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BOND PERFORMANCE
MEASUREMENT AND EVALUATION
CHAPTER SUMMARY
In this chapter we will see how to measure and evaluate the investment performance of
a fixed-income portfolio manager. Performance measurement involves the calculation of the
return realized by a portfolio manager over some time interval, which we call the evaluation
period. Performance evaluation is concerned with two issues. The first is to determine whether
the manager added value by outperforming the established benchmark. The second is to
determine how the manager achieved the calculated return.
There are three desired requirements of a bond performance and attribution analysis process. The
first is that the process be accurate. The second requirement is that the process be informative.
The final requirement is that the process be simple.
PERFORMANCE MEASUREMENT
The starting point for evaluating the performance of a manager is measuring return. Because
different methodologies are available and these methodologies can lead to quite disparate results,
it is difficult to compare the performances of managers.
Lets begin with the basic concept. The dollar return realized on a portfolio for any evaluation
period (i.e., a year, month, or week) is equal to the sum of (i) the difference between the market
value of the portfolio at the end of the evaluation period and the market value at the beginning of
the evaluation period, and (ii) any distributions made from the portfolio.
MV1 MV0 D
Rp =
MV0
where Rp = return on the portfolio, MV1 = portfolio market value at the end of the evaluation
period; MV0 = portfolio market value at the beginning of the evaluation period; and, D = cash
distributions from the portfolio to the client during the evaluation period.
There are three assumptions in measuring return as given by the above equation. First, it assumes
that a periods cash inflow into the portfolio from interest is either distributed or reinvested in the
From a practical point of view the three assumptions limit its application. The longer the
evaluation period, the more likely the assumptions will be violated. Not only does the violation
of the assumptions make it difficult to compare the returns of two managers over some
evaluation period, but it is also not useful for evaluating performance over different periods.
The way to handle these practical issues is to calculate the return for a short unit of time such as
a month or a quarter. We call the return so calculated the subperiod return. To get the return for
the evaluation period, the subperiod returns are then averaged.
There are three methodologies that have been used in practice to calculate the average of the
subperiod returns: (1) the arithmetic average rate of return, (2) the time-weighted rate of return
(also called the geometric rate of return), and (3) the dollar-weighted rate of return.
The arithmetic average rate of return is an unweighted average of the subperiod returns. The
general formula is
RP1 RP 2 RPN
RA =
N
where RA = arithmetic average rate of return; Rpk = portfolio return for subperiod k for k = 1, . . . ,
N; and, N = number of subperiods in the evaluation period.
It is improper to interpret the arithmetic average rate of return as a measure of the average return
over an evaluation period. The proper interpretation is that it is the average value of the
withdrawals (expressed as a fraction of the initial portfolio market value) that can be made at the
end of each subperiod while keeping the initial portfolio market value intact.
The time-weighted rate of return measures the compounded rate of growth of the initial
portfolio market value during the evaluation period, assuming that all cash distributions are
reinvested in the portfolio. It is also commonly referred to as the geometric rate of return
because it is computed by taking the geometric average of the portfolio subperiod returns
computed from equation. The general formula is
where RT is the time-weighted rate of return, RPk is the return for subperiod k, and N is the
number of subperiods.
In general, the arithmetic average rate of return will exceed the time-weighted average rate of
return. The exception is in the special situation where all the subperiod returns are the same, in
which case the averages are identical. The magnitude of the difference between the two averages
is smaller the less the variation in the subperiod returns over the evaluation period.
The dollar-weighted rate of return is computed by finding the interest rate that will make the
present value of the cash flows from all the subperiods in the evaluation period plus the terminal
market value of the portfolio equal to the initial market value of the portfolio. Cash flows are
defined as follows:
A cash withdrawal is treated as a cash inflow. So, in the absence of any cash contribution made
by a client for a given time period, a cash withdrawal (e.g., a distribution to a client) is a positive
cash flow for that time period.
A cash contribution is treated as a cash outflow. Consequently, in the absence of any cash
withdrawal for a given time period, a cash contribution is treated as a negative cash flow for that
period.
