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Investment - Compliance Risk
Compliance risk is the risk that a corporation fails to comply with all applicable rules, laws, and regulations. The risk of non-compliance with laws and regulations is higher than non-compliance with internal policies and processes because fines might be enforced. These fines can harm both individuals and companies and may be severe.
Ensuring compliance with rules and regulations has traditionally been considered as a pretty dull duty, but the quickly changing regulatory environment has in recent years propelled compliance to the forefront of company objectives. Many people believe that the tendency towards less regulation contributed to the global financial crisis that began in 2008.
The tendency has reversed with the re-imposition of increased regulation and control. This additional law, in turn, has led to more compliance tasks and more compliance risk.
Framework for Legal and Regulatory Compliance
Every corporation has to obey a set of rules, beginning with the statutory laws and other restrictions imposed by regulatory agencies. In addition, many investment businesses must follow requirements from authorities, stock exchanges, and industry bodies that have been given responsibilities to regulate members. Because of their prominence in the financial system, banks and insurance businesses have historically been subject to severe supervision, with extensive rules and monitoring from regulatory bodies. For example, banks are subject to the Basel Accords.
Accords are international agreements that normally take the name of the location where they are signed. The Basel Accords, which specify worldwide norms for banks’ capital, leverage, and liquidity requirements, are considered regularly in Basel, Switzerland and revised as needed.
Complying with applicable rules and regulations is needed of every company. The repercussions of not doing so can be severe and can include financial penalties, loss of business licences, litigation by clients, and in catastrophic cases, prison terms. Often the greatest effects are the damage to the company’s reputation and the loss of present and potential commercial possibilities.
Companies should have internal reporting mechanisms to encourage employees to come forward and report incidents in which they feel someone has broken internal policies, procedures, laws, or regulations.
This technique is called whistleblowing. Whistleblowing has become an important tool for authorities to learn about infractions, and rules to protect and reward whistleblowers have been tightened in the wake of financial scandals.
Examples of Compliance Risks
Corruption, which is defined as the abuse of power for private gain, has attracted heightened attention because of tougher laws and regulations on bribery and greater regulatory monitoring, investigations, prosecutions, and fines. Some national authorities may apply these laws extra-territorially, even to overseas corporations. Firms that operate through agents and other third parties should be aware that their duty for combating corruption extends to the acts of these third parties. Ignoring the practices of third parties does not provide a defence in the case of a regulatory examination.
To safeguard against corruption, firms must start by establishing a tone at the top, with senior management conveying an unequivocal policy of zero tolerance for unethical business practices and bribery.
Risk assessments should identify major risk areas and susceptible employees. For instance, personnel who contact with government officials for licensing or deal with government or state-owned enterprises should be given extra training and be supervised constantly. Controls over corporate gifts and hospitality, especially in payment-processing sectors, are vital for the prevention of unlawful or unethical payments.
Compliance with tax regulations is hard because the principles and standards vary widely by jurisdiction. Companies are continuously creating financial and legal structures, generally with the purpose of reducing taxes overall. Uncertainty arises in how tax authorities will apply their laws, which is heightened by the fact that the rules change constantly. A conservative approach is to conform to tried-and-tested precedents. A more aggressive approach is to seek to exploit loopholes in the tax code, low-tax jurisdictions (so-called offshore tax havens), and other grey areas.
There is a technical difference between ‘tax avoidance’, which involves employing tax code provisions to limit the tax that is owing, and ‘tax evasion’, which means not paying taxes in violation of the tax law. In practice, however, the border between tax avoidance and tax evasion is not always clear and specialist tax guidance is important.
There are rules that restrict the trading of a security when in possession of critical sensitive information relevant to the security in question. Most markets have lately toughened legislation regulating insider trading. Another trend is an increase in investigations of insider trading; some such investigations are even relying on techniques similar to those used in investigations of organised crime cases — including tapping telephones, using evidence already collected to make peripheral suspects cooperate, and gradually closing in to catch the central participants of the scheme.
Companies must develop policies and procedures to ensure that traders understand the laws and that nobody in the organization will be in the position to break them. Investment organizations that face a high risk of insider trading, such as investment banks, use ‘control rooms’ to monitor information passing between teams. They also have virtual walls or information barriers to restrict and segregate information and to handle other conflicts of interest.
Anti-money-laundering law is a set of measures to prohibit money produced from illicit activity from entering the financial system and obtaining the appearance of being acquired from legitimate sources. These rules require companies in the financial services industry, including those in the investment industry, to obtain sufficient original or certified documentation to perform a formal risk assessment on each client and counterparty; the procedures of such an assessment are called know-your-customer procedures.
International agreements defining basic principles and requirements for anti-money-laundering frameworks have been formed and are implemented with modest modifications according to the jurisdiction. A significant aspect of most anti-money-laundering rules is a severe liability approach to compliance. That is, a corporation might be liable to harsh consequences as a result of not following specified procedures and record keeping, regardless of whether any questionable transactions are handled or any actual damage is made.
Compliance risk is the risk that a corporation fails to comply with all applicable rules, laws, and regulations. The risk of non-compliance with laws and regulations is higher than non-compliance with internal policies and processes because fines might be enforced. These fines can harm both individuals and companies and may be severe.
Ensuring compliance with rules and regulations has traditionally been considered as a pretty dull duty, but the quickly changing regulatory environment has in recent years propelled compliance to the forefront of company objectives. Many people believe that the tendency towards less regulation contributed to the global financial crisis that began in 2008.
The tendency has reversed with the re-imposition of increased regulation and control. This additional law, in turn, has led to more compliance tasks and more compliance risk.
Framework for Legal and Regulatory Compliance
Every corporation has to obey a set of rules, beginning with the statutory laws and other restrictions imposed by regulatory agencies. In addition, many investment businesses must follow requirements from authorities, stock exchanges, and industry bodies that have been given responsibilities to regulate members. Because of their prominence in the financial system, banks and insurance businesses have historically been subject to severe supervision, with extensive rules and monitoring from regulatory bodies. For example, banks are subject to the Basel Accords.
Accords are international agreements that normally take the name of the location where they are signed. The Basel Accords, which specify worldwide norms for banks’ capital, leverage, and liquidity requirements, are considered regularly in Basel, Switzerland and revised as needed.
Complying with applicable rules and regulations is needed of every company. The repercussions of not doing so can be severe and can include financial penalties, loss of business licences, litigation by clients, and in catastrophic cases, prison terms. Often the greatest effects are the damage to the company’s reputation and the loss of present and potential commercial possibilities.
Companies should have internal reporting mechanisms to encourage employees to come forward and report incidents in which they feel someone has broken internal policies, procedures, laws, or regulations.
This technique is called whistleblowing. Whistleblowing has become an important tool for authorities to learn about infractions, and rules to protect and reward whistleblowers have been tightened in the wake of financial scandals.
Examples of Compliance Risks
Corruption, which is defined as the abuse of power for private gain, has attracted heightened attention because of tougher laws and regulations on bribery and greater regulatory monitoring, investigations, prosecutions, and fines. Some national authorities may apply these laws extra-territorially, even to overseas corporations. Firms that operate through agents and other third parties should be aware that their duty for combating corruption extends to the acts of these third parties. Ignoring the practices of third parties does not provide a defence in the case of a regulatory examination.
To safeguard against corruption, firms must start by establishing a tone at the top, with senior management conveying an unequivocal policy of zero tolerance for unethical business practices and bribery.
Risk assessments should identify major risk areas and susceptible employees. For instance, personnel who contact with government officials for licensing or deal with government or state-owned enterprises should be given extra training and be supervised constantly. Controls over corporate gifts and hospitality, especially in payment-processing sectors, are vital for the prevention of unlawful or unethical payments.
Compliance with tax regulations is hard because the principles and standards vary widely by jurisdiction. Companies are continuously creating financial and legal structures, generally with the purpose of reducing taxes overall. Uncertainty arises in how tax authorities will apply their laws, which is heightened by the fact that the rules change constantly. A conservative approach is to conform to tried-and-tested precedents. A more aggressive approach is to seek to exploit loopholes in the tax code, low-tax jurisdictions (so-called offshore tax havens), and other grey areas.
