Trading and Performance Evaluation
What is implementation shortfall?
(IS) The difference between the return for a notional or paper portfolio, where all transactions are assumed to take place at the manager's decision price, and the portfolio's actual return, which reflects realized transactions, including all fees and costs. IS = Paper return - Actual return IS decomposes total cost of trade into three categories: - execution cost (The difference between the (trading related) cost of the real portfolio and the paper portfolio, based on shares and prices transacted - delay cost + trading cost) - opportunity cost (The (trading related) cost associated with not being able to transact the entire order at the decision price) - fixed fees
Which attribution approach is more complicated?
- A returns-based attribution uses regressions of indexes against portfolio returns instead of the actual holdings of a portfolio, and is the easiest one to perform. - Holdings-based attribution does not adjust holdings for transactions that occur during a measurement period. - Because a transaction-based attribution adjusts the portfolio for subsequent trades, it is more complicated than a holdings-based attribution.
What are some factors making hedge funds a difficult asset class to find benchmark for?
- Individual hedge funds tend to be unique in their investment process, which makes generating an appropriate peer group very difficult. - Hedge fund data are frequently self-reported. - Hedge funds can hold illiquid assets that are subjectively priced because market-driven prices are not available.
What are the components of a performance evaluation?
- Performance measurement—what was the portfolio's performance? - Performance attribution—how was the performance achieved? - Performance appraisal—was the performance achieved through manager skill or luck?
What are the benefits of using an SMA vs a pooled vehicle?
- cost sensitivity: pooled investment vehicles are typically operated at a lower cost than SMAs because operational costs can be spread among multiple investor - tax efficiency: a taxable investor would prefer an SMA because it allows the implementation of tax-efficient investing and trading strategies, and the investor pays taxes only on capital gains realized (doesn't matter for tax-exempt investors) - legal ownership: if the investor requires clear legal ownership, they would prefer an SMA in which the investor owns the individual security directly - transparency: an investor who requires real-time details on investment positions would prefer an SMA - custom preferences: an investor who has expressed certain constraints and preferences for the portfolio would prefer an SMA
What are the costs of modifying asset exposure using futures?
- cost to roll a contract - price impact - bid/offer spread Although the bid/offer spread and price impact are valid cost components with using futures for rebalancing, the cost to roll a futures contract is by far the largest cost.
When are scheduled algorithms appropriate to use?
- for orders in which PMs do not have expectations of adverse price movement during the trade horizon - PMs have greater risk tolerance for longer execution time periods and are more concerned with minimizing market impact - when the order size is relatively small (e.g., no more than 5%-10% of expected volume) - the security is relatively liquid - the orders are part of a risk-balanced basket and trading all orders at a similar pace will maintain the risk balance
What are trading specifics of fixed income?
- market transparency and price discovery is lower than equities - fixed income is a very heterogeneous asset class - bond issuers can have large numbers of bonds outstanding with different features - securities are traded in a bilateral, dealer-centric market structure; investors will get quotes from dealers, banks, which make markets in the securities - limited algorithmic trading in bond markets except for on-the-run treasuries
What are the key items to be included in any trade policy?
- meaning of best execution (execution price, trading costs, speed of execution, likelihood of execution and settlement, order size, nature of trade) - factors determining the optimal order execution approach (urgency of an order, characteristics of the securities traded, characteristics of execution venues used, investment strategy objective, rationale for a trade) - listing of eligible brokers and execution venues - process to monitor execution arrangements
What are trading specifics of spot FX markets?
- no exchange or centralized clearing place for majority of FX trades - spot FX markets consist of electronic venues and broker markets - entirely OTC market - almost no cross border regulation Consists of multiple levels: - top level - interbank market. Participants are international banks and firms that act as dealers. Large trade sizes. - medium level - small and medium sized banks that turn to large bank dealers for their currency trading and thus pay higher bid ask spreads - lower level - commercial companies and retail traders that turn to second-level institutions for their currency trading and pay higher bid ask spreads
What are the PM's primary motivations to trade?
- profit seeking - risk mgmt / hedging - cash flow needs - corporate actions / index reconstitutions / margin calls
What are some types of performance attribution?
- returns-based vs holdings based vs transaction based - macro vs micro - return vs risk
What are trading specifics of equity markets?
