Below, you’ll find my personal CFA level 3 performance evaluation notes…
You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.
Performance Evaluation Three Parts
- Performance Measurement
- Performance Attribution
- Performance Appraisal
Time-Weighted Rate of Return (TWR) calculates the return every time an external cashflow occurs. So assets need to be able to be valued on a daily basis.
Chain-Linking combines subperiod returns for TWR. Each subperiod is given one unit of money and the returns are multiplied together.
Money-Weighted Return (MWR) is the Internal Rate of Return (IRR).
TWR is more common than MWR since managers don’t have control over cash inflows and outflows. If cash inflows occur before periods of strong performance, MWR will be larger than TWR.
Linked Internal Rate of Return (LIRR) is a combo of MWR and TWR… chain-link the MWRs.
Matrix Pricing uses similar securities with more volume to value the illiquid securities.
P = M + S + A
P = Portfolio Return
M = Market Index Return
S = Style Return = B – M
B = Benchmark Return
A = Active Management Decision Return
Valid Benchmark Properties
Reflective of Current Investment Opinions
Specified in Advance
Memory Acronym… MARIO-SU
Factor Models help relate systematic sources of risk to account returns.
Sector Weighting and Stock Selection Return Formulas
Macro Performance Attribution
Conducted at the fund sponsor level. Policy to control asset allocations, benchmark returns, account returns, valuations, and external cash flows.
Micro Performance Attribution
Conducted at individual portfolio level and since evaluation on a security basis is unwieldly, factor model work to determine value-added.
Investment Skill (aka active return and value-added return) is the ability to consistently outperform a benchmark overtime.
Risk-Adjusted Performance Measures
Ex Post Alpha (Jensen’s Alpha) uses ex ante and ex post CAPM.
Treynor measure shows the excess returns compared to systematic risk. Both Treynor measure and ex post alpha will always give the same investment skill assessment.
Sharpe ratio compares returns to total risk of the account.
M2 and Sharpe ratio can give different results when determining if a manager is skillful or unskillful. A different result is more likely if the manager takes on a large amount of unsystematic risk.
Quality Control Charts
First Assumption: The null hypothesis is that the investment manager has no investment skill.
Second Assumption: The manager’s value-added returns are normally distributed and independent in each period.
Third Assumption: The manager’s investment process doesn’t change between periods.
Manager Continuation Policies (MCPs) seek to retain superior managers and remove inferior ones. It’s a two-step process of manager monitoring and manager review.
Null Hypothesis: Managers under evaluation are zero-value-added managers.
Type 1 Error: Keeping/Hiring a manager that is zero-value-added (rejecting the null when it’s correct).
Type 2 Error: Firing/Not Hiring a manager that adds value (not rejecting the null when it’s incorrect).
Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Global Investment Performance Standards.