There is a technical difference between ‘tax avoidance’, which involves employing tax code provisions to limit the tax that is owing, and ‘tax evasion’, which means not paying taxes in violation of the tax law. In practice, however, the border between tax avoidance and tax evasion is not always clear and specialist tax guidance is important.
There are rules that restrict the trading of a security when in possession of critical sensitive information relevant to the security in question. Most markets have lately toughened legislation regulating insider trading. Another trend is an increase in investigations of insider trading; some such investigations are even relying on techniques similar to those used in investigations of organised crime cases — including tapping telephones, using evidence already collected to make peripheral suspects cooperate, and gradually closing in to catch the central participants of the scheme.
Companies must develop policies and procedures to ensure that traders understand the laws and that nobody in the organization will be in the position to break them. Investment organizations that face a high risk of insider trading, such as investment banks, use ‘control rooms’ to monitor information passing between teams. They also have virtual walls or information barriers to restrict and segregate information and to handle other conflicts of interest.
Anti-money-laundering law is a set of measures to prohibit money produced from illicit activity from entering the financial system and obtaining the appearance of being acquired from legitimate sources. These rules require companies in the financial services industry, including those in the investment industry, to obtain sufficient original or certified documentation to perform a formal risk assessment on each client and counterparty; the procedures of such an assessment are called know-your-customer procedures.
International agreements defining basic principles and requirements for anti-money-laundering frameworks have been formed and are implemented with modest modifications according to the jurisdiction. A significant aspect of most anti-money-laundering rules is a severe liability approach to compliance. That is, a corporation might be liable to harsh consequences as a result of not following specified procedures and record keeping, regardless of whether any questionable transactions are handled or any actual damage is made.
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Investment - Investment Risk
Risk is a significant factor of financial decisions. Investors, for instance, buy equities securities, commodities, or real estate. When they do, they are subject to investment risk – that is, the risk connected with investing. For example, investors may experience losses if the company in which they bought common shares loses value or goes bankrupt, or if commodity or real estate values collapse.
Investment risk can take numerous forms based on the company’s investments and operations. Companies in the investment industry often suffer three primary forms of investment risk.
Market risk is risk generated by changes in market conditions affecting prices.
Credit risk is the risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal.
Liquidity risk is the risk that an asset or security cannot be acquired or sold rapidly without a major sacrifice in price.
A common feature for success in all sorts of investment risk management is the requirement to recognize the risks and price them appropriately.
Market Risk
Market risk, which originates from price movements in financial markets, can be categorized into the risks associated with the underlying market instruments:
Equity price risk
Interest rate risk (for debt securities)
Foreign exchange rate risk
Commodity price risk
Many investment firms are in the business of assuming investment risks, and they tend to tolerate market hazards. But like any other organization, they must align their risk profiles with their risk tolerance. They commonly adopt an approach called risk budgeting to establish how risk should be shared across different business units, portfolios, or individuals.
For example, an asset management business may apply the following risk budgeting steps:
Quantify the level of risk that can be carried by the firm
Set risk budgets and restrictions for each asset class and/or investment manager
Allocate assets in line with the risk budgets
Monitor to verify that risk budgets are respected
Market risks that cannot be tolerated must be managed, and companies have different solutions available. One of them is to hedge undesirable risks by employing derivative products.
Credit Risk
When analyzing the creditworthiness of borrowers, it is crucial to examine both their ability and willingness to repay their obligations.
For example, after the decrease in real estate prices in 2008, many homeowners in the United States were left with mortgage loan obligations that surpassed the market worth of the property. Some of those borrowers still had the means to keep paying their mortgage payments but elected to fail and let the bank take possession of the property.
This potentially unethical option is rational from a purely financial perspective, except from the lower credit profile for future borrowing.
The predicted loss from credit exposure is a function of three elements:
Amount of money lent to a given borrower
Probability that the borrower defaults
Loss that would be incurred if the borrower defaults
The amount that is at risk may be decreased if collateral or assurances from third parties are added. Enforcing contract restrictions to acquire possession of collateral, however, can be a time-consuming legal process. The value of collateral assets for a lender depends on their liquidity and marketability – that is, how easy it is to sell the assets to a third party and at how big of a discount if sold on short notice. Assets for which a consistent market demand exists and that can be moved and easily transferred are more valuable than assets that are exchanged less frequently and are less mobile.
Various sources of independent information exist on borrower creditworthiness, such as credit rating organizations, which should be used in conjunction with internal risk analysis. Any analysis, whether internal or external, should incorporate a degree of critical judgement and scepticism.
There are numerous techniques to managing credit risk:
EXPOSURE LIMITS
Credit risk can be managed by placing restrictions on the amount of exposure to a given counterparty or level of credit rating allowed. For example, a maximum limit of 5% exposure could be specified for a certain counterparty.
COLLATERAL AND COVENANTS
Credit risk can also be addressed by requesting more collateral and enforcing covenants. Covenants are terms for loans that describe both what a borrower must do (positive covenants) and what a borrower is not allowed to do (negative covenants).
For example, a bank may prevent borrowers from issuing more debt, paying dividends, or getting into very risky business projects. When one of the restrictive criteria is broken, the lender may recall the loan or require some action, such as the assignment of extra collateral.
DERIVATIVE INSTRUMENTS
Credit risk can also be addressed through the use of derivative products. For example, credit default swaps are typically employed when corporations seek to protect themselves against the risk of a drop in value of a debt security or index of debt securities.
Lending to governments or state-owned firms raises another sort of credit risk. Sovereign risk is the risk that a government will not return its debt because it does not have either the ability or the motivation to do so. The distinctive characteristic of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to retrieve the assets themselves. A government can also restrict borrowers in its country from repaying their loans to foreign investors — for example, by instituting currency controls to make it difficult or impossible for money to leave the country.
Liquidity Risk
As noted previously, liquidity refers to the capacity to purchase and sell fast without incurring a loss. It is a basic worry for organizations and is often disregarded when sources of financing, such as bank loans, are plentiful.
But during the global financial crisis of 2008, an acute shortage of liquidity in the banking institutions in several nations led to failures. These failures happened because some companies were unable to maintain access to sufficient money to fund their working capital (inventories and receivables from customers net of payables from suppliers) and, thus, to keep their companies functioning.
Firms in the investing industry suffer a greater level of liquidity risk than, for example, manufacturers. To function profitably, they need marketplaces that can handle their trades without large unfavorable effects on prices.
When markets are illiquid — either temporarily, such as during financial crises, or more structurally, such as in some emerging markets — the capacity to trade assets is severely limited, which has a detrimental effect for these firms.
Risk is a significant factor of financial decisions. Investors, for instance, buy equities securities, commodities, or real estate. When they do, they are subject to investment risk – that is, the risk connected with investing. For example, investors may experience losses if the company in which they bought common shares loses value or goes bankrupt, or if commodity or real estate values collapse.
Investment risk can take numerous forms based on the company’s investments and operations. Companies in the investment industry often suffer three primary forms of investment risk.
Market risk is risk generated by changes in market conditions affecting prices.
Credit risk is the risk for a lender that a borrower fails to honour a contract and make timely payments of interest and principal.
Liquidity risk is the risk that an asset or security cannot be acquired or sold rapidly without a major sacrifice in price.
A common feature for success in all sorts of investment risk management is the requirement to recognize the risks and price them appropriately.
Market Risk
Market risk, which originates from price movements in financial markets, can be categorized into the risks associated with the underlying market instruments:
Equity price risk
Interest rate risk (for debt securities)
Foreign exchange rate risk
Commodity price risk
Many investment firms are in the business of assuming investment risks, and they tend to tolerate market hazards. But like any other organization, they must align their risk profiles with their risk tolerance. They commonly adopt an approach called risk budgeting to establish how risk should be shared across different business units, portfolios, or individuals.
For example, an asset management business may apply the following risk budgeting steps:
Quantify the level of risk that can be carried by the firm
Set risk budgets and restrictions for each asset class and/or investment manager
Allocate assets in line with the risk budgets
Monitor to verify that risk budgets are respected
Market risks that cannot be tolerated must be managed, and companies have different solutions available. One of them is to hedge undesirable risks by employing derivative products.