If there are both cash contributions and cash withdrawals for a given time period, then the cash
flow is as follows for that time period: If cash withdrawals exceed cash contributions, then there is
a positive cash flow (which is the cash difference). If cash withdrawals are less than cash
contributions, then there is a negative cash flow (which is also the cash difference).
The dollar-weighted rate of return is simply an internal rate-of-return calculation and hence it is
also called the internal rate of return. The general formula for the dollar-weighted return is
C1 C1 CN VN
V0 =
1 RD 1 RD 2 1 RD
N
Notice that it is not necessary to know the market value of the portfolio for each subperiod to
determine the dollar-weighted rate of return.
The dollar-weighted rate of return and the time-weighted rate of return will produce the same
result if no withdrawals or contributions occur over the evaluation period and all investment
income is reinvested. The problem with the dollar-weighted rate of return is that it is affected by
Annualizing Returns
The evaluation period may be less than or greater than one year. Typically, return measures are
reported as an average annual return. This requires the annualization of the subperiod returns.
The subperiod returns are typically calculated for a period of less than one year.
The subperiod returns are then annualized using the following formula:
Bond attribution models seek to identify the active management decisions that contributed to the
portfolios performance and give a quantitative assessment of the contribution of these decisions.
The performance of a portfolio can be decomposed in terms of four active strategies in managing
a fixed-income portfolio: interest-rate expectation strategies, yield curve expectations strategies,
yield spread strategies, and individual security selection strategies.
Benchmark Portfolios
To evaluate the performance of a manager, a client must specify a benchmark against which the
manager will be measured.
There are two types of benchmarks that have been used in evaluating fixed-income portfolio
managers: (i) market indexes published by dealer firms and vendors, and (ii) normal portfolios.
A normal portfolio is a customized benchmark that includes a set of securities that contains all
of the securities from which a manager normally chooses, weighted as the manager would
weight them in a portfolio. Thus a normal portfolio is a specialized index. It is argued that
normal portfolios are more appropriate benchmarks than market indexes because they control for
investment management style, thereby representing a passive portfolio against which a manager
can be evaluated.
The construction of a normal portfolio for a manager requires (i) defining the universe of
fixed-income securities to be included in the normal portfolio, and (ii) determining how these
securities should be weighted (i.e., equally weighted or capitalization weighted).
Plan sponsors work with pension consultants to develop normal portfolios for a manager. The
consultants use vendor systems that have been developed for performing the needed statistical
analysis and the necessary optimization program to create a portfolio displaying similar factor
positions to replicate the normal position of a manager. A plan sponsor must recognize that
there is a cost to developing and updating the normal portfolio.
Clients of asset management firms need to have more information than merely if a portfolio
manager outperformed a benchmark and by how much. They need to know the reasons why
a portfolio manager realized the performance relative to the benchmark. It is possible that the
manager can outperform a benchmark due to a mismatch in duration and invested in specific
securities that did poorly. There is no way that the client can determine that by simply looking at
the portfolios return relative to the benchmarks return.
There are single metrics that have been commonly used to measure performance. Although
useful, single metric do not provide sufficient more information about performance to address
the questions that need answers. The model that can be used is performance attribution analysis,
a quantitative technique for identifying the sources of portfolio risk and performance so that the
contributions of members of the portfolio management team can be measured and the major
portfolio decisions can be quantified.
There are several performance attribution models that are available from third-party entities. In
selecting a third-party model, there are requirements that a good attribution model should possess
in order to evaluate the decision-making ability of the members of the portfolio management
team: additivity, completeness, and fairness. Additivity means that contribution to performance
of two or more decision makers of the portfolio management team should be equal to the sum of
the contributions of those decision makers. Completeness means that when the contribution to
portfolio performance of all decision makers is added up, the result should be equal to the
contribution to portfolio performance relative to the benchmark. Fairness means that the
portfolio management team members should view the performance attribution model selected as
being fair with respect to representing their contribution.
