Investment principles and risk

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To understand investment markets generally

To assess the competence of fund managers and investment portfolio managers

To calculate performance related fees, where applicable, which reward fund managers for achieving and surpassing target returns

Predictions

When assessing investment performance, past performance is all there is to go on, but when it...

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An understanding of financial calculations and the basic concept of compound interest is fundamental to performance assessment. Previous chapters have covered compounding interest to calculate future values and discounting for present values. In this chapter, we consider using return to measure performance over multiple periods, incorporating cashflows and the importance of benchmarks.

What have the FCA excluded from their product league tables?

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The holding period return is a simple measure used to calculate the return on an investment over the period of time it is held.

When cash flows are incorporated and returns are calculated over multiple periods, two other methods are used:

Money weighted return (MWR)

Time weighted return (TWR)

Money weighted return measures the return of capital invested over a particular period, whereas time weighted return allows comparisons to be made of the performance of one fund manager to another.

Money Weighted Return (MWR)

Can also be referred to as holding period return.

Portfolio returns are expressed as being equal to the total of:

The difference in value of the portfolio at the end of the period and the value of the portfolio at the start of the period plus any income or capital distributions made from the portfolio during that period

The rate of return expresses the money return in terms of the amount of the value of the po...

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Where R is the return in the overall period

V 0 is the value of the fund at the beginning of the period

V 1 is the value of the fund immediately before the introduction of additional money

V 2 is the value of the fund at the end of the period

C is the additional money introduced

We can then link all these discrete returns together to calculate the TWR for the overall period. The general formula is:

1 + R = (1+r 1 )(1+r 2 )(1+r 3 )(1+r 4 )...........(1+r n )

Where R = TWR and r 1 is the holding period return in each sub-period, when there are n sub periods.

In the case of two periods it would be:

An exact calculation of a TWR would require a full valuation of the portfolio whenever a cashflow occurs. In practice, an approximation is made so that the TWR can be calculated using either monthly or quarterly portfolio valuations.

The following example demonstrates the performance of two portfolio managers in accordance with the funds they receive and when.

What is the main difference between MWR and TWR?

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Asset allocation – the division of the investments into the different types of assets, such as different markets or different types of securities. If the US market outperforms other markets during a period, and the manager has a high proportion of the portfolio in that market, it will make a considerable difference to the returns achieved. Most portfolio managers tend to describe themselves as top-down strategists, where performance comes first from asset allocation

Stock selection – the choice of shares that have individually outperformed

Market timing – deciding on when to introduce or withdraw funds from the market

Risk – managers may decide to take more or less risk than the benchmark (beta) depending on their views on the market

In performance evaluation, it is necessary to show the separate contribution of these approaches. Some investment managers aim to achieve above average returns from their skill in stock selection, while others may choose to run a riskier portfolio.

It is important to be able to distinguish the basis of success or failure by performance evaluation. This is usually achieved by comparing the composition of the portfolio with a suitable benchmark portfolio and then looking at the effects of asset allocation and stock selection separately.

Step 1: The benchmark

Choose an appropriate benchmark to compare the portfolio. There are a variety of portfolios that have now been benchmarked for different purposes, depending on the attitude to risk and the income needs of the clients. The benchmark selected should accurately reflect the client’s investment objectives and attitude to risk, for example, the FTSE 100 would not be appropriate for an investor with a low risk profile investing for income as the make up of the FTSE 100 would not bear any resemblance to the appropriate portfolio for that client. However, the FTSE 100 would be appropriate for a client investing for income with a higher risk profile.

Step 2: The benchmark asset allocation

Find out the asset allocation for the benchmark fund over the period to be evaluated. For...

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The aim is to see how the manager’s selection of investments within each asset class performed relative to the appropriate index. Outperformance or underperformance could be the result of either:

Sector choice - i.e. being overweight or underweight in particular sectors. For example, in the financial crisis, bank shares underperformed most of the rest of the UK market and so a portfolio that was overweight in this sector would probably have underperformed. In large markets like the UK, there are individual indices for each component part of the overall index

Stock selection - i.e. being overweight or underweight in a particular share in a sector. For example, within the construction and building materials sector, one particular share may have outperformed the rest of the constituent companies

The contribution of stock or sector selection can be isolated from asset allocation by multiplying the difference in actual and index performance by the benchmark asset allocation.