Credit Risk
When analyzing the creditworthiness of borrowers, it is crucial to examine both their ability and willingness to repay their obligations.
For example, after the decrease in real estate prices in 2008, many homeowners in the United States were left with mortgage loan obligations that surpassed the market worth of the property. Some of those borrowers still had the means to keep paying their mortgage payments but elected to fail and let the bank take possession of the property.
This potentially unethical option is rational from a purely financial perspective, except from the lower credit profile for future borrowing.
The predicted loss from credit exposure is a function of three elements:
Amount of money lent to a given borrower
Probability that the borrower defaults
Loss that would be incurred if the borrower defaults
The amount that is at risk may be decreased if collateral or assurances from third parties are added. Enforcing contract restrictions to acquire possession of collateral, however, can be a time-consuming legal process. The value of collateral assets for a lender depends on their liquidity and marketability – that is, how easy it is to sell the assets to a third party and at how big of a discount if sold on short notice. Assets for which a consistent market demand exists and that can be moved and easily transferred are more valuable than assets that are exchanged less frequently and are less mobile.
Various sources of independent information exist on borrower creditworthiness, such as credit rating organizations, which should be used in conjunction with internal risk analysis. Any analysis, whether internal or external, should incorporate a degree of critical judgement and scepticism.
There are numerous techniques to managing credit risk:
EXPOSURE LIMITS
Credit risk can be managed by placing restrictions on the amount of exposure to a given counterparty or level of credit rating allowed. For example, a maximum limit of 5% exposure could be specified for a certain counterparty.
COLLATERAL AND COVENANTS
Credit risk can also be addressed by requesting more collateral and enforcing covenants. Covenants are terms for loans that describe both what a borrower must do (positive covenants) and what a borrower is not allowed to do (negative covenants).
For example, a bank may prevent borrowers from issuing more debt, paying dividends, or getting into very risky business projects. When one of the restrictive criteria is broken, the lender may recall the loan or require some action, such as the assignment of extra collateral.
DERIVATIVE INSTRUMENTS
Credit risk can also be addressed through the use of derivative products. For example, credit default swaps are typically employed when corporations seek to protect themselves against the risk of a drop in value of a debt security or index of debt securities.
Lending to governments or state-owned firms raises another sort of credit risk. Sovereign risk is the risk that a government will not return its debt because it does not have either the ability or the motivation to do so. The distinctive characteristic of sovereign risk is that lenders have limited legal remedies available to compel the borrower to repay or to be able to retrieve the assets themselves. A government can also restrict borrowers in its country from repaying their loans to foreign investors — for example, by instituting currency controls to make it difficult or impossible for money to leave the country.
Liquidity Risk
As noted previously, liquidity refers to the capacity to purchase and sell fast without incurring a loss. It is a basic worry for organizations and is often disregarded when sources of financing, such as bank loans, are plentiful.
But during the global financial crisis of 2008, an acute shortage of liquidity in the banking institutions in several nations led to failures. These failures happened because some companies were unable to maintain access to sufficient money to fund their working capital (inventories and receivables from customers net of payables from suppliers) and, thus, to keep their companies functioning.
Firms in the investing industry suffer a greater level of liquidity risk than, for example, manufacturers. To function profitably, they need marketplaces that can handle their trades without large unfavorable effects on prices.
When markets are illiquid — either temporarily, such as during financial crises, or more structurally, such as in some emerging markets — the capacity to trade assets is severely limited, which has a detrimental effect for these firms.
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Investment - Value at Risk
Companies in the financial services industry believe that the assets and securities they possess will provide them with a positive return. But they also need to quantify the possible loss on an investment if their expectations for the asset or security turn out to be erroneous. This potential loss is commonly assessed using a metric known as value at risk.
Use and Advantages of Value at Risk
Value at risk (VaR) was developed in the late 1980s and is now a commonly used statistic. It relies on statistical notions, such as standard deviation.
VaR gives an estimate of the least loss of value that may be predicted for a certain duration with a given level of probability.
For example, an asset management firm may estimate that a portfolio has a VaR of USD1 million for one day with a probability of 5%. This estimate suggests that there is a 5% risk that the portfolio will fall in value by at least USD1 million in a single day, assuming no further trading. In other words, a loss of USD1 million or more for this portfolio is likely to occur, on average, once in 20 trading days (1/0.05).
VaR offers various advantages:
It is a common statistic that can be utilized across diverse assets, portfolios, business units, businesses, and markets.
It is relatively easy to compute and well understood by senior managers and directors.
It is a valuable tool for risk budgeting if there is a common procedure for allocating capital across business units according to risk.
It is widely utilized and mandated for usage by several regulators.
Weaknesses of VaR There are also limitations inherent in the VaR measure of risk. VaR gives an estimate of the least, but not the maximum, loss of value that can be predicted. Referring back to the preceding scenario, the asset management business can expect a loss of at least USD1 million 12 or 13 times a year (5% of the about 250 trading days a year). VaR does not represent the highest loss of value the portfolio manager may anticipate to sustain in one day, and it does not guarantee that a loss in excess of USD1 million will not occur more frequently than a dozen times a year.
In fact, VaR generally underestimates the frequency and amount of losses, mostly due to erroneous assumptions and models.
First, VaR mostly depends on previous data to anticipate future expected losses. But past returns may not be a strong indicator of future returns. In addition, history is not helpful in forecasting occurrences that have far-reaching repercussions, but are unforeseen or deemed impossible – that is, black swan events.
Second, VaR makes an assumption regarding the distribution of returns.
For example, it is typically believed that returns are regularly distributed and follow the bell-shaped distribution. The use of historical data and the assumption of a normal distribution may perform quite effectively in normal market conditions but not during periods of market upheaval.
The global financial crisis of 2008 is a case in point. Until 2007, most banks had a low daily VaR, which provided them a false sense of security. Once the crisis hit, the number of days when trading losses exceeded the daily VaR and the magnitude of those losses were much larger than projected. Some banks stated that the frequency of losses was 10 to 20 times higher than the VaR estimates, and some banks experienced losses that considerably depleted their equity capital.
To counter these limitations, firms, particularly banks, often adopt alternative risk management approaches in addition to VaR. These complementing techniques include scenario analysis and stress testing, which focus on the influence of more extreme events that would not be adequately captured or examined by VaR.
For example, an asset management firm may perform a scenario analysis by identifying different scenarios for the economy (strong growth, moderate growth, slow growth, no growth, mild recession, and severe recession) and then determining how each scenario would affect the value of a portfolio and the firm’s earnings and equity capital.
The firm may also engage in stress testing by evaluating the consequences of extreme market conditions, like as a liquidity crisis, to make sure that it would be robust and survive the crisis.
It is worth mentioning that the problems associated to VaR apply to all measurements that rely on models. The danger emerging from the usage of models is collectively known as model risk. This risk is related with improper underlying assumptions, the unavailability or inaccuracy of historical data, data problems, and misapplication of models.
Companies in the financial services industry believe that the assets and securities they possess will provide them with a positive return. But they also need to quantify the possible loss on an investment if their expectations for the asset or security turn out to be erroneous. This potential loss is commonly assessed using a metric known as value at risk.
Use and Advantages of Value at Risk
Value at risk (VaR) was developed in the late 1980s and is now a commonly used statistic. It relies on statistical notions, such as standard deviation.
VaR gives an estimate of the least loss of value that may be predicted for a certain duration with a given level of probability.
For example, an asset management firm may estimate that a portfolio has a VaR of USD1 million for one day with a probability of 5%. This estimate suggests that there is a 5% risk that the portfolio will fall in value by at least USD1 million in a single day, assuming no further trading. In other words, a loss of USD1 million or more for this portfolio is likely to occur, on average, once in 20 trading days (1/0.05).
VaR offers various advantages:
It is a common statistic that can be utilized across diverse assets, portfolios, business units, businesses, and markets.
It is relatively easy to compute and well understood by senior managers and directors.
It is a valuable tool for risk budgeting if there is a common procedure for allocating capital across business units according to risk.
