You are on page 1of 49

Business School


Week 12
Currency and International Diversification
Performance Measurement and Attribution

Revision (1)
• Market efficiency, anomalies, and behavioral finance
• Fundamental law and transfer coefficient
• The three hurdles for active management:
1. Are there anomalies to market efficiency?
2. Can some managers translate anomalies into consistent
3. Can funds reliably appoint and retain successful managers?
• Secured Loans – how secure? Spread duration. Secondary market
liquidity. The cycle of default rates.
• FCFF versus DDM. CAPM beta adjustments.
• Hedge funds. Alpha reliability net of fees versus market risk premiums.


Revision (2)
• Economic indicators. What leads, what lags? How foes the market move
relative to the economy?
• APRA SPG-530 and asset allocation, constant mix rebalancing
• Black-Litterman
• The asset-liability modeling framework and interest rate sensitivity


Australian Equity Manager Performance
Mercer Survey – Rolling 3 Year Quartiles and Median

Past performance is not a reliable indicator of future performance. You should not rely on
past performance to make investment decisions


Australian Equity Manager versus Fund Performance . Mercer. FTSE/ASFA. SuperRatings Active Management contribution is Mercer survey median minus S&P/ASX 200 Tax Effect is FTSE ASFA Superannuation Index less non-tax adjusted index Super Fund Fees are estimated from a survey of Fund Product Disclosure Statements Median Super Fund is from SuperRatings (SR50) Australian Share Options Survey.periods ending June 2015 Sources: S&P/ASX. Past performance is not a reliable indicator of future performance. You should not rely on past performance to make investment decisions 5 .

t) ( D / E )) if a stock has the same unlevered beta as the market its beta can still be different to one due to leverage 6 . Dimson and Marsh (1983) • Direct Leverage Adjustment bL = bU ´ (1+ (1.Practical Beta Estimation (3) • Thin trading can lead to low beta estimates – trade to trade estimation.

Multifactor Model Example Ri = E(Ri) + BetaGDP (GDP) + BetaIR (IR) + ei Ri = Excess return for security i GDP = GDP deviation from expected BetaGDP= Factor sensitivity to GDP deviation IR = Interest rate deviation from expected BetaIR = Factor sensitivity for Interest Rate deviation ei = return due to firm specific events 7 .

US Leading Economic Indicator .Conference Board Note the equity market is a leading economic indicator. Economic indicators don’t lead the market 8 .

Lagging Indices 9 .US Coincident.

often starting abruptly 10 .The market cycle leads the business cycle • • The market cycle is more ahead of the business cycle at the peak than the trough The market cycle transpires in phases.

Firm Valuation Model t=¥ ValueofFirm = å t=1 FCFF t (1+WACC ) t • The current value of equity is obtained by deducting the value of outstanding debt from the value of the firm • The FCFF is a pre debt cash flow and is independent of the current capital structure • However some assumption about an ‘optimal’ capital structure needs to made to determine the WACC • As with the DDM the cash flows can be summarised in phases 11 .

Δ(Working Capital) If statements comply with US GAAP (Generally Accepted Accounting Principles): FCFF = Cash flow from operations + Interest expense x (1 – Tax rate) .Free Cash Flow to the Firm (FCFF) FCFF = EBIT x (1 – Tax rate) + Depreciation .Capital Expenditure FCFE = FCFF – Interest expense x (1 – Tax rate) 12 .Capital Expenditure .

a margin/turnover decomposition can be useful 13 .Decomposition of ROE ROE = Net Profit x Pretax Profit (1) Tax Burden Pretax Profit x x (2) x Sales EBIT x EBIT x (3) Sales x Assets x (4) Assets Equity x (5) Interest Burden x Margin x Turnover x Leverage When forecasting ROE or ROA and trending towards stable assumptions.

and enhances performance. FAJ Jan-Feb 1988 • How to respond as market movements change the asset allocation • Constant mix rebalancing (CMR) sells the outperforming asset class and buys the underperforming asset class • CMR is effective. Dynamic Strategies for Asset Allocation. when markets oscillate without trend • Usually operates after a threshold of drift is breached • However if an asset class trends (equities in a bull market) CRM will underperform buy and hold .Managing asset allocation around the Strategic Asset Allocation (1) • Perold and Sharpe.