Asset class

Benchmark asset allocation

Index performance for each asset

Actual performance

Contribution to return

 UK equities

55%

20%

25

+2.75%

 Overseas equities

25%

15%

5

-2.50%

 Fixed interest

25%

10%

10

0

 Cash

5%

5%

10

+0.25%

Overall contribution to return

+0.50%

The manager outperformed the UK equity index over the period by 5% and this constituted 55% of the benchmark portfolio. So (25 – 20) x 55% = 2.75%.

The outperformance of UK equities and cash in this portfolio was largely offset by the underperformance of stock or sector selection in overseas equities, and the overall stock selection contribution was very low at only 0.5%.

This explanation is an oversimplification. In practice, the analysis of overseas equities would look at the weighting of different markets and the performance of each group of overseas shares in relation to its local market index.

What are the five steps in performance evaluation?

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Past performance is not a guarantee of future returns. It can be used as an indication of future performance as long as it is clear how the previous returns were achieved

Past performance should be considered over a variety of time periods to evaluate consiste...

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Funds may not be classified in a sector where direct comparison with their peers can be made, or there may simply be a lack of comparable funds to analyse statistics thoroughly enough

As funds tend to change their make up over time, long term performance may reflect a very different set of investment objectives than those being currently adhered to

Measuring returns alone does not account for the risk that has been taken

Investor policy statement

FSMA requires authorised organisations to agree investment objectives with their clients. This should include investment objectives, how the portfolio will be managed and any constraints (e.g. legal, taxation, etc). These should be set out in the investor policy statement.

The statement should include the investment style that will be used and a description of client objectives and acceptable levels of risk. These should be agreed in writing and will apply until they are amended by discussion and again confirmed in writing.

Examples of overall investment objectives are:

Overall investment objective

Explanation

Capital growth

Income requirements are not a prime concern and emphasis should be placed on investments considered to have longer- term growth potential.

Income priority

Income considerations will be given priority over the long- term prospects for capital growth. This could result in the erosion of the capital's purchasing power.

Balance between income and capital growth

A combination of capital growth and income investments designed to produce growth in both capital and income.

Examples of classification of risk:

Overall investment objective             

Explanation

Lower or secure

Investments would normally comprise of cash, gilts and fixed interest securities with a credit rating of at least A (the same as many building societies).

Medium or balanced

In addition to those included in lower or secure risk, investments might include larger UK companies as well as larger overseas listed companies, unit trusts,...

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Churning is a switch of investments where the primary aim is to generate commission for the benefit of the firm rather than the client. These clearly breach the Conduct of Business rules imposed by the FCA

Any investment genuinely underperforming should be replaced as a switch can be demonstrated to be in the best interest of the client, after taking into account transaction costs and any tax implications

Justifiable switches can arise on the following:

Where there has been a clear change in the client's objectives or circumstances that necessitates a move to investments with less or more risk or a change in yield;

Where market conditions adversely affect the original investment or weigh in favour of an alternative investment

The client gives clear instructions to effect a switch

There has been consistent underperformance of an investment over a medium to long period

The value of the investment is returned as part of a takeover or capital reconstruction

Tax issues on switches are as follows:

There could be a CGT liability on disposal of an asset, such as unit trusts and OEICs

It may be possible to reduce or eliminate any tax charge by transferring assets to a spouse or civil partner before making the disposal, so that they both can use  their annual exempt amounts or disposals could be spread over two different tax years if appropriate

Any gains could be offset against previous unrelieved losses

The potential tax implications need to be weighed up against the potential advantages of making a switch

Why is it important to review the investor policy statement on a regular basis?

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Your results and the estimated s...

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Estimated study time 4.7 hours