It is widely utilized and mandated for usage by several regulators.
Weaknesses of VaR There are also limitations inherent in the VaR measure of risk. VaR gives an estimate of the least, but not the maximum, loss of value that can be predicted. Referring back to the preceding scenario, the asset management business can expect a loss of at least USD1 million 12 or 13 times a year (5% of the about 250 trading days a year). VaR does not represent the highest loss of value the portfolio manager may anticipate to sustain in one day, and it does not guarantee that a loss in excess of USD1 million will not occur more frequently than a dozen times a year.
In fact, VaR generally underestimates the frequency and amount of losses, mostly due to erroneous assumptions and models.
First, VaR mostly depends on previous data to anticipate future expected losses. But past returns may not be a strong indicator of future returns. In addition, history is not helpful in forecasting occurrences that have far-reaching repercussions, but are unforeseen or deemed impossible – that is, black swan events.
Second, VaR makes an assumption regarding the distribution of returns.
For example, it is typically believed that returns are regularly distributed and follow the bell-shaped distribution. The use of historical data and the assumption of a normal distribution may perform quite effectively in normal market conditions but not during periods of market upheaval.
The global financial crisis of 2008 is a case in point. Until 2007, most banks had a low daily VaR, which provided them a false sense of security. Once the crisis hit, the number of days when trading losses exceeded the daily VaR and the magnitude of those losses were much larger than projected. Some banks stated that the frequency of losses was 10 to 20 times higher than the VaR estimates, and some banks experienced losses that considerably depleted their equity capital.
To counter these limitations, firms, particularly banks, often adopt alternative risk management approaches in addition to VaR. These complementing techniques include scenario analysis and stress testing, which focus on the influence of more extreme events that would not be adequately captured or examined by VaR.
For example, an asset management firm may perform a scenario analysis by identifying different scenarios for the economy (strong growth, moderate growth, slow growth, no growth, mild recession, and severe recession) and then determining how each scenario would affect the value of a portfolio and the firm’s earnings and equity capital.
The firm may also engage in stress testing by evaluating the consequences of extreme market conditions, like as a liquidity crisis, to make sure that it would be robust and survive the crisis.
It is worth mentioning that the problems associated to VaR apply to all measurements that rely on models. The danger emerging from the usage of models is collectively known as model risk. This risk is related with improper underlying assumptions, the unavailability or inaccuracy of historical data, data problems, and misapplication of models.
- Published on
Investment - The Performance Evaluation Process
Performance Evaluation
Investors are interested in knowing how their investments have performed. For retail investors, the success of their investments may determine whether they will experience a happy retirement, if they will have enough money to send their children to university, or whether they can finance their ideal getaway. Likewise, pension plans, foundations, and other institutional investors want to monitor the performance of their investments to guarantee that the assets will be sufficient to meet their spending needs.
The performance of a fund is also crucial to an investing firm. Measuring and analyzing fund performance is crucial to controlling and enhancing the investing process.
But knowing the return achieved by a fund is only half of the process of performance review. Investment management is a competitive industry.
Both investors and investment businesses will want to know how funds have done relative to key financial market benchmarks (e.g., a stock index like the S&P 500 Index in the United States or the Hang Seng Index in Hong Kong) and comparing to their peers.
" " In addition, interested parties will want to know how the fund manager accomplished the performance – for example, if the performance was the consequence of talent or luck, or possibly even excessive risk-taking.
It is only via the rigorous evaluation of investment performance that investors and investment firms can make informed judgments about their investments. After reviewing a fund’s performance, investors can decide whether they wish to continue to invest in the fund or sell all or part of their investment in the fund. Similarly, an investment firm can analyze the fund’s performance to see whether the fund is performing as predicted given its strategy and market conditions or whether changes need to be made to the investment process.
The performance evaluation process contains four discrete, but connected, components:
measure absolute returns
measure relative returns
alter returns for risk
attribute performance
Performance Evaluation
Investors are interested in knowing how their investments have performed. For retail investors, the success of their investments may determine whether they will experience a happy retirement, if they will have enough money to send their children to university, or whether they can finance their ideal getaway. Likewise, pension plans, foundations, and other institutional investors want to monitor the performance of their investments to guarantee that the assets will be sufficient to meet their spending needs.
The performance of a fund is also crucial to an investing firm. Measuring and analyzing fund performance is crucial to controlling and enhancing the investing process.
But knowing the return achieved by a fund is only half of the process of performance review. Investment management is a competitive industry.
Both investors and investment businesses will want to know how funds have done relative to key financial market benchmarks (e.g., a stock index like the S&P 500 Index in the United States or the Hang Seng Index in Hong Kong) and comparing to their peers.
" " In addition, interested parties will want to know how the fund manager accomplished the performance – for example, if the performance was the consequence of talent or luck, or possibly even excessive risk-taking.
It is only via the rigorous evaluation of investment performance that investors and investment firms can make informed judgments about their investments. After reviewing a fund’s performance, investors can decide whether they wish to continue to invest in the fund or sell all or part of their investment in the fund. Similarly, an investment firm can analyze the fund’s performance to see whether the fund is performing as predicted given its strategy and market conditions or whether changes need to be made to the investment process.
The performance evaluation process contains four discrete, but connected, components:
measure absolute returns
measure relative returns
alter returns for risk
attribute performance
- Published on
Investment - Measures of Return
Absolute Returns Absolute returns are the returns achieved over a specific time period. Absolute returns do not consider the risk of the investment.
Total Return
The performance of a security, such as an equity (stock) or debt (bond) security, over a defined time period — called the holding period — is referred to as its holding-period return or, as is frequently referred to in industry practice, its total return.
The total return measures the entire gain or loss that an investor owning a security achieves over the defined period compared with the investment at the beginning of the period. The return over the holding period comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest).
The total return from owning an ordinary or common share of a company comes from a change in the price of the share between the beginning and the end of the term as well as from the dividends collected over the course of the period. The change in the price of the shares throughout the time is the capital gain or loss element of the return. The dividends received over the time constitute the income element of the return. Similarly, the entire return from owning a bond comes from changes in price (capital gain or loss) and from generating interest income.
The following example explains how total return is computed. As always, you are not responsible for computations, but the presentation of equations and calculations may increase your knowledge.
Example: Total Return
An investor buys one ordinary share in Company A on 1 January at a price of GBP100. On 31 December, Company A pays a dividend per share of GBP5, and an ordinary share of Company A is selling for GBP110 on that date.
In this scenario, the holding period is one year – from 1 January to 31 December. The return achieved by the investor from the growth (appreciation) in the share price throughout this period is calculated as follows:
Absolute Returns Absolute returns are the returns achieved over a specific time period. Absolute returns do not consider the risk of the investment.
Total Return
The performance of a security, such as an equity (stock) or debt (bond) security, over a defined time period — called the holding period — is referred to as its holding-period return or, as is frequently referred to in industry practice, its total return.
The total return measures the entire gain or loss that an investor owning a security achieves over the defined period compared with the investment at the beginning of the period. The return over the holding period comes from two sources: changes in the price (capital gain or loss) and income (dividends or interest).
The total return from owning an ordinary or common share of a company comes from a change in the price of the share between the beginning and the end of the term as well as from the dividends collected over the course of the period. The change in the price of the shares throughout the time is the capital gain or loss element of the return. The dividends received over the time constitute the income element of the return. Similarly, the entire return from owning a bond comes from changes in price (capital gain or loss) and from generating interest income.
The following example explains how total return is computed. As always, you are not responsible for computations, but the presentation of equations and calculations may increase your knowledge.
Example: Total Return
An investor buys one ordinary share in Company A on 1 January at a price of GBP100. On 31 December, Company A pays a dividend per share of GBP5, and an ordinary share of Company A is selling for GBP110 on that date.
In this scenario, the holding period is one year – from 1 January to 31 December. The return achieved by the investor from the growth (appreciation) in the share price throughout this period is calculated as follows:
But the total return should also include the dividend given to the investor. The return achieved by the investor from the income received on the share is as follows:
The total return is the sum of the capital and income components (i.e., 15%). Mathematically, this total can be shown as:
The return of an investment fund over the course of a given time is typically made of the capital gains or losses on all of the assets held during that period plus any income produced on those assets over the same period. Examples of income include dividend income from equity securities, interest income from debt securities, and rental revenue from commercial real estate.