Constant Mix Rebalancing .

This week’s coverage Bodie et al Chapter 24 Chapter 25 Revision Portfolio performance evaluation International diversification 16 .

the price falls and the income is no longer embedded in the price • An asset return calculation therefore adds income to change in price • At the portfolio level the valuation retains the income generated by assets. because it is not typically payed out of the portfolio • A portfolio return calculation does not add income to change in valuation because the change in valuation already includes asset income -P P Asset Return = P t t-1 +It t-1 17 .Portfolio and asset returns .income recognition • When an asset pays income.

particularly where cash flows are significant and/or intra-period market behaviour is uneven 18 .Time Weighted (TWR) and Money Weighted Returns (MWR) • Benchmark returns are time weighted so portfolio return calculations need to be time weighted for comparison • Time weighted returns for a period (eg 3 years) are calculated as the product of sub-period returns (eg monthly) • Sub-period returns should ideally also be calculated time weighted • In practice sub-period returns are sometimes money weighted because of legacy custodian practices • Money weighted sub-period returns should be avoided where possible.

CFt V1 TWR = × V0 Vt 19 .The sub-period portfolio return When cash flows occur there are two choices: 1. Adjust for the cash flows using a Modified Dietz calculation MWR = V1 -V0 . Revalue the portfolio on the date of cashflow Vt .åCFt V0 + åWt × CFt 2.

5/125) = -5. lowering the MWR below the TWR 20 .o.10)) • MWR = (112.o.5 – 100 – 20)/(100+ 20 x 1/3) = -7.50% • The cash flow has created more exposure to the negative performance in the final ten days.05 + $20m) • The value of the portfolio at c.b 20 September is $125m ($100m x 1.Calculation of sub-period returns (1) Example • A portfolio is valued at $100m at the end of August • A cash flow of $20m into the portfolio occurs on 20 September • The underlying return is +5% for the first 20 days of September then 10% in the final 10 days • The value of the portfolio at c.03% • TWR = ((125-20)/100) x (112.b 30 September is $112.5m ($125m x (1 – 0.

• The investment management agreement (IMA) will also stipulate that the investment manager maintain comparable records • Custodians routinely reconcile their valuations to a manager’s portfolio valuation at month end • This ensures agreement about portfolio holdings and accruals (outstanding trades.Calculation of sub-period returns (2) • Recall a fund employs a custodian to maintain the records of their portfolio. and manage custody. income due but not received) • In the event of significant cashflow (eg 10% of the portfolio) the custodian should be requested to value the portfolio so that a proper TWR can be calculated • The MWR in the event of cashflows is a second best option • Where performance fees are involved accurate return calculation is even more important 21 .

000 for a net valuation of $99.15% • Note gross valuations are used.15))/(100 + (-0.000 for a net valuation of $104.o.15)x11/31) = 5.b 30 June and a fee accrual of $150.85m • The custodian valuation at 31 July shows a gross valuation of $105m and a fee accrual of $50.000 is payed on 20 July • The gross MWR = (105 – 100 – (-0.95m • A quarterly management fee of $150.Net and gross of management fees • Investment management fees are normally payed directly from the portfolio • A manager’s performance is normally measured gross of fees • Payments of fees should be recognised as a cash outflow and the portfolio valuation should be gross of any fee accrual • Example: a portfolio has a gross valueation of $100m at c. and the fee is treated as cash out • If the fee was the only cash flow the MWR calculation would be reasonable in this instance because the cash flow is small 22 .

and cash flows in the same way as the managers portfolio. rather than for individual managers within a fund.After tax performance • Comparing manager performance to benchmarks after tax is complicated. the benchmark portfolio should be impacted similarly • After tax benchmarks are available (eg FTSE/ASFA) but these are generic and not matched to a particular portfolio’s cash flow history • In practice funds can monitor tax inefficient behaviour (losing franking entitlement by breaching the 45 day rule. 23 . realising gains after 11 months instead of 12 months) • After tax return calculations are more relevant at the overall fund level. A sale might realise a short gain for the manager (15% tax) but the total fund inventory may enable it to be a long gain (10% tax) with parcel selection. • For example if the manager is forced to realise gains to meet a cash outflow. • The benchmark portfolio in theory should have a cost inventory affected by inception date.