Today, performance attribution models can be classified into three types: sector-based attribution
models, factor-based attribution models, and hybrid sector-based/factor-based attribution models.
The simplest model is the sector-based attribution, also referred to as the Brinson model. In this
model, the portfolio return relative to the benchmark is represented by two decisions: (1) the
allocation of funds among the different sectors and the (2) the selection of the specific securities
within each sector. The first decision is referred to as the asset allocation decision and the
second the security selection decision.
Notice that once yield curve risk is decomposed as shown above, it turns out that the manager of
Portfolio E did indeed make interest-rate bets. It turns out that the two bets almost offset each
other so that net there was only a one basis point return attributable to the interest-rate bet.
Portfolio Ds manager basically made a major duration bet but virtually no bet on changes in the
shape of the yield curve. The interest-rate bet by the manager of Portfolio F was on changes in
the shape of the yield curve but otherwise was basically duration neutral.
KEY POINTS
Performance measurement involves calculation of the return realized by a portfolio manager over
some evaluation period.
Performance evaluation is concerned with determining whether the portfolio manager added
value by outperforming the established benchmark and how the portfolio manager achieved the
calculated return.
2. Suppose that the monthly return for two bond managers is as follows:
What is the arithmetic average monthly rate of return for the two managers?
The arithmetic average rate of return is an unweighted average of the subperiod returns. The
general formula is
RP1 RP 2 RPN
RA =
N
where RA = arithmetic average rate of return; Rpk = portfolio return for subperiod k for k = 1, . . . ,
N; and, N = number of subperiods in the evaluation period.
In our problem, we have subperiod or monthly portfolio returns for Manager I of RP1 = 9%,
RP21 = 13%, RP3 = 22% and RP4 = 18%, for months 1, 2, 3, and 4, respectively.
The time-weighted rate of return measures the compounded rate of growth of the initial portfolio
market value during the evaluation period, assuming that all cash distributions are reinvested in
the portfolio. It is also commonly referred to as the geometric rate of return because it is
computed by taking the geometric average of the portfolio subperiod returns. The general
formula is
where RT is the time-weighted rate of return, RPk is the return for subperiod k for k = 1, . . . , N,
and N is the number of subperiods.
In our problem, we have the portfolio returns for Manager I of RP1 = 9%, RP2 = 13%, RP3 = 22%
and RP4 = 18%, for months 1, 2, 3, and 4, respectively. Solving for N = 4, the time-weighted rate
of return is:
If the time-weighted rate of return is 5.36% per month, one dollar invested in the portfolio at the
beginning of month 1 would have grown at a rate of 5.36% per month during the four-month
evaluation period.
4. Why does the arithmetic average monthly rate of return diverge more from the
time-weighted monthly rate of return for manager II than for manager I in Question 2?
The table below summarizes the managerial performances and differences between the two types
of monthly returns.
As can be seen in the last column of the above table, the arithmetic average monthly rate of
return diverges more from the time-weighted monthly rate of return for manager II than for
manager I. This is because the arithmetic average rate of return typically is greater than the
time-weighted average rate of return with the magnitude of the difference between the two
averages greater when the variation (in the subperiod returns over the evaluation period) is
In general, the arithmetic and time-weighted average returns will give different values for the
portfolio return over some evaluation period. This is because in computing the arithmetic
average rate of return, the amount invested is assumed to be maintained (through additions or
withdrawals) at its initial portfolio market value. The time-weighted return, on the other hand, is
the return on a portfolio that varies in size because of the assumption that all proceeds are
reinvested.
In general, the arithmetic average rate of return will exceed the time-weighted average rate of
return. The exception is in the special situation where all the subperiod returns are the same, in
which case the averages are identical. The magnitude of the difference between the two averages
is smaller the less the variation in the subperiod returns over the evaluation period. For example,
suppose that the evaluation period is four months and that the four monthly returns are as
follows:
RP1 = 4%; RP1 = 6%; RP1 = 2%; RP1 = 2%.