Cash Flows and Time-Weighted Rates of Return
In the total return calculation example, the income (the dividend) was received at the end of the holding period. The timing of the receipt of this payment, plus the fact that no additional investments were made over the period, makes the calculation of the return reasonably uncomplicated. But in practice, determining a fund’s overall return is more complex.
In particular, funds may consist of hundreds of distinct investments that pay income at different times over the holding period, and investors may make further investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period. In other words, there is a steady movement of cash into and out of most investment funds. Additional investments and withdrawals by investors will alter the calculation of the performance of the fund. The following example shows this principle.
Example: Effect of a Deposit on a Fund’s Investment Performance
Suppose that an investment fund has a value of USD100 million on 1 January. By 31 December, the fund has risen in value to USD110 million. The increase in the value of this fund comes from changes in the values of the securities owned in the fund and from income collected during the year. The overall return of the fund is 10%, computed as follows:
Cash Flows and Time-Weighted Rates of Return
In the total return calculation example, the income (the dividend) was received at the end of the holding period. The timing of the receipt of this payment, plus the fact that no additional investments were made over the period, makes the calculation of the return reasonably uncomplicated. But in practice, determining a fund’s overall return is more complex.
In particular, funds may consist of hundreds of distinct investments that pay income at different times over the holding period, and investors may make further investments (cash inflows) in and withdrawals (cash outflows) from a fund throughout the holding period. In other words, there is a steady movement of cash into and out of most investment funds. Additional investments and withdrawals by investors will alter the calculation of the performance of the fund. The following example shows this principle.
Example: Effect of a Deposit on a Fund’s Investment Performance
Suppose that an investment fund has a value of USD100 million on 1 January. By 31 December, the fund has risen in value to USD110 million. The increase in the value of this fund comes from changes in the values of the securities owned in the fund and from income collected during the year. The overall return of the fund is 10%, computed as follows:
But imagine that one of the fund’s investors contributed an additional USD5 million into the fund on 30 June. This contribution means that some of the changes in the fund’s value over the year were not from the performance of the securities or the income on these securities but were instead attributed to the receipt of extra investor money. In other words, a total return of 10% overstates the fund’s investing performance.
Flows of money into and out of funds throughout time can be accounted for by breaking the measuring period into shorter holding periods. A new holding period starts each time a cash flow happens – that is, each time money flows into or out of a fund. If there is just one cash flow during the holding period, the measurement period will be divided into two shorter holding periods. If there are two cash flows, there will be three holding periods, and so on. In actuality, investor cash inflows and outflows may occur on a daily basis, in which case an annual holding term is broken into daily holding periods.
The next example explains how the total return is computed when a cash flow happens during the holding period. There are two ways used to combine returns. The first way is to calculate the arithmetic mean by summing the two six-month returns. But this approach does not consider compounding; in the time value of money discussion in Course 3, Investment Instruments, you learned that compounding is the process in which interest is added to the principal and reinvested to generate its own interest. The second way is to calculate the geometric mean, which does consider compounding and is the preferable option.
Example: Calculation of a Fund’s Return When There Is a Contribution
Suppose that the fund from the prior example had received one investor cash contribution of USD5 million at the close of business on 30 June. No additional cash inflows or outflows happened in the time. The holding time of one year can be broken into two periods of six months. The overall return is computed as follows:
First, compute the six-month total return for the period from 1 January to 30 June, before the additional contribution.
Next, compute the six-month total return for the period from 1 July to 31 December, including the cash influx of USD5 million that raised the value of the fund on 30 June.
Finally, calculate the annual total return by adding the two six-month total returns.
There is one more piece of information required to determine the return over each of these two six-month periods: the valuation of the fund on 30 June immediately before the intake of USD5 million.
Date Fund’s Value
1 January. $100 million
30 June $98 million
31 December. $110 million
The overall return during the first six months (1 January to 30 June) is computed as follows:
Flows of money into and out of funds throughout time can be accounted for by breaking the measuring period into shorter holding periods. A new holding period starts each time a cash flow happens – that is, each time money flows into or out of a fund. If there is just one cash flow during the holding period, the measurement period will be divided into two shorter holding periods. If there are two cash flows, there will be three holding periods, and so on. In actuality, investor cash inflows and outflows may occur on a daily basis, in which case an annual holding term is broken into daily holding periods.
The next example explains how the total return is computed when a cash flow happens during the holding period. There are two ways used to combine returns. The first way is to calculate the arithmetic mean by summing the two six-month returns. But this approach does not consider compounding; in the time value of money discussion in Course 3, Investment Instruments, you learned that compounding is the process in which interest is added to the principal and reinvested to generate its own interest. The second way is to calculate the geometric mean, which does consider compounding and is the preferable option.
Example: Calculation of a Fund’s Return When There Is a Contribution
Suppose that the fund from the prior example had received one investor cash contribution of USD5 million at the close of business on 30 June. No additional cash inflows or outflows happened in the time. The holding time of one year can be broken into two periods of six months. The overall return is computed as follows:
First, compute the six-month total return for the period from 1 January to 30 June, before the additional contribution.
Next, compute the six-month total return for the period from 1 July to 31 December, including the cash influx of USD5 million that raised the value of the fund on 30 June.
Finally, calculate the annual total return by adding the two six-month total returns.
There is one more piece of information required to determine the return over each of these two six-month periods: the valuation of the fund on 30 June immediately before the intake of USD5 million.
Date Fund’s Value
1 January. $100 million
30 June $98 million
31 December. $110 million
The overall return during the first six months (1 January to 30 June) is computed as follows:
On 30 June, the fund’s worth is USD98 million, a fall in value of USD2 million from the 1 January fund value. But on this date, the fund receives a cash inflow of USD5 million. Therefore, at the commencement of the second holding period on 1 July, the fund has a value of USD103 million ($98 million + $5 million). On 31 December, the fund has a value of USD110 million. Thus, the total return for the second six-month period (1 July to 31 December) is determined as follows:
The fund’s investors may prefer to know the return achieved by the fund throughout the full calendar year rather than during each six-month period. Using our present example, the fund return was –2.0% for the first six months and 6.8% for the last six months. The fund’s compounded return for the year is computed as follows:
Fund return = [(1 – 2.0%) × (1 + 6.8%)] – 1 = 0.0466 = 4.66%
The fund achieved an annual total return of 4.66% between 1 January and 31 December.
Returns determined in the way shown in the above example are known as time-weighted rates of returns. The time-weighted rate of return computation separates the entire measurement period (e.g., one year) into sub-periods reflecting one month, week, or day of that year. The timing of each individual cash flow specifies the sub-periods to employ for calculating sub-period total returns. Each sub-period has its own independent rate of return. These sub-period returns are then utilized to compute the return for the total period. By computing total returns in this manner, investor cash inflows and outflows do not skew the assessment and reporting of a fund’s investment performance.
To compare the performance of one fund from one year with the next year or to compare the performance of one fund with another fund necessitates that returns be measured on a consistent basis over time and across funds.
In 1999, a set of voluntary investment performance criteria — the Global Investment Performance criteria (GIPS®) — was proposed for this purpose. Investment management firms around the globe have accepted the GIPS standards, and organisations in more than 40 markets sponsor and promote the GIPS standards, which were designed by and are maintained by CFA Institute. In most circumstances, the GIPS guidelines demand the adoption of a time-weighted rate of return technique since time-weighted returns are not skewed by cash inflows and outflows.
Fund return = [(1 – 2.0%) × (1 + 6.8%)] – 1 = 0.0466 = 4.66%
The fund achieved an annual total return of 4.66% between 1 January and 31 December.
Returns determined in the way shown in the above example are known as time-weighted rates of returns. The time-weighted rate of return computation separates the entire measurement period (e.g., one year) into sub-periods reflecting one month, week, or day of that year. The timing of each individual cash flow specifies the sub-periods to employ for calculating sub-period total returns. Each sub-period has its own independent rate of return. These sub-period returns are then utilized to compute the return for the total period. By computing total returns in this manner, investor cash inflows and outflows do not skew the assessment and reporting of a fund’s investment performance.
