegel. There is no guarantee that the U.S. economy will continue to flourishover the next 200 years like it has over the last 200 years. Even in the UnitedStates, over fairly long time spans we have seen very different marketconditions. The bull market of the 1950s started in mid-1949 when the cashdividend for stocks in the Dow Jones Industrial Average (DJIA) was 7 percent,while U.S. Treasury bonds were paying a low interest of only 2.5 percent. In2006, the relative values of stocks and bonds were exactly the opposite. InJanuary 2006, the DJIA was around 10,000, and its aggregate cash dividend wasonly about 2.5 percent while the interest on intermediate Treasury bonds wasover 5 percent.

(Continues...)

(Continues...)

Excerpted from Portfolio Performance Measurement and Benchmarking by JON A. CHRISTOPHERSON, DAVID R. CARI, *NULL* #209;O, WAYNE E. FERSON. Copyright © 2009 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Edition details

• Publisher: McGraw Hill
• Publication date: 2009
• Language: English
• ISBN 10: 0071496653
• ISBN 13: 9780071496650
• Binding: Hardcover
• Number of pages: 480