The average arithmetic rate of return is 2.50% and the time-weighted average rate of return is
2.46%. Not much of a difference. However, in the textbook example elsewhere, there was an
arithmetic average rate of return of 25% but a time-weighted average rate of return of 0%. The
large discrepancy is due to the substantial variation in the two monthly returns.
5. Smith & Jones is a money management firm specializing in fixed-income securities. One
of its clients gave the firm $100 million to manage. The market value for the portfolio for
the four months after receiving the funds was as follows:
(b) Smith & Jones reported to the client that over the four-month period the average
monthly rate of return was 33.33%. How was that value obtained?
The value was obtained by using arithmetic average rate of return, which is an unweighted
average of the subperiod returns. The general formula is
RP1 RP 2 RPN
RA =
N
where RA = arithmetic average rate of return; Rpk = portfolio return for subperiod k for k = 1, . . . ,
N; and, N = number of subperiods in the evaluation period.
In our problem, we have subperiod or monthly portfolio returns for a client of RP1 = 50%,
RP21 = 200%, RP3 = 50% and RP4 = 33.33%, for months 1, 2, 3, and 4, respectively. Solving
for N = 4, the arithmetic average rate of return is:
50% 200% ( 50%) 33.33%
RSmith & Jones = = 0.3333333 or about 33.33%.
4
The 33.33% monthly rate of return is not indicative of the performance of Smith & Jones. A
more appropriate measure would be the time-weighted rate of return or the dollar-weighted
rate of return.
First, let us look at the time-weighted rate of return, which measures the compounded rate of
growth of the initial portfolio market value during the evaluation period, assuming that all cash
distributions are reinvested in the portfolio. It is also commonly referred to as the geometric rate
of return because it is computed by taking the geometric average of the portfolio subperiod
returns. The general formula is
where RT is the time-weighted rate of return, RPk is the return for subperiod k for k = 1, . . . , N,
and N is the number of subperiods.
In our problem, we have the portfolio returns for the client of RP1 = 50%, RP2 = 200%, RP3 =
50% and RP4 = 33.33%, for months 1, 2, 3, and 4, respectively. Solving for N = 4,
the time-weighted rate of return is:
If the time-weighted rate of return is 0% per month, one dollar invested in the portfolio at the
beginning of month 1 would have grown at a rate of 0% per month during the four-month
evaluation period. This answer is consistent with the fact that Smith and Jones client began with
$100 million and ended with $100 million. Note that the computation does not take into account
the time value of money which is influenced by the fact inflation causes purchasing power to
decline. Thus, the client is actually worse off than they began.
Now, let us look at the dollar-weighted rate of return, which is computed by finding the
interest rate that will make the present value of the cash flows from all the subperiods in the
evaluation period plus the terminal market value of the portfolio equal to the initial market value
of the portfolio.
The dollar-weighted rate of return is simply an internal rate-of-return calculation and hence it is
also called the internal rate of return. The general formula for the dollar-weighted return is:
C1 C1 CN VN
V0 =
1 RD 1 RD 2 1 RD
N
Notice that it is not necessary to know the market value of the portfolio for each subperiod to
determine the dollar-weighted rate of return.
Another way of looking at this problem is to consider the change in value each period to be like a
cash inflow (withdrawal) or cash outflow (contribution). If so, for our problem, we would have:
V0 = $100 million, N = 4, C1 = $50 million, C2 = $100 million, C3 = $75 million,
C4 = $25 million, and V4 = $100 million. Given these values, RD is the interest rate that satisfies
the below equation:
$50, 000, 000 $100, 000, 000 $75, 000, 000 $25, 000, 000 $100, 000, 000
$100,000,000 =
1 RD 1 RD 1 RD 1 RD
2 3 4
Inserting RD = 0% gives:
Because zero percent is the internal rate of return that satisfies our expression above, zero
percent is the dollar-weighted return. The dollar-weighted rate of return and the time-weighted
rate of return will produce the same result if no withdrawals or contributions occur over the
evaluation period and all investment income is reinvested. The dollar-weighted rate of return can
be affected by factors that are beyond the control of the manager. Specifically, any contributions
made by the client or withdrawals that the client requires will affect the calculated return. This
makes it difficult to compare the performance of two managers when using this method.
