In a previous article, we introduced the CFA Institute Investment Foundation Program (Read more here). It is a free program designed for anyone who wants to enter or advance within the investment management industry, including IT, operations, accounting, administration, and marketing. Candidates who successfully pass the online exam earn the CFA Institute Investment Foundations Certificate.
There are total of 20 Chapters in 7 modules, covering all the essential topics in finance, economics, ethics and regulations. This series of articles will highlight the core knowledge of each chapter.
Chapter 19 provides an overview of the performance valuation. The learning outcome of chapter 19 is as follows:
· Describe a performance evaluation process;
· Describe measures of return, including holding-period returns and time-weighted rates of return;
· Compare use of arithmetic and geometric mean rates of returns in performance evaluation;
· Describe measures of risk, including standard deviation and downside deviation;
· Describe reward-to-risk ratios, including the Sharpe and Treynor ratios;
· Describe uses of benchmarks and explain the selection of a benchmark;
· Explain measures of relative performance, including tracking error and the information ratio;
· Explain the concept of alpha;
· Explain uses of performance attribution.
The performance evaluation process includes four discrete but related components:
Absolute returns are the returns achieved over a certain time period. Absolute returns do not consider the risk of the investment or the returns achieved by similar investments.
The performance of a security, such as an equity (stock) or debt (bond) security, over a specific time period—called the holding period—is referred to as the holding-period return. The holding-period return measures the total gain or loss that an investor owning a security achieves over the specified period compared with the investment at the beginning of the period. The return over the holding period usually comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest).
The time-weighted rate of return calculation divides the overall measurement period (e.g., one year) into sub-periods representing one month, week, or day of that year. The timing of each individual cash flow identifies the sub-periods to use for calculating holding-period returns. Each sub-period has its own separate rate of return. These sub-period returns are then used to calculate the return for the whole period. By calculating holding-period returns in this manner, client cash inflows and outflows do not distort the measurement and reporting of a fund’s investment performance.
Investors want to get as much return as possible for as little risk as possible. So, if two investments have a holding-period return of 10% but the first investment has very little risk whereas the second one is very risky, the first investment is better than the second one on a risk-adjusted basis. Investment risk is often measured using some measure of variability (or volatility) of returns, and a common measure of variability is the standard deviation. The standard deviation of returns reflects the variability of returns around the mean (or average) return; the higher the standard deviation of returns, the higher the variability (or volatility) of returns and the higher the risk.
The Sharpe and Treynor ratios are important reward-to-risk ratios that compare a portfolio’s excess return with a measure of portfolio risk. Each reflects the return achieved per unit of risk taken.