Global Investment Performance Standards (GIPS) • First version 1998 by the CFA Institute • Goal is to have managers calculate and present their investment performance consistently • All of a managers client portfolios should be grouped into composites (eg Australian equity broad cap. Australian equity small cap etc) • If a client portfolio has the same mandate specifications as the composite it must be included in that composite • Managers should present results for the relevant composite in marketing presentations. rather than concealed in multiyear averages • Returns for periods less than a year should not be annualised 24 . rather than selecting the best performing portfolio(s) • Returns should be presented annually.

Jensen.Sharpe. Treynor.rf ) sp . M2 or Information Ratio? • The decision about market exposure (beta) normally rests with the superannuation fund. and does not diversify away • The exception to the information ratio is absolute return managers (eg hedge funds) where the Sharpe measure is more appropriate ap IR= s (ep ) SharpeMeasure = 25 (rp . not external managers • An equity manager is expected to have a beta close to one and performance is measured in excess of index typically without beta adjustment • It is worthwhile validating that beta is close to one for risk management • The information ratio is therefore the common measure in practice • In a multi-manager configuration tracking error still matters.

σ(ep) .Information Ratio • The numerator. αp . is normally taken as the simple excess of portfolio return over the market. is the volatility of portfolio returns in excess of the market (rP – rB) • In practice calculations are made on monthly excess returns and the ratio is annualised by sqrt(12) • A cleaner approach mathematically is to work with ln((1+rP)/(1+rB)) so that the sqrt(12) annualisation is mathematically appropriate • Even then the underlying assumption is that monthly active returns are independent • Where there is serial correlation of active returns due to style bias the annualised volatility via this simple approach is understated • Bear this in mind in manager configuration (risk budgeting) 26 . without explicit beta adjustment • This is equivalent to assuming that the underlying beta is 1 • Similarly.

• The objective of attribution analysis is to analyse the incremental performance relative to benchmark by the activities which contribute to it – asset allocation and security selection RP .RB = AA + SS 27 . not always replicable (eg property). can be established for most asset classes • Benchmarks for private equity and absolute return strategies are less obvious. In practice you might use public market indices and cash respectively.Performance Attribution (1) • An investment option within a superannuation fund will usually have a strategic asset allocation (SAA) giving benchmark weights for each asset class • A passive index.

rBi ) Note the last step works because the sum of difference in weights must be zero 28 .wBi × rBi ) n n i=1 i=1 = å(wPi .wBi )× rBi + å wPi × (rPi .å wBi × rBi = å(wPi × rPi .wBi )× (rBi .rBi ) n n i=1 i=1 = å(wPi .Performance Attribution (2) The framework is based on representing portfolio and benchmark returns as the sum of products of asset class weights and asset class returns n n n i=1 i=1 t=1 RP .RB ) + å wPi × (rPi .RB = å wPi × rPi .

Performance Attribution (3) Asset Security Asset Portfolio Portfolio Benchmark Benchmark Allocation Selection Class Allocation Return Allocation Return Contribution Contribution Equities 50% 3.000% 100% 1.50% 0.0%-1.110% -0.55% -0.00% -0.250% Property 0% NA 10% 0.00% 60% 2. while positive. so the table is complete 29 .050% 0.110% The benchmark bond return.55%)=0.75% 100% 1.00% -0.045% 0.500% Bonds 50% 0.250% • • • • The asset allocation contribution for bonds is (50%-30%)x(1.105% 0.50% 30% 1. is less than the benchmark portfolio return Allocating more to bonds makes a negative contribution There is no portfolio return for property but the security selection item is multiplied by the portfolio allocation of 0%.

Multi-Period Performance Attribution(1) The attribution elements need to be converted to a multiplicative structure for multi-period attribution n AAt = å (wtPi .wtBi )× (r tBi .r tBi ) i=1 t t 1+ R + AA B 1+ AA*t = 1+ RtB 1+ SS = t * 1+ RtB + AAt + SS t 1+ RBt + AAt 30 1+ RPt = 1+ RBt + AAt .RtB ) i=1 n SS t = å wtPi × (r tPi .

