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# CHAPTER 28

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.

## REQUIREMENTS FOR A BOND PERFORMANCE AND

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.

## Alternative Return Measures

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.

## In equation form, the portfolios return can be expressed as follows:

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

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portfolio. Second, if there are distributions from the portfolio, they occur at the end of the
evaluation period or are held in the form of cash until the end of the evaluation period. Third, no
cash is paid into the portfolio by the client.

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.

## Arithmetic Average 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.

## Time-Weighted Rate of Return

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

## RT = [(1 + RP1)(1 + RP2) . . . (1 + RPN)]1/ N 1

where RT is the time-weighted rate of return, RPk is the return for subperiod k, and N is the
number of subperiods.

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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.

## Dollar-Weighted Rate of Return

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

## where RD = dollar-weighted rate of return; V0 = initial market value of the portfolio;

VN = terminal market value of the portfolio; and, Ck = cash flow for the portfolio (cash inflows
minus cash outflows) for subperiod k for k = 1, . . . , 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

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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.

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:

## annual return = (1 + average period return)number of periods in year 1.

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.

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A more appropriate benchmark for institutional investors such as defined benefit pension plans is
one that reflects its liability structure. It has been argued that the major reason for the failure of
both public and private defined benefit plans is the wrong benchmarks have been used. Instead of
using a bond index as is commonly used, the appropriate benchmark should be one that is
customized liability index based on a specific pension plans actuarially determined liability
structure.

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
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
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.

## Types of Performance Attribution Models

Today, performance attribution models can be classified into three types: sector-based attribution

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.

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Factor-based attribution models actually allow a decomposition of the yield curve risk into level
risk and changes in the shape of the yield curve. For example, suppose that the attribution due to
yield curve risk is determined to be as follows:

## Risk Factor Portfolio D Portfolio E Portfolio F

Yield curve risk 140 1 60
Level risk 135 60 3
Shape risk 5 59 63

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.

## As the name suggests, a hybrid sector-based/factor-based attribution model combines the

previous two attribution models. This model allows for much more detail regarding not only the
bets on the primary systematic risk factors driving returns but the impact of decisions with
respect to sector and security selection.

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.
The rate of return expresses the dollar return in terms of the amount of the initial investment
(i.e., the initial market value of the portfolio).
Three methodologies have been used in practice to calculate the average of the sub-period
returns: (1) the arithmetic average rate of return, (2) the time-weighted (or geometric) rate of
return, and (3) the dollar-weighted return.
The arithmetic average rate of return 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 period
while keeping the initial portfolio market value intact.
The time-weighted rate of return measures the compounded rate of growth of the initial
portfolio over the evaluation period, assuming that all cash distributions are reinvested in the
portfolio. The time-weighted return 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 magnitude of the difference
between the two averages is smaller the less the variation in the sub-period returns over the
evaluation period.

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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 sub-periods 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 an internal rate-of-return calculation and will produce
the same result as the time-weighted rate of return if (1) no withdrawals or contributions occur
over the evaluation period, and (2) all coupon interest payments are reinvested.
The problem with using the dollar-weighted rate of return to evaluate the performance of
money managers is that it is affected by factors that are beyond the control of the money
manager. Specifically, any contributions made by the client or withdrawals that the client
requires will affect the calculated return, making it difficult to compare the performance of
two portfolio managers.
The role of performance evaluation is to determine if a portfolio manager added value beyond
what could have been achieved by a passive strategy in a benchmark portfolio. The analysis
requires the establishment of a benchmark.
One such benchmark is a normal portfolio. This is a customized benchmark that includes a set
of securities that contains the universe of securities that a manager normally selects from and
weighted as the manager would weight them in a portfolio. Advocates claim 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.
Bond indexes are commonly used as benchmarks.
For defined benefit pension plans, a more appropriate benchmark would be a customized
liability index determined by the funds actuarially projected future liabilities.
Performance attribution models can be used explain why the active return of a portfolio was
realized. The three types of performance attribution models available are sector-based

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ANSWERS TO QUESTIONS FOR CHAPTER 28
(Questions are in bold print followed by answers.)

## 1. What is the difference between performance measurement and performance evaluation?

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:

## Month Manager I Manager II

1 9% 25%
2 13% 13%
3 22% 22%
4 18% 24%

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.