To compare the performance of one fund from one year with the next year or to compare the performance of one fund with another fund necessitates that returns be measured on a consistent basis over time and across funds.
In 1999, a set of voluntary investment performance criteria — the Global Investment Performance criteria (GIPS®) — was proposed for this purpose. Investment management firms around the globe have accepted the GIPS standards, and organisations in more than 40 markets sponsor and promote the GIPS standards, which were designed by and are maintained by CFA Institute. In most circumstances, the GIPS guidelines demand the adoption of a time-weighted rate of return technique since time-weighted returns are not skewed by cash inflows and outflows.
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Investment -Benchmarks and Relative Returns
Benchmarks and Relative Returns
By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns.
Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.
" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.
When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.
To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.
Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.
Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.
Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.
Indices
Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.
For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.
Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities.
Relative Returns
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.
Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.
Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.
Benchmarks and Relative Returns
By measuring relative returns — that is, returns compared to an appropriate benchmark — investors can decide if they could have made more money in other investments for a similar degree of risk. Assessing returns on a relative basis allows investors to analyze their opportunity cost and determine whether their investments are delivering suitable returns.
Many investors wish to compare the performance of their fund with that of a financial market benchmark, such as a stock index. It is widespread practice in all businesses, and indeed in many spheres of life, to benchmark or compare performance. Olympic sprinters, for instance, may compare themselves to a time benchmark or a close competition. Beating the time standard or the rival allows them to determine how they are performing.
" " Fund managers may use a benchmark not only for assessment, but some, such as index fund managers, may also manage their funds to a benchmark. This means that managers must periodically compare the composition and performance of their funds with the composition of a financial market index, such as the FTSE 100 Index or the S&P 500 Index. For investors, understanding the financial market index that a fund uses as a benchmark can offer them some sense of the return and risk that they can expect from investing in that fund.
When choosing a manager for a separately managed account mandate, institutional investors will often define the financial market benchmark that they intend to use to judge the performance of the investment manager. For example, a US stock manager may be asked, or ordered, to actively manage a portfolio of US equities for a client and instructed that they will be ‘benchmarked against’ the S&P 500. As another example, a manager may simply be a passive index fund manager tracking the S&P 500 as the reference index. Alternatively, a manager can be given a specific mandate reflecting style or sector preferences. In this situation, a style or sector index may be chosen as the suitable benchmark.
To assist investors reach their objectives, a benchmark should meet specific requirements.
Investable
The benchmark should be constituted of assets that can be bought and sold by the fund manager. For passive fund managers, it would be impossible to match the benchmark if it featured assets that they could not buy. For active fund managers, not being able to invest in some of the benchmark’s components could limit their potential to outperform it.
Compatible
The benchmark should have an appropriate composition and level of risk for the investor. In other words, it should meet the investor’s objectives. For example, for investors who desire to invest in assets that carry little credit or default risk, a financial market index of government bonds might be compatible (based on previous performance) with investor preferences. A benchmark composed of corporate bonds would not be compatible.
Transparent
The guidelines regulating the construction of the benchmark should be explicit. This transparency should extend to the weighting of individual benchmark constituents, to the mechanism used to generate benchmark returns, and to the process used to add and remove constituents to and from the benchmark over time.
Pre-Specified
The benchmark should be defined before an investment is made so that the fund management is aware about the fund’s objectives and so the fund manager may create a portfolio accordingly.
Indices
Several companies publish financial market indexes that allow investors to compare the total return earned by a fund with that generated by the wider market.
For most equities exchanges across the world, there is at least one index that represents the bulk of its stocks. In addition to these broad indices, stock indices that evaluate performance of industrial sectors are also available, both within a given country and globally. These indices make it possible, for instance, for investors to compare the performance of a fund of global information technology (IT) equities with the performance of a fund of Indian IT stocks, as long as the indexes have been built using the same technique.
Index providers also supply a wide selection of bond indexes. Bond indices are offered for several types of issuers located in various locations, including in developed and emerging countries. In addition to aggregate bond indices that are designed to cover the bond market as a whole, bond indices exist for bonds classified by maturity, credit rating, currency, and industry, among other categories. Many index providers, such as FTSE International, S&P Dow Jones, and MSCI, produce indexes for practically every asset class, including cash, currencies, commercial property, hedge funds, private equity, and commodities, as well as for bonds and equities.
Relative Returns
The large selection of financial market indices available enables investors to compare the performance of their fund over time against an independent benchmark. In brief, a benchmark index allows investors to evaluate relative returns.
Some investors compare their fund’s performance with that of the fund’s peers. For example, investors may compare the performance of one European equities fund with that of other European equity funds.
Each fund is granted a performance ranking within its particular sector of the financial markets. Funds that are in the top 10% of performers among their peers during a certain period are said to be top-decile performers. Funds’ performance is often collected and assessed by independent organisations, such as Morningstar, who then publishes the data, allowing investors to examine the rankings of their particular funds relative to those of other funds that they may have chosen.
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Investment- Risk-Adjusted Returns
Most investors aim to gain as much profit as possible for as little risk as feasible. Therefore, if two investments have a total return of 10% and the first investment has very little risk while the second one is quite dangerous, the first investment is better than the second one on a risk-adjusted basis.
Standard Deviation
Risk can take numerous forms. The risk we refer to throughout the rest of this module is investment risk. In Course 3, Investment Instruments, you learned that investment risk is commonly quantified based on the unpredictability of returns, and a common measure of variability is the standard deviation. The standard deviation of returns represents the variability of returns around the mean (or average) return — the larger the standard deviation of returns, the higher the variability of returns and the higher the risk.
There are at least two reasons why investors care about historical variability (the standard deviation of past returns). First, prior variability of returns might be indicative of how variable returns may be in the future. But it is vital to be aware that variability can alter over time and that there is no guarantee that future returns will behave like past returns.
Second, the variability of returns may impair the attainment of an investor’s objectives. Pension funds invest to create the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and people invest because they usually have a future spend in mind. Investing in a fund whose returns vary dramatically over time could possibly disturb investors’ plans. If returns are substantially negative one year, then the investors’ commitments, such as paying pensions, may be harder to meet.
Downside Deviation
Standard deviation is a measure of the variability of returns around the mean. Sometimes there is a positive deviation — that is, the return is more than the mean — and sometimes there is a negative deviation — that is, the return is less than the mean. Which of these two sorts of variation do you think investors would be more concerned about?
Well, psychologists and economists have discovered that investors loathe losses more than they prefer similar gains. So, investors can be moderately happy with earning an investment return of +10%, but quite upset about achieving a return of –10%. Because of this asymmetry in the way investors see the dispersion around the average, some investing professionals utilize a modified version of standard deviation known as downside deviation.
Downside deviation is computed in almost precisely the same way as standard deviation, except instead of utilizing all the deviations from the mean — positive and negative — downside deviation is calculated using only negative deviations. In other words, it is a measure of return variability that emphasizes primarily on outcomes that are less than the mean. Downside deviation may also be evaluated by focused on outcomes that are below a defined return target.
The following illustration demonstrates the standard and downside deviations of returns associated with investing in a diversified fund of global stocks and in a diversified fund of global bonds.
As we see, the downside deviations are lower than the standard deviations; this outcome is expected because downside deviations only consider the negative variances. Investors who are confined in their willingness or ability to endure losses will likely prefer the bond fund given its 3.8% downside deviation and reduced chance of losses against the equity fund with its 10.4% downside deviation and larger predicted losses.
Reward-to-Risk Ratios
Investors seek to earn a large return rather than a low return on their assets. That said, all things being equal, they also prefer lower risk (less variability of returns) over higher risk (more variability of returns).
In other words, investors are interested in optimizing the return on their investments while simultaneously striving to limit the dangers. That is, they choose investments that offer a high return per unit of risk — assets with a high reward-to-risk ratio. The measurement of a reward-to-risk ratio allows investors to compare the performance of one investment with another on a risk-adjusted basis.