Multi-Period Performance Attribution(2) The attribution ratios are then multiplied through time to calculate full period attribution p p t=1 t=1 AA = (Õ (1+ RBt ))× (Õ (1+ AA*t ) -1) p p t=1 t=1 SS = (Õ (1+ RBt )× (1+ AA*t ))× (Õ (1+ SS*t ) -1) p p t (1+ R ) -1 = ( (1+ R Õ Õ B ) -1) + AA + SS t P t=1 t=1 31 .

Performance attribution in practice • It is more straightforward to attribute gross performance rather than after tax/fees performance • The impact of tax and fees can be summarised at the total portfolio level • A portfolio return may not exactly equal the sum of products of sector weights and sector returns due to cashflow distortions etc • At the calculation stage any discrepancy should be isolated in subperiod and multi-period attribution – not obscured by arbitrarily merging with other elements • If the discrepancy accumulates significantly over time then there could be something structurally wrong with the attribution framework (eg the portfolio returns have been assumed gross of fees when in fact they have been calculated net) • Random unbiased discrepancies should not accumulate significantly 32 .

Australian companies investing overseas (1) NAB’s US adventure • ‘NAB sells off HomeSide’ (Money Management 12/12/01) ‘National Australia Bank (NAB) has rid itself of its troubled American mortgage business. That NAB would never again revisit mortgage products in foreign markets’ 33 .7b ‘The Florida-based business ..7b . after offloading it to Washington Mutual Inc for $3. HomeSide. made spectacular losses of more than $3b as a result of bungled interest-rate calculations …’ ‘NAB chief executive Frank Cicutto vowed . acquired by NAB in 1997 for $1.

Australian companies investing overseas (2) NAB’s UK adventure • ‘NAB committed to UK despite Clydesdale downgrade’ (AFR 29/9/11) • ‘NAB’s Clydesdale on credit watch in Britain’ (AFR 2/6/13) • ‘Brokers urge NAB to move on Clydesdale sale’ (AFR 21/1/14) • ‘RBS fallout casts shadow over NAB UK’ (AFR 29/1/14) • ‘Cameron Clyne confident NAB will “get out” of UK (AFR 10/9/14) • ‘NAB flags profit drop on $1b UK write-downs’ (AFR 9/10/14) 34 .

Hong Kong’ (AFR 7/3/12) • ‘QBE playing catch-up after aggressive expansion’ (AFR 21/1/13) • ‘Profit warning tipped for QBE after US strife’ (AFR 9/12/13) • ‘QBE should sell Winterthur.Australian companies investing overseas (3) QBE’s ill-fated global acquisition strategy • ‘QBE buys into Argentina. take write-down’ (AFR 15/4/14) • ‘Argentinian woes cause yet another QBE downgrade’ (AFR 30/7/14) 35 .

but that’s just an example of how these things work. ‘Oh yeah.9b. wagons.” he said. how hard can that be?’ “And it’s bloody hard. “They just think they are sending people from here to there and think. the wash plant was going and they still managed to screw it.” – vendor who initially sold asset to RIO 36 . You have to manage it and you have to manage it well. the mine was already developed.Australian companies investing overseas (4) Rio takes massive loss on Mozambique sale (paid $3. port. rail. “And I don’t want to talk publicly about how that happened. sold for $50m) (AFR 31/7/14) ‘‘We were a company with $500 million in cash.

Australian companies investing overseas (5) • Some companies have unique products that generate strong demand overseas (eg Cochlear hearing implants. Computershare registry services) • But generally Australian companies tend to acquire smaller overseas operations that are cheap often because they are in compromised competitive positions • At the outset there is hope that the talents of Australian management can turn these frogs into princes (why hasn’t a local acquirer tried?) • In practice that is often a steeper challenge than it first appears • Overseas diversification via the overseas subsidiaries of Australian companies is a constrained alternative • Buying overseas companies gives access to stronger global companies • Are these available at good prices? 37 .