Finally, the evaluation period may be less than or greater than one year. Typically, return
measures are reported as an average annual return. This requires the annualization of the
subperiod returns. The subperiod returns are typically calculated for a period of less than one
year. The subperiod returns are then annualized using the following formula:
For example, suppose that the evaluation period is three years and a monthly period return is
calculated. Suppose further that the average monthly return is 2%. Then the annual return is
In our problem, the evaluation period is four months and the average monthly return is 0%. Then
the annual return is
6. The Mercury Company is a fixed-income management firm that manages the funds of
pension plan sponsors. For one of its clients it manages $200 million. The cash flow for this
particular clients portfolio for the past three months was $20 million, $8 million, and
$4 million. The market value of the portfolio at the end of three months was $208 million.
(a) What is the dollar-weighted rate of return for this clients portfolio over the three-month
period?
The dollar-weighted rate of return is computed by finding the interest rate that will make the
present value of the cash flows from all the subperiods in the evaluation period plus the terminal
A cash withdrawal is treated as a cash inflow. So, in the absence of any cash contribution made
by a client for a given time period, a cash withdrawal (e.g., a distribution to a client) is a positive
cash flow for that time period.
A cash contribution is treated as a cash outflow. Consequently, in the absence of any cash
withdrawal for a given time period, a cash contribution is treated as a negative cash flow for that
period.
If there are both cash contributions and cash withdrawals for a given time period, then the cash
flow is as follows for that time period: If cash withdrawals exceed cash contributions, then there
is a positive cash flow. If cash withdrawals are less than cash contributions, then there is a
negative cash flow.
The dollar-weighted rate of return is simply an internal rate-of-return calculation and hence it is
also called the internal rate of return. The general formula for the dollar-weighted return is:
C1 C1 CN VN
V0 =
1 RD 1 RD 2 1 RD
N
Notice that it is not necessary to know the market value of the portfolio for each subperiod to
determine the dollar-weighted rate of return.
For our problem, we consider a portfolio with a market value of $1,000,000 at the beginning of
month 1. For months 1, 2, 3, and 4, we have: V0 = $200 million, N = 3, C1 = $20 million,
C2 = $8 million, C3 = $4 million, and V3 = $208 million. Given these value, RD is the interest
rate that satisfies the following equation:
$20, 000, 000 $8, 000, 000 $4, 000, 000 $208, 000,000
$200,000,000 = .
1 RD 1 RD 1 RD
2 3
Below we verify that 4.0550924080% or about 4.055% is the internal rate of return satisfies the
above expression.
$200,000,000 = $200,000,000.
(b) Suppose that the $8 million cash outflow in the second month was a result of withdrawals
by the plan sponsor and that the cash flow after adjusting for this withdrawal is therefore
zero. What would the dollar-weighted rate of return then be for this clients portfolio?
A cash withdrawal is treated as a cash inflow. So, in the absence of any cash contribution made
by a client for a given time period, a cash withdrawal (e.g., a distribution to a client) is a positive
cash flow for that time period. However, this withdrawal is not by the client but by the plan
sponsor so that C2 no longer equals $8 million but zero. Thus, we now have: V0 = $200 million,
N = 3, C1 = $20 million, C2 = $0 million, C3 = $4 million, and V3 = $208 million. Given these
values, RD is the interest rate that satisfies the following equation:
Below we verify that 5.4059618263% or about 5.406% is the internal rate of return satisfies the
above expression.
$200,000,000 = $200,000,000.
Because about 5.406% is the internal rate of return that satisfies the above expression, 5.406%
is the dollar-weighted return.
7. If the average quarterly return for a portfolio is 1.23%, what is the annualized return?
The evaluation period may be less than or greater than one year. Typically, return measures are
reported as an average annual return. This requires the annualization of the subperiod returns.
