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.
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