This followed the imposition of martial law on Tuesday 20 May 2014 which was implemented after several months of anti-government protests in Bangkok.’ – Company Announcement 27/5/14 38 .Sovereign Risk ‘Kingsgate Consolidated Limited (ASX: KCN) wishes to advise that business is continuing as usual at its Chatree operations in Thailand following the move by the army to take control of the administration of the country on Wednesday 22 May.

the structure of taxes.Social Capital and Economic Development ‘Social capital is the set of institutions – including the legal framework. The development of social capital conflicts with the interests of entrenched rent-seeking elites. political practices and traditions. the nature of corporate governance. the financial system. 39 . etc. – that determine the way individuals are given incentives to create value with the tools and infrastructure that they have. educational and health levels. Peking University The Pettis thesis is that a deficiency in social capital makes it hard for developing economies to transition to developed economies.’ – Michael Pettis.

Emerging markets (1) • Emerging markets currently represent around 11% of the MSCI All Countries Index. Volatility of 24% compares to 18% for developed markets 40 .

Emerging markets (2) 41 .

47 in $US) • Equity returns depend on profitability per share • Economic growth can occur through expansion of the capital base (debt and equity funded) without improvement in profitability per share • Scrutiny of how companies manage their capital (adequate returns on retained capital) is an important prerequisite for equity performance • Capital management may be better scrutinised in developed markets 42 .32 in $US) • For 22 developed markets over the period 1970-2011 the correlation is virtually zero (-0.Does stronger economic growth mean higher equity returns? • For 19 developed markets since 1900 the correlation is firmly negative (-0.39 in local currency.04 in local currency.01 in $US) • For 15 emerging markets over the period 1988-2011 the correlation is firmly negative (-0. 0.41 in local currency and -0. -0.

Exposure to non-$A currencies improves diversification (to a point) 43 .

Asset and currency separation (1) • A portfolio has two layers of allocation • Asset class weights. divisible by country (eg US equity allocation) which add to 100% • Currency allocation weights (eg to $A. but cross-hedge the currency exposure to Euro • Separating assets and currencies allows allocation to strong markets in local currency terms. Yen etc) which add to 100% • For example it is possible to allocate to UK equities. and currency returns considered as including the local interest rate • In that way currency allocation creates forward premiums 44 . $US. Euro. but where the currency is weak • Without separation a perspective on the currency will influence the allocation to the asset (eg avoid markets where currency is weak) • Asset returns should be considered in excess of the local interest rate.

this currency allocation could be achieved by a 10% cross-hedge from Yen to Euro. and a 10% hedge from $US to $A.Asset and currency separation (2) Asset % Currency % Australian Equities 50 $A 60 US Equities 25 $US 15 European Equities 10 Euro 20 Japanese Equities 15 Yen 5 100 100 Starting with the currency profile of the assets. 45 . Currency hedging establishes a new currency exposure and an interest rate differential (forward premium).

Currency and asset correlation . 30% international shares (hedged). R-squared is 21%. 15% Australian bonds and 15% international bonds (hedged).Australia Asset returns in this illustration are a composite of 40% Australian equities. 46 .

Overseas investors are attracted to Australian assets. and Australian assets • In times of crisis overseas investors have a tendency to repatriate capital. especially resource companies • When there are concerns about the global economy overseas investors have less appetite for the Australian dollar.Currency and asset correlation . selling peripheral asset/currency exposures • For the above reasons the Australian dollar has a tendency to be weak when assets returns are weak • But there is a silver lining .Australian dollar weakness buoys the returns from overseas assets due to currency translation 47 . Australia’s terms of trade tend to be strong (commodities) and the Australian dollar is well supported.Australia • International investors view Australia as a global cyclical exposure • When the global economy is strong.

market efficiency – for and against • Modeling asset class returns – equity trend stationarity. by type of inflation • Equity management styles – value and growth • Property .Revision Focus • CAPM. regime switching.valuation • Risk budgeting – manager allocation 48 . Nelson Siegel. historical context • Expectations of asset class returns – Black-Litterman • Inflation and asset class returns.

Thank you for your attention Greg Vaughan School of Risk and Actuarial Studies University of New South Wales 49 .