The subperiod returns are typically calculated for a period of less than one year. The subperiod
returns are then annualized using the following formula:
8. If the average quarterly return for a portfolio is 1.78%, what is the annualized return?
For our problem, the period used to calculate returns is quarterly and the average quarterly return
is 1.78%. Thus, the annual return is:
The difficulties of constructing a normal portfolio involve defining the universe of fixed-income
securities to be included in the normal portfolio, and determining how these securities should be
weighted. More details are given below.
To evaluate the performance of a manager, a client must specify a benchmark against which the
manager will be measured. There are two types of benchmarks that have been used in evaluating
fixed-income portfolio managers: (i) market indexes published by dealer firms and vendors, and
(ii) normal portfolios.
A normal portfolio is a customized benchmark that includes a set of securities that contains all
of the securities from which a manager normally chooses, weighted as the manager would
weight them in a portfolio. Thus a normal portfolio is a specialized index. It is argued that
normal portfolios are more appropriate benchmarks than market indexes because they control for
investment management style, thereby representing a passive portfolio against which a manager
can be evaluated.
The construction of a normal portfolio for a particular manager is no simple task. The principle is
to construct a portfolio that, given the historical portfolios held by the manager, will reflect that
managers style in terms of assets and the weighting of those assets. The construction of a
normal portfolio for a manager requires (i) defining the universe of fixed-income securities to be
included in the normal portfolio, and (ii) determining how these securities should be weighted
(i.e., equally weighted or capitalization weighted).
Given these securities, the next question is how they should be weighted in the normal portfolio.
The two choices are equal weighting or capitalization weighting of each security. Various
methodologies can be used to determine the weights. These methodologies typically involve
a statistical analysis of the historical holdings of a manager and the risk exposure contained in
those holdings.
Plan sponsors work with pension consultants to develop normal portfolios for a manager. The
consultants use vendor systems that have been developed for performing the needed statistical
analysis and the necessary optimization program to create a portfolio displaying similar factor
positions to replicate the normal position of a manager. A plan sponsor must recognize that
there is a cost to developing and updating the normal portfolio.
There are some who advocate the responsibility of developing normal portfolios should be left to
the manager. However, many clients are reluctant to let their managers control the construction
of normal portfolios because they believe that the managers will produce easily beaten, or slow
rabbit, benchmarks. Bailey and Tierney demonstrate that under reasonable conditions there is
no long-term benefit for the manager to construct a slow rabbit benchmark and explain the
disadvantage of a manager pursuing such a strategy.8 In addition, they recommend that clients let
managers control the benchmarks. Clients should, instead, focus their efforts on monitoring the
quality of the benchmarks and the effectiveness of the managers active management strategies.
10. Suppose that the active return for a portfolio over the past year was 130 basis points
after management fees. What questions would you have to before concluding that the
managers performance was exceptional?
Clients of asset management firms need to have more information than merely if a portfolio
manager outperformed a benchmark and by how much. For example, you want to know the
reasons. Thus, a first question you might ask is: What are the reasons for why a portfolio
manager realized the performance relative to the benchmark? This question is important
because it is possible a pension fund engaged an external manager based on the managers claim
that return enhancement can be achieved via security selection.
Given that the manager has in fact outperformed the benchmark by more than enough to cover
management fees, we need to ask: Did this manager achieve the stated objective? This
question is important because it is not known what specific risks relative to the benchmark that
the manager took to generate the return. It is entirely possible that the outperformance was
attributable to being mismatched against the benchmarks duration. In fact, it is possible that the
manager could have outperformed the benchmark due to a mismatch in duration and invested in
specific securities that did poorly. There is no way that the client can determine that by simply
looking at the portfolios return relative to the benchmarks return.
11. Not only do clients find performance attribution analysis helpful but so does the chief
investment officer of an asset management firm in evaluating the firms bond portfolio
team. Explain why.
The chief investment officer of an asset management firm finds it useful for fairly evaluating the
performance of employees and properly allocating bonuses and promotions within the firm.
