Archive for the 'Performance Measurement' Category

High Yield Bond Returns: Downgrades versus Original Issues

Bonds may either be issued as speculative grade bonds (original issue)or become so following a rating downgrade (fallen angels). In either case, their risk-adjusted returns should be similar. However, in an article published in the Fall 2007Journal of Portfolio Management Fridson and Sterling point out that fallen angels have historically delivered far higher risk-adjusted returns, and discuss several explanations for an apparent market inefficiency.

The authors find the correlation between fallen angels and original-issue speculative grade debt to be lower than that between Treasuries and investment-grade corporate bonds, suggesting dissimilar attributes and below the threshold normally used to classify securities as part of the same asset class.

Possible reasons for the disparity include:

  • Lack of investor awareness, given that the primary high-yield index only recently began breaking out the performance of the two categories
  • Emphasis on security selection and possible overconfidence among managers that they can pick the superior original-issue bonds
  • Investability – fallen angels account for just 30% of available speculative-grade debt and trade infrequently
  • Lottery-like returns for specific original issue bonds
  • Yield appeal due to higher yields typically found with original issue bonds

Posted on 6th October 2008
Under: Active Management, Investing in Distressed Securities, Investing in bonds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »

Why Do Hedge Funds Stop Reporting Performance?

Hedge funds are not required to report their performance, and those who voluntarily report can opt out of reporting at any time. There are at least two possible reasons a hedge fund might choose to stop reporting results:

  • Poor performance, possibly including fund closure
  • Very good performance has eliminated the need to attract capital

In the Fall 2007 Journal of Portfolio Management, Grecu Malkiel and Saha examine both hypotheses, and find a pattern of declining performance in the months leading up to cessation of reporting. Further the probability that a fund will stop reporting increases rapidly during the first five years of a fund’s life and then gradually declines from the peak. Funds with high Sharpe ratios, more assets and peer-beating performance are less likely to stop reporting.

The authors conclude that hedge funds stop reporting results due to poor performance, rather than strong performance.

Posted on 6th September 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Portfolio Management, Research | No Comments »

Forecasting Fund Manager Alphas

Because the investment returns of all managers, on average, will be average paying higher fees for active management is justified only if the superior managers can be identified in advance.

In the March/April 2008 Financial Analysts Journal Waring and Ramkumar write that the expected alpha from active fund managers can be forecasted, as long as investors pay heed to the rules of zero-sum-game investing.

The forecasts are based on two equations derived from the fundamental law of active management. Variables for the equation are estimates of the manager’s skill, estimates of the sponsor’s assessment of its own skill in identifying skilled managers, the cross-sectional standard deviation of manager skill, portfolio breadth, implementation efficiency, expected active risk, and fees.

Posted on 5th September 2008
Under: Active Management, Institutional Investing, Investment Returns, Performance Measurement, Portfolio Management, Risk Management | No Comments »

Do Market Timing Hedge Funds Time the Market?

Many studies have questioned the ability of mutual funds and pension funds to time the market. In an article published in the December 2007 Journal of Financial and Quantitative Analysis, Chen and Liang examine the returns of 221 hedge funds self-identified as market timers. They find that, for the 1994-2005 period, evidence supports timing ability – especially in volatile or bear markets.

The results are robust to model specification and volatility timing. They do not appear to result primarily from option-like trading or luck.

The authors conclude that the flexible strategies associated with hedge funds are useful for professional market timers, and that funds promising market-timing results are likely to deliver them.

Posted on 6th August 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Research | No Comments »

How Many Stocks are Needed for Diversification?

Portfolio management theory asserts, based on the variance between a given asset and the rest of the portfolio, that as few as 8-20 stocks are sufficient to provide most of the benefits of diversification.

In the November 2007 Financial Review Domian, Louton and Racine challenge this assumption by proposing that long-term investors are likely to be more concerned with shortfall risk (failure to reach a target ending wealth) than with return variance.

Based on the returns of 1,000 stocks and a safety first criterion, they find that at least 164 stocks are necessary to reduce shortfall risk to no more than a 1% chance of underperforming Treasury bonds. Although smaller portfolios can be enhanced by diversifying across industries, the benefit is not as powerful as that provided by simply adding more stocks to the portfolio.

Posted on 9th July 2008
Under: Active Management, Asset Allocation, FInancial Planning, Institutional Investing, Investing in Stocks, Investment Returns, Passive Management, Performance Measurement, Portfolio Management, Research, Risk Management, Security Selection | No Comments »

Market Timing by Mutual Funds

Previous studies based on returns-based analysis have found no evidence of market-timing ability by mutual funds. In the December 2007 Journal of Financial Economics, Jiang Yao and Yu conduct a holdings-based analysis of 2,300 equity mutual funds and conclude that mutual fund managers have positive and statistically significant market timing ability for three- and six-month periods.

Mutual fund characteristics associated with positive market timing ability include high industry concentrations, large size, and small-capitalization orientations. The authors also find that stronger market timing results are associated with shifting between industries than by adjusting allocations within an industry.

Posted on 8th July 2008
Under: Investing in Stocks, Performance Measurement, Research | No Comments »

Risk Adjusted Return Measures: The Information Ratio

The information ratio is a generalized form of the Sharpe ratio, with active return in the numerator and active risk in the denominator.

Active return is measured as the difference between the portfolio’s return and that of the benchmark. Active risk is the standard deviation of active return.

The information ratio measures the reward earned by the manager for each unit of risk created by deviating from benchmark holdings.

Posted on 7th July 2008
Under: Active Management, Investment Returns, Performance Measurement, Portfolio Management | No Comments »

Are Hedge Fund Strategies Just About Leverage?

The growth in the hedge fund industry has increased the importance of measuring how hedge funds achieve their returns. Since many funds either explicitly or implicitly use leverage, a useful question is whether hedge funds merely represent an expensive way to use leverage.

In an article published in the Winter 2007 Journal of Wealth Management, Jean Brunel finds that simple leverage does not appear to be the primary determinant of market-neutral or long-short hedge fund returns. Instead, three broad themes emerge:

  • Beta leverage is not a strong element of long-short or market neutral returns
  • Hedge fund return replication requires dynamic management of leverage
  • When hedge fund managers use leverage, they tend to lever their value added skills rather than generic risk exposures

Posted on 6th July 2008
Under: Active Management, Alternative Assets, Hedge Funds, Investment Returns, Performance Measurement, Research, Risk Management | No Comments »

Constructing a Custom Security Based Benchmark

Several steps are needed to construct a custom benchmark for a portfolio.

  1. Identify prominent aspects of the manager’s investment process
  2. Select securities that are consistent with that process
  3. Devise a weighting scheme for the benchmark securities, including an appropriate allocation to cash
  4. Review the preliminary benchmark and make modifications
  5. Rebalance the benchmark portfolio on a predetermined schedule

Posted on 6th July 2008
Under: Active Management, Asset Allocation, Investment Returns, Performance Measurement, Portfolio Management | No Comments »

Risk Adjusted Return Measures: The Sharpe Ratio

The Sharpe ratio compares excess returns to total portfolio risk, measuring risk as the standard deviation of portfolio returns.

The numerator of the Sharpe ratio is the difference between the portfolio return and the risk-free rate. The denominator is the standard deviation of portfolio returns.

The Sharpe ratio may identify a manager as not being skillful even when the Treynor measure or Jensen’s alpha suggest skill. This could result when the manager accepts large amounts of non-systematic risks (which would be reflected in standard deviation of returns but not portfolio beta.)

Posted on 7th June 2008
Under: Active Management, Investment Returns, Performance Measurement, Portfolio Management | No Comments »