19. Performance Evaluation

A fund manager who uses analytical and trading skills to try to beat a benchmark is best described as a(n): A. active manager. B. index replicator. C. passive manager.

A is correct. Active fund managers use analytical and trading skills to try to beat a benchmark. They seek out investments that meet the investment mandate, and their portfolios look different from the benchmark. B and C re incorrect because passive fund managers, including index replicators, try to match the performance of the benchmark.

The process of decomposing a fund manager's performance to identify the source(s) of that performance is best described as: A. attribution analysis. B. risk-adjusted analysis. C. relative performance analysis.

A is correct. Attribution analysis is used to identify the source(s) of a fund's or fund manager's performance—that is, how much of the return was attributable to the manager's asset allocation, sector selection, security selection, or currency exposure. B is incorrect because risk-adjusted analysis, such as calculating reward-to-risk ratios, is used to determine how much return was generated per unit of risk. C is incorrect because relative performance analysis is the comparison of the fund manager's holding-period return with the return on an appropriate benchmark.

The Sharpe ratio is used in the performance evaluation process to: A. adjust return for risk. B. attribute performance. C. measure absolute returns.

A is correct. The Sharpe ratio evaluates the reward for each unit of risk. B and C are incorrect because the Sharpe ratio is not used in the attribution of performance or in the measurement of absolute performance.

The criterion that a benchmark should be made up of assets that can be bought or sold by the fund manager is known as: A. investability. B. compatibility. C. pre-specification.

A is correct. The ability to buy and sell the assets in a benchmark means it is investable. B is incorrect because compatibility means that the benchmark's composition and level of risk should be in line with the investor's objectives, including desired level of risk. C is incorrect because pre-specification means that the benchmark should be specified in advance so that the manager is clear about the client's objectives.

Standard deviation is a measure of the variability of a fund's return: A. relative to its average return. B. relative to a benchmark return. C. below its average return.

A is correct. The standard deviation is a measure of the variability of returns relative to the fund's average return. B and C are incorrect because the fund's return relative to the benchmark is the tracking error and a measure that considers a fund's returns that are less than the average return is the downside deviation.

The measure that best reflects the variability of returns around the mean return is the: A. standard deviation. B. reward-to-risk ratio. C. downside deviation.

A is correct. The standard deviation reflects the variability (or volatility) of returns around the mean (or average) return. B is incorrect because the reward-to-risk ratio is a measure of risk-adjusted performance, which indicates how much return was generated per unit of risk. C is incorrect because the downside deviation is calculated by using only deviations that are negative; the downside deviation considers only the outcomes that are less than the mean return.

Tracking error for a passive investment fund is most likely: A. lower than the tracking error for an active investment fund. B. equal to the tracking error for an active investment fund. C. higher than tracking error for an active investment fund.

A is correct. The tracking error reflects how the performance of the investment fund deviates from the performance of its benchmark. Because a passive investment fund is seeking to replicate a benchmark, the tracking error should be very low. Active investment funds attempt to select assets in a benchmark that will outperform the benchmark, and as a result the tracking error is typically higher than the passive fund. B and C are incorrect because the tracking error for the passive investment fund is most likely lower than the tracking error for active investment funds.

Beta measures the portion of the investment fund's return attributable to: A. randomness. B. broad market movements. C. the fund manager's judgment.

B is correct. Beta measures the portion of the investment fund's return attributable to broad market movements, over which the fund manager has no control. A is incorrect because randomness is the portion of the investment fund's return attributable to luck. C is incorrect because the portion of the investment fund's return attributable to the fund manager's judgment (or skill) is referred to as alpha, not beta.

The consistent outperformance of an investment fund compared with its benchmark is best described as: A. beta. B. alpha. C. tracking error.

B is correct. The consistent outperformance of an investment fund compared with its benchmark is generally referred to as alpha. Alpha reflects the investment skill of the fund manager. A is incorrect because beta reflects the market performance, over which the fund manager has no control. C is incorrect because the tracking error reflects how much the performance of the investment fund deviates from the performance of its benchmark.

The measurement of relative returns involves comparing the fund manager's holding-period return with: A. a measure of risk. B. the return on a benchmark. C. the fund manager's past performance.

B is correct. The measurement of relative returns involves comparing the fund manager's holding-period return with the return on an appropriate benchmark. A is incorrect because measures of risk, such as the standard deviation, are used to calculate risk-adjusted returns (the second step of the performance evaluation process) rather than relative returns (the third step of the performance evaluation process). C is incorrect because the fund manager's past performance is not an appropriate benchmark.

The Sharpe ratio is a measure of the excess return on a portfolio compared with the: A. beta of portfolio returns. B. portfolio's tracking error. C. standard deviation of portfolio returns.

C is correct. The Sharpe ratio is calculated as reward per unit of risk, where reward is excess return on the portfolio and risk is the standard deviation of portfolio returns. A is incorrect because the Treynor ratio is calculated as the excess return on the portfolio relative to the beta, a measure of systematic risk, of portfolio returns. B is incorrect because the information ratio is calculated as the difference between average return of the portfolio and the benchmark relative to the fund's tracking error.

The Sharpe ratio is a measure of: A. historical volatility. B. downside deviation. C. risk-adjusted performance.

C is correct. The Sharpe ratio is a commonly used reward-to-risk ratio that is a measure of risk-adjusted performance; the higher the value of the Sharpe ratio, the better the risk-adjusted performance. A is incorrect because the measure of historical volatility is the standard deviation. B is incorrect because the downside deviation is a measure of risk that focuses only on the negative deviations—that is, the returns that are less than the mean return.

The measure that is best suited for investors who dislike losses more than they like equivalent gains is the: A. Sharpe ratio. B. standard deviation. C. downside deviation.

C is correct. The downside deviation focuses only on the negative deviations—that is, the returns that are less than the mean return. Thus, it is an appropriate measure of risk for investors who dislike losses (negative outcomes) more than they like equivalent gains (positive outcomes). A is incorrect because the Sharpe ratio is a measure of risk-adjusted performance that reflects the excess return on a portfolio per unit of risk. B is incorrect because the standard deviation considers all outcomes, both above and below the mean return. It is a better measure for investors who like gains as much as they dislike equivalent losses.

The first step of performance evaluation is: A. attributing performance. B. measuring relative returns. C. measuring absolute returns.

C is correct. The performance evaluation process begins with the measurement of absolute returns. Absolute returns are the holding-period returns. They measure the total gain or loss that an investor owning a security achieved over the holding period compared with the investment at the beginning of the period. Holding-period returns usually come from the changes in the price of the security between the beginning and the end of the period, as well as the income received over the period (dividend, interest). B and A are incorrect because measuring relative returns and attributing performance are the third and fourth steps of the performance evaluation process, respectively.