More details are given below.
At the firm level, bonuses to members of the portfolio management team will be determined
based on performance. Breaking down the performance to the team member level is important
for this purpose, because it impacts decisions about the advancement and retention of such
personnel.
There are single metrics that have been commonly used to measure performance such as the
information ratio. Although useful, single metric do not provide sufficient more information
about performance to address the questions posed earlier. The model that can be used is
performance attribution analysis, a quantitative technique for identifying the sources of portfolio
risk and performance so that the contributions of members of the portfolio management team can
be measured and the major portfolio decisions can be quantified.
There are several performance attribution models that are available from third-party entities.
(Some of the larger asset management firms have developed their own models.) In selecting
a third-party model, there are requirements that a good attribution model should possess in order
to evaluate the decision-making ability of the members of the portfolio management team:
additivity, completeness, and fairness. Additivity means that contribution to performance of two
or more decision makers of the portfolio management team should be equal to the sum of the
contributions of those decision makers. Completeness means that when the contribution to
portfolio performance of all decision makers is added up, the result should be equal to the
contribution to portfolio performance relative to the benchmark. Finally, the decision-making
process is one that involves the interaction of many members of the portfolio management team.
Fairness means that the portfolio management team members should view the performance
attribution model selected as being fair with respect to representing their contribution.
The financial institutions investment committee is using the above information to assess
the performance of the three external managers. Below is a statement from three members
of the performance evaluation committee. Respond to each statement.
(a) Committee member 1: Based on overall performance, it is clear that manager Y was the
best performing manager given the 96 basis points.
Below we report totals when the basis points (plus and minus) are added for all six risk factors:
Portfolio X Portfolio Y Portfolio Z
Total of all 6 risk factors: 95 105 90
(b) Committee member 2: All three of the managers were hired because they claimed that
they had the ability to capitalize on corporate credit opportunities. Although they have all
outperformed the benchmark, I am concerned about the claims that they made when we retained
them.
Clients of asset management firms need to have more information than merely if a portfolio
manager outperformed a benchmark and by how much. They need to know the reasons why
a portfolio manager realized the performance relative to the benchmark. For the three portfolios,
suppose a pension fund engaged an external manager based on the managers claim that return
enhancement can be achieved via corporate spread risk selection. As seen below, portfolio
managers for Portfolios Y and Z did in fact do well in this area.
However, only for Portfolio Z can we say there is strong proof that performance in the corporate
spread risk was achieved. Thus, the concern of committee member #2 is valid due to differences
in performances for the corporate credit products.
(c) Committee member 3: It seems that managers X and Z were able to outperform the
benchmark without taking on any interest rate risk at all.
Interest-rate risk is captured by the yield curve risk factor, while non-interest-rate risk is captured
by the other five risk factors. As seen below, it does appear that committee member #3 is correct
in believing that managers of Portfolios X and Z were neutral in regards to interest-rate risk (as
we find small active returns in the interest-rate risk category).
However, what the above breakdown does not include are the individual components of yield
curve risk (level and shape risks). This is explained in more detail below.
Factor-based attribution models actually allow a decomposition of the yield curve risk into level
(duration) risk and changes in the shape of the yield curve. For example, for the three portfolios
just discussed, suppose that the attribution due to yield curve risk is determined to be as follows:
Notice that once yield curve risk is decomposed as shown above, it turns out those managers of
Portfolios X and Z did indeed make interest-rate bets on both level risk and shape risk. It turns
out that the two bets almost offset each other so there were only small basis point returns
attributable to the interest-rate bets. It appears that Portfolio Zs manager made a major duration
bet and a minor bet on changes in the shape of the yield curve. Thus, as it turns out, committee
member #3 was incorrect as managers of Portfolios X and Z were making greater interest-rate
bets than that of Portfolio Y. Thus, given the above breakdown of yield curve risk, their
performance was not all related to their lack of interest-rate bets. We one cannot make definitive
conclusions about portfolio managerial performance in terms of interest-rate bets without a more
detailed analysis.