## 9% 13% 22% (18%)

RManager I = = 0.0650 or 6.50%.
4

## 25% 13% 22% (24%)

RManager II = = 0.0900 or 9.00%.
4

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3. What is the time-weighted average monthly rate of return for the two managers in
Question 2?

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

## RT = [(1 + RP1)(1 + RP2) . . . (1 + RPN)]1/ N 1

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:

## RManager I = [(1 + 0.09)(1 + 0.13)(1 + 0.22)(1 + {1 + 0.18}]1/4 1 = [(1.09)(1.13)(1.22)(0.82)]1/4

1 = [1.23211943]1/4 1 = 1.05358519 1 = 0.05358519 or about 5.36%.

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.

## RManager II = [(1 + 0.25)(1 + 0.13)(1 + 0.22)(1 + {1 + 0.24}]1/4 1 = [(1.25)(1.13)(1.22)(0.76)]1/4

1 = [1.30967000]1/4 1 = 1.06977014 1 = 0.06977014 or about 6.98%.

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.

## Two Types of Monthly Returns:

Arithmetic Average Return Time-Weighted Return Difference in Returns
Manager I 6.50% 5.36% 1.14%
Manager II 9.00% 6.98% 2.02%

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

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greater. Thus, because there is more variation in returns for Manager II, this causes a greater
difference between the arithmetic average monthly rate of return and the time-weighted monthly
rate of return. More details are given below.

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:

1 \$ 50
2 \$150
3 \$ 75
4 \$100

## In equation form, the portfolios return can be expressed as follows:

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. Since there is no cash
distribution (i.e., D = 0), we have:

MV1 MV0
Rp = .
MV0

## MV1 MV0 \$50 million \$100 million \$50

Rmonth 1 = = = = 0.5000 or 50.00%.
MV0 \$100 million \$100

## \$150 million \$50 million \$100 million

Rmonth 2 = = = 2.000 or 200.00%.
\$50 million \$50 million

## \$75 million \$150 million \$75 million

Rmonth 3 = = = 0.5000 or 50.00%.
\$150 million \$150 million

## \$100 million \$75 million \$25 million

Rmonth 4 = = = 0.333333 or about 33.33%.
\$75 million \$75 million

(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

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(c) Is the average monthly rate of return of 33.33% indicative of the performance of Smith
& Jones? If not, what would be a more appropriate measure?

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

## RT = [(1 + RP1)(1 + RP2) . . . (1 + RPN)]1/ N 1

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:

## = [(0.50)(2.00)(0.55)(1.33333)]1/4 1 = [1.00000]1/4 1 = 1 1 = 0 or 0%.

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.

## Cash flows, referred to above, are defined as follows:

(1) 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.
(2) 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.

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(3) 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

## where RD = dollar-weighted rate of return; V0 = initial market value of the portfolio;

VN = terminal market value of the portfolio; and, Ck = cash flow for the portfolio (cash inflows
minus cash outflows) for subperiod k for k = 1, . . . , 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 have: V0 = \$100 million, N = 4, C1 = \$0 million, C2 = \$0 million,

C3 = \$0 million, C4 = \$0 million, and V4 = \$100 million. Given these values, RD is the interest
rate that satisfies the below equation:

\$100,000,000 =
1 RD 1 RD 1 RD
2 3
1 RD
4

## \$100, 000, 000 \$100,000,000

\$100,000,000 = (1 + RD)4 = (1 + RD) = 4
1 1
1 RD
4
\$100,000,000

## RD = 1 1 RD = 0. Thus, RD = 0% satisfies the equation.

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:

## \$50,000,000 \$100,000,000 \$75,000,000 \$75,000,000

\$100,000,000 =
1.00 (1) 2 (1) 4 (1) 4

## Copyright 2016 Pearson Education, Inc. 636

\$100,000,000 = \$50,000,000 + \$100,000,000 + \$75,000,000 + \$75,0000

## \$100,000,000 = \$100,000,000. Thus, RD = 0% satisfies the equation.

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:

## annual return = (1 + average period return)number of periods in year 1.

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

## annual return = (1 + average period return)number of periods in year 1 = (1.02)12 1 = 26.8%.

In our problem, the evaluation period is four months and the average monthly return is 0%. Then
the annual return is

## In conclusion, either a time-weighted or dollar-weighted rate of return is more indicative of the

portfolios performance and thus a more appropriate measure.