A reward-to-risk ratio is a measure that takes the following basic form:
Most investors aim to gain as much profit as possible for as little risk as feasible. Therefore, if two investments have a total return of 10% and the first investment has very little risk while the second one is quite dangerous, the first investment is better than the second one on a risk-adjusted basis.
Standard Deviation
Risk can take numerous forms. The risk we refer to throughout the rest of this module is investment risk. In Course 3, Investment Instruments, you learned that investment risk is commonly quantified based on the unpredictability of returns, and a common measure of variability is the standard deviation. The standard deviation of returns represents the variability of returns around the mean (or average) return — the larger the standard deviation of returns, the higher the variability of returns and the higher the risk.
There are at least two reasons why investors care about historical variability (the standard deviation of past returns). First, prior variability of returns might be indicative of how variable returns may be in the future. But it is vital to be aware that variability can alter over time and that there is no guarantee that future returns will behave like past returns.
Second, the variability of returns may impair the attainment of an investor’s objectives. Pension funds invest to create the returns necessary to pay their beneficiaries, insurance companies invest to generate returns to meet the claims on their policies, and people invest because they usually have a future spend in mind. Investing in a fund whose returns vary dramatically over time could possibly disturb investors’ plans. If returns are substantially negative one year, then the investors’ commitments, such as paying pensions, may be harder to meet.
Downside Deviation
Standard deviation is a measure of the variability of returns around the mean. Sometimes there is a positive deviation — that is, the return is more than the mean — and sometimes there is a negative deviation — that is, the return is less than the mean. Which of these two sorts of variation do you think investors would be more concerned about?
Well, psychologists and economists have discovered that investors loathe losses more than they prefer similar gains. So, investors can be moderately happy with earning an investment return of +10%, but quite upset about achieving a return of –10%. Because of this asymmetry in the way investors see the dispersion around the average, some investing professionals utilize a modified version of standard deviation known as downside deviation.
Downside deviation is computed in almost precisely the same way as standard deviation, except instead of utilizing all the deviations from the mean — positive and negative — downside deviation is calculated using only negative deviations. In other words, it is a measure of return variability that emphasizes primarily on outcomes that are less than the mean. Downside deviation may also be evaluated by focused on outcomes that are below a defined return target.
The following illustration demonstrates the standard and downside deviations of returns associated with investing in a diversified fund of global stocks and in a diversified fund of global bonds.
As we see, the downside deviations are lower than the standard deviations; this outcome is expected because downside deviations only consider the negative variances. Investors who are confined in their willingness or ability to endure losses will likely prefer the bond fund given its 3.8% downside deviation and reduced chance of losses against the equity fund with its 10.4% downside deviation and larger predicted losses.
Reward-to-Risk Ratios
Investors seek to earn a large return rather than a low return on their assets. That said, all things being equal, they also prefer lower risk (less variability of returns) over higher risk (more variability of returns).
In other words, investors are interested in optimizing the return on their investments while simultaneously striving to limit the dangers. That is, they choose investments that offer a high return per unit of risk — assets with a high reward-to-risk ratio. The measurement of a reward-to-risk ratio allows investors to compare the performance of one investment with another on a risk-adjusted basis.
A reward-to-risk ratio is a measure that takes the following basic form:
The higher the value of the reward-to-risk ratio, the better the risk-adjusted return – that is, the higher the return per unit of risk.
A commonly used reward-to-risk ratio is the Sharpe ratio, so-called because it was initially suggested by Nobel Prize–winning economist William Sharpe.1 A fund’s reward is measured as the fund’s excess return, which is equal to the difference between the fund’s total return and the return on a ‘risk-free’ investment. The risk-free investment return is usually the return from investing in short-term government bonds because in most nations, government bonds are the assets that entail the lowest level of risk. The measure of fund risk is the standard deviation of the fund returns. The Sharpe ratio is determined as follows:
A commonly used reward-to-risk ratio is the Sharpe ratio, so-called because it was initially suggested by Nobel Prize–winning economist William Sharpe.1 A fund’s reward is measured as the fund’s excess return, which is equal to the difference between the fund’s total return and the return on a ‘risk-free’ investment. The risk-free investment return is usually the return from investing in short-term government bonds because in most nations, government bonds are the assets that entail the lowest level of risk. The measure of fund risk is the standard deviation of the fund returns. The Sharpe ratio is determined as follows:
Another often used reward-to-risk ratio is the Treynor ratio, introduced by Jack Treynor.2 The measure of fund reward is the same as that used in the Sharpe ratio, but the measure of fund risk is different. The measure of fund risk is the beta of the fund — beta being a measure of the fund’s systematic risk (also called market risk). Systematic risk was explored in the Investment Management module of this course. Thus, the Treynor ratio is a measure of the fund’s performance in relation to the degree of market risk assumed by the manager. The Treynor ratio is determined as follows:
Example: Calculation of Sharpe and Treynor Ratios
Suppose that over a year, the overall return of a fund was 10% and the return from investing in government bonds (‘risk-free’ assets) was 4%. Also assume that the standard deviation and beta of the fund’s returns over this period were 5% and 1.8, respectively.
The Sharpe ratio for this fund is
Suppose that over a year, the overall return of a fund was 10% and the return from investing in government bonds (‘risk-free’ assets) was 4%. Also assume that the standard deviation and beta of the fund’s returns over this period were 5% and 1.8, respectively.
The Sharpe ratio for this fund is
The Treynor ratio for this fund is
Each of these ratios can be compared with the same ratios for similar funds to evaluate the fund’s performance. As stated previously, the higher the value of the reward-to-risk ratio, the better the risk-adjusted return — that is, the higher the return per unit of risk.
The Sharpe ratio — along with other reward-to-risk ratios, such as the information ratio — is a key indicator for determining the quality of the returns provided by a fund. A fund with high returns but with significant risk might be said to have delivered worse-quality returns than a fund with similarly high returns but with substantially reduced risk. Reward-to-risk ratios, such as the Sharpe ratio, are one of the key quality control checks that investors can apply to their investment returns. Such ratios are also beneficial for comparing and analyzing investments.
The Sharpe ratio — along with other reward-to-risk ratios, such as the information ratio — is a key indicator for determining the quality of the returns provided by a fund. A fund with high returns but with significant risk might be said to have delivered worse-quality returns than a fund with similarly high returns but with substantially reduced risk. Reward-to-risk ratios, such as the Sharpe ratio, are one of the key quality control checks that investors can apply to their investment returns. Such ratios are also beneficial for comparing and analyzing investments.
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Investment- Tracking Error and Information Ratio
The tracking error of a fund reveals how the performance of the fund deviates from the performance of its benchmark. The tracking error so informs you how much active risk the manager took.
The tracking error is measured by taking the standard deviation of the discrepancies between the returns on the fund and the returns on its benchmark. The bigger these variances, the more active risk was taken and the worse the tracking inaccuracy. A passive fund may be expected to have a very low tracking error relative to its benchmark index because the management is aiming to duplicate an index. But for an actively managed fund, the tracking error should be larger.
Tracking error can also be utilized to build another widely used reward-to-risk ratio known as the information ratio. The information ratio tells you how much benefit a manager generated given the amount of active risk they took relative to the benchmark. In other words, did a manager’s wagers against the benchmark pay off? The ‘reward’ element of the information ratio is the difference between the total return of the fund and the return of an applicable benchmark index over the same period. The ‘risk’ element of the information ratio is based on the tracking error of the fund — that is, its departure from the performance of the benchmark. It is calculated as follows:
The tracking error of a fund reveals how the performance of the fund deviates from the performance of its benchmark. The tracking error so informs you how much active risk the manager took.
The tracking error is measured by taking the standard deviation of the discrepancies between the returns on the fund and the returns on its benchmark. The bigger these variances, the more active risk was taken and the worse the tracking inaccuracy. A passive fund may be expected to have a very low tracking error relative to its benchmark index because the management is aiming to duplicate an index. But for an actively managed fund, the tracking error should be larger.