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

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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. 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

## where RD = dollar-weighted rate of return; V0 = initial market value of the portfolio;

VN = terminal market value of the portfolio; and, Ck = cash flow for the portfolio (cash inflows
minus cash outflows) for subperiod k for k = 1, . . . , 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.

## \$20,000,000 \$8,000,000 \$4,000,000 \$208,000,000

\$200,000,000 = 2

1.04055092408 (1.04055092408) (1.04055092408)3

## \$200,000,000 = \$19,220,587.4188 + {\$7,388,619.6145) + \$188,168,032.1957

\$200,000,000 = \$200,000,000.

## Copyright 2016 Pearson Education, Inc. 638

Because about 4.055% is the internal rate of return that satisfies the above expression, 4.055%
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.

(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:

## \$20,000,000 \$0 \$4,000,000 \$208,000,000

\$200,000,000 = .
1 RD 1 RD 1 RD
2 3

Below we verify that 5.4059618263% or about 5.406% is the internal rate of return satisfies the
above expression.

## \$20,000,000 \$0 \$4,000,000 \$208,000,000

\$200,000,000 = 2

1.054059618263 (1.054059618263) (1.054059618263)3

## \$200,000,000 = \$18,974,258.812 + \$0 + \$181,025,741.188

\$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:

## Copyright 2016 Pearson Education, Inc. 639

For our problem, the period used to calculate returns is monthly and the average monthly return
is 1.23%. Thus, the annual return is:

## annual return = (1 + average period return)number of periods in year 1

= (1.0123)12 1 = 1.158006 1 = 0.158006 or about 15.80%.

8. If the average quarterly return for a portfolio is 1.78%, what is the annualized return?

## annual return = (1 + average period return)number of periods in year 1.

For our problem, the period used to calculate returns is quarterly and the average quarterly return
is 1.78%. Thus, the annual return is:

## annual return = (1 + average period return)number of periods in year 1

= (1.0178)4 1 = 1.073124 1 = 0.073124 or about 7.31%.

## 9. What are the difficulties of constructing a normal portfolio?

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).

## Copyright 2016 Pearson Education, Inc. 640

Defining the set of securities to be included in the normal portfolio begins with discussions
between the client and the manager to determine the managers investment style. Based on these
discussions, the universe of all publicly traded securities is reduced to a subset that includes
those securities that the manager considers eligible given his or her investment style.

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.

## Copyright 2016 Pearson Education, Inc. 641

A third question we might want to ask is: How did members of the team perform? Not only do
clients need information about why the portfolios return differed from that of the benchmark,
but so do the individuals at the asset management firm engaged by the client. 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.
A fourth question we might want to ask is: What performance models were used? 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.

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.

## Copyright 2016 Pearson Education, Inc. 642

12. A financial institution has hired three external portfolio managers: X, Y, and Z. All three
managers have the same benchmark. A performance attribution analysis of the portfolios
managed by the three managers for the past year was (in basis points):

## Risk Factor Portfolio X Portfolio Y Portfolio Z

Yield curve risk 1 92 3
Swap spread risk 20 4 20
Volatility risk 40 3 25
Government related spread risk 35 5 10
Corporate spread risk 2 6 30
Securitized spread risk 2 4 5

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

## Based on overall performance, committee member #1 is correct because those in charge of

Portfolio Y have an overall better performance. However, as seen above it achieves a 105 basis
point active return beyond the benchmark and not an active return of 96 basis points. Its superior
return was caused almost exclusively by its performance attributed to yield curve risk (92 basis
point active return). Thus, its achievement is based on an interest-rate bet, while its non-interest-
rate bets were slightly positive. In terms of its interest-rate bet, we do not know to what extent its
performance can be attributed to either level (duration) risk or shape risk.

(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.

## Copyright 2016 Pearson Education, Inc. 643

Risk Factor Portfolio X Portfolio Y Portfolio Z
Corporate spread risk 2 6 30

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).

## Risk Factor Portfolio X Portfolio Y Portfolio Z

Yield curve risk 1 92 3

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:

## Risk Factor Portfolio X Portfolio Y Portfolio Z

Yield curve risk 1 92 3
Level risk 51 80 +40
Shape risk +50 12 43

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.