Tracking error can also be utilized to build another widely used reward-to-risk ratio known as the information ratio. The information ratio tells you how much benefit a manager generated given the amount of active risk they took relative to the benchmark. In other words, did a manager’s wagers against the benchmark pay off? The ‘reward’ element of the information ratio is the difference between the total return of the fund and the return of an applicable benchmark index over the same period. The ‘risk’ element of the information ratio is based on the tracking error of the fund — that is, its departure from the performance of the benchmark. It is calculated as follows:
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Investment- Alpha
Skill vs. Luck
If each person in a roomful of people randomly buys 10 stocks and holds them for five years, some of those persons may see the value of their investments rise. Does this suggest that they are skilful investors? At the same time, other people in the room may watch the value of their investments plummet. Does that suggest that they are terrible investors?
The answer to both queries is no. The stocks were chosen randomly, thus the result is entirely attributable to luck. But even when stocks are not chosen randomly, luck can play a large factor in investment outcomes, so investors need a mechanism to discern between skill and luck.
The calculation and analysis of reward-to-risk ratios allow investors to understand the level of risk that has historically been taken to earn the total return generated by the fund. All things being equal, a manager who delivers a consistently high reward-to-risk ratio could be said to be more competent than one who consistently produces a lower ratio. Investors who invest in a fund that is managed on an active rather than a passive basis are effectively paying for the manager’s investment ability and expertise.
Manager skill is commonly referred to as alpha. Perhaps the best approach to describe the concept of alpha is to evaluate the sources of a fund’s return, which is formed of three elements:
Market return
Luck Skill
Market Return Managers of passive funds attempt to provide returns for investors just as active managers intend to produce returns. But passive managers are not attempting to generate value by picking stocks that they feel will outperform other securities. Instead, they typically acquire and hold in the appropriate amounts only those securities that are contained in their benchmark. Although this procedure involves some expertise, it is not so much investment skill as effective management. When the value of the benchmark rises, the value of the passive fund monitoring it should also rise; conversely, when the value of the benchmark declines, the value of the passive fund should also fall. Therefore, over time, the fund should deliver a return (before the deduction of costs) equivalent to that of the set benchmark
Given that most actively managed funds are benchmarked against market indexes, such as the S&P 500, and fund managers will own many of the same securities that are in the index, some of the return generated by an actively managed fund will come from market movements due to the benchmark. Arguably then, investors in actively managed funds should not pay higher fees for fund returns that are generated by the market rather than by the investment acumen of their fund manager because investors can get market returns more cheaply by participating in passively managed funds.
Luck
Some of the return earned by a fund is the consequence of luck rather than discretion. The prices of financial assets held in funds are altered by events that cannot be expected by a fund management, such as natural disasters or geopolitical events.
Skilful fund managers may be unlucky on sometimes while unskilled fund managers could experience some good luck. Because luck tends to equal out over the long term, it is crucial that investors are able to separate luck from expertise. But it is not always easy to do so.
Skill A skillful fund manager is able to contribute value to a fund over and above changes to the fund’s value that are driven by market movements and that might have been achieved by a passive fund manager.
Because luck may even out over time, a skilful manager is one who contributes this value consistently over time. Outperformance over the returns from a relevant market benchmark that are the result of manager talent and not luck is often referred to as alpha.
Distinguishing Between Sources of Return
Investors strive to discern between these three sources of fund returns. To do so, reward-to-risk ratios, such as the Sharpe ratio and the information ratio, are evaluated together with other indicators, such as a fund’s alpha, beta, standard deviation, and tracking error. A careful review of these variables over multiple time periods can assist investors decide whether outperformance has lasted over time and whether there is evidence of manager talent.
Skill vs. Luck
If each person in a roomful of people randomly buys 10 stocks and holds them for five years, some of those persons may see the value of their investments rise. Does this suggest that they are skilful investors? At the same time, other people in the room may watch the value of their investments plummet. Does that suggest that they are terrible investors?
The answer to both queries is no. The stocks were chosen randomly, thus the result is entirely attributable to luck. But even when stocks are not chosen randomly, luck can play a large factor in investment outcomes, so investors need a mechanism to discern between skill and luck.
The calculation and analysis of reward-to-risk ratios allow investors to understand the level of risk that has historically been taken to earn the total return generated by the fund. All things being equal, a manager who delivers a consistently high reward-to-risk ratio could be said to be more competent than one who consistently produces a lower ratio. Investors who invest in a fund that is managed on an active rather than a passive basis are effectively paying for the manager’s investment ability and expertise.
Manager skill is commonly referred to as alpha. Perhaps the best approach to describe the concept of alpha is to evaluate the sources of a fund’s return, which is formed of three elements:
Market return
Luck Skill
Market Return Managers of passive funds attempt to provide returns for investors just as active managers intend to produce returns. But passive managers are not attempting to generate value by picking stocks that they feel will outperform other securities. Instead, they typically acquire and hold in the appropriate amounts only those securities that are contained in their benchmark. Although this procedure involves some expertise, it is not so much investment skill as effective management. When the value of the benchmark rises, the value of the passive fund monitoring it should also rise; conversely, when the value of the benchmark declines, the value of the passive fund should also fall. Therefore, over time, the fund should deliver a return (before the deduction of costs) equivalent to that of the set benchmark
Given that most actively managed funds are benchmarked against market indexes, such as the S&P 500, and fund managers will own many of the same securities that are in the index, some of the return generated by an actively managed fund will come from market movements due to the benchmark. Arguably then, investors in actively managed funds should not pay higher fees for fund returns that are generated by the market rather than by the investment acumen of their fund manager because investors can get market returns more cheaply by participating in passively managed funds.
Luck
Some of the return earned by a fund is the consequence of luck rather than discretion. The prices of financial assets held in funds are altered by events that cannot be expected by a fund management, such as natural disasters or geopolitical events.
Skilful fund managers may be unlucky on sometimes while unskilled fund managers could experience some good luck. Because luck tends to equal out over the long term, it is crucial that investors are able to separate luck from expertise. But it is not always easy to do so.
Skill A skillful fund manager is able to contribute value to a fund over and above changes to the fund’s value that are driven by market movements and that might have been achieved by a passive fund manager.
Because luck may even out over time, a skilful manager is one who contributes this value consistently over time. Outperformance over the returns from a relevant market benchmark that are the result of manager talent and not luck is often referred to as alpha.
Distinguishing Between Sources of Return
Investors strive to discern between these three sources of fund returns. To do so, reward-to-risk ratios, such as the Sharpe ratio and the information ratio, are evaluated together with other indicators, such as a fund’s alpha, beta, standard deviation, and tracking error. A careful review of these variables over multiple time periods can assist investors decide whether outperformance has lasted over time and whether there is evidence of manager talent.
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Investment- Performance Attribution
Benchmarks constitute the basis of performance measurement, which is an important aspect of performance evaluation. By comparing the performance of a UK equity fund with the performance of an appropriate UK equity index, the fund’s investors can get an idea of how well the fund is performing relative to the market in general, both in terms of average return and in terms of risk, by calculating the fund’s tracking error or information ratio.
Benchmarks can also be utilized to analyze the causes behind the fund’s performance. By employing proper financial market indicators, the fund manager’s performance can be deconstructed to uncover the sources of returns. Depending on the nature of the fund, the performance itself could originate from the following sources:
Asset allocation
Sector selection
Stock selection
Currency exposure
Determining how much of the performance is the consequence of the choices of asset classes, sectors, individual stocks, and currencies is known as performance attribution. The following example provides an illustration of performance attribution.
Benchmarks constitute the basis of performance measurement, which is an important aspect of performance evaluation. By comparing the performance of a UK equity fund with the performance of an appropriate UK equity index, the fund’s investors can get an idea of how well the fund is performing relative to the market in general, both in terms of average return and in terms of risk, by calculating the fund’s tracking error or information ratio.
Benchmarks can also be utilized to analyze the causes behind the fund’s performance. By employing proper financial market indicators, the fund manager’s performance can be deconstructed to uncover the sources of returns. Depending on the nature of the fund, the performance itself could originate from the following sources:
Asset allocation
Sector selection
Stock selection
Currency exposure
Determining how much of the performance is the consequence of the choices of asset classes, sectors, individual stocks, and currencies is known as performance attribution. The following example provides an illustration of performance attribution.