- traded on exchanges and dark pools - transactions and quantities are always reported - exchanges are known as lit markets (as opposed to dark markets) because they provide pre-trade transparency - dark pools have low transparency and provide anonymity - equities are the most technologically advanced market - algorithmic trading is common
What are the three basic types of fee structures?
1. A symmetrical fee structure is one in which the fees are affected by both positive and negative performance. The fund's profit sharing component will be negative if its return is negative and positive if it is positive. The manager is fully exposed to both the downside and upside: (Computed fee = Base + Sharing of performance) 2. A bonus structure in which the manager is not fully exposed to the downside but is fully exposed to the upside: (Computed fee = Higher of either (1) Base or (2) Base plus sharing of positive performance) 3. A bonus structure in which the manager is not fully exposed to either the downside or the upside: (Computed fee = Higher of (1) Base or (2) Base plus sharing of performance, to a limit)
What are approaches to fixed income return attribution?
1. Exposure decomposition - duration based 2. Yield curve decomposition - duration based % Total return = % Income return + % Price return, where % Price return ≈ -Duration × Change in YTM 3. Yield curve decomposition - full repricing based The use of spot rates (zero-coupon curves) is known as the full-repricing method and is the most accurate measure of price changes in securities. However, it requires more data than the duration-based approach.
What are types of benchmarks?
1. Market index 2. Liability based benchmarks - focus on cash flows the asset must generate 3. Asset based benchmarks - absolute (including target) return benchmarks, - broad market indexes, - style indexes, - factor-model-based benchmarks, - returns-based (Sharpe style analysis) benchmarks, - manager universes (peer groups), and - custom security-based (strategy) benchmarks.
What are the key inputs for trade strategy selection?
1. Order characteristics - side (buy, sell, cover, short) - size (amount) - relative size (% of average daily volume) 2. Security characteristics - security type (underlying, ETF, ADR etc.) - short vs long-term alpha (expected price movement in security over trading horizon) - price volatility - security liquidity (bid-ask spread, average daily volume, average trade size) 3. Market conditions - liquidity crises 4. Individual risk aversion
What is a limit order?
A limit order is an order to buy or sell a stock at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher. A limit order is not guaranteed to execute.
The payoff to investment managers using a performance-based fee schedule with upside limits is similar to the payoff diagram of which derivative strategy?
A performance-based fee schedule with limited upside replicates the payoff profile of a bull call spread: the upside is capped, while minimum returns are earned regardless of market performance.
What is a principal order?
A principal order is an order in which a broker-dealer buys or sells for its own account rather than carrying out trades for its clients. Brokerages must register their principal orders on the exchanges on which shares are traded before transactions are executed.
What is a feature of dark pools that provides lower transparency?
Dark pools provide anonymity because no pre-trade transparency exists. Exchanges are known as lit markets (as opposed to dark markets) because they provide pre-trade transparency—namely, limit orders that reflect trader intentions for trade side (buy or sell), price, and size. However, with a dark pool, there is less certainty of execution as compared to an exchange. Regardless of the trading venue, transactions and quantities are always reported.
What is a stop-loss order?
sell when the price drops to (or below) a particular price
What are the components of a micro attribution (Brinson-Fachler approach)?
where B - total benchmark return and B_i are benchmark component returns W_i are benchmark component weights w_i are portfolio component weights R_i are portfolio component returns
What are the types of execution algorithms?
1. Scheduled (POV, TWAP, VWAP) Scheduled algorithms send orders to the market following a schedule that is determined by historical volumes or specified time periods. 2. Liquidity seeking (aka opportunistic) take advantage of market liquidity across multiple venues by trading faster when liquidity exists at a favorable price. 3. Arrival price seek to trade close to current market prices at the time the order is received for execution. 4. Dark strategies/liquidity aggregators execute shares away from "lit" markets, such as exchanges and other displayed venues that provide pre- and post-trade transparency regarding prices, volumes, market spreads, and depth.
What are the two primary purposes of trading algorithms?
1. Trade execution An execution algorithm is tasked with transacting an investment decision made by the portfolio manager. 2. Profit generation A profit-seeking algorithm will determine what to buy and sell and then implement those decisions in the market as efficiently as possible. Profit-seeking algorithms are used by electronic market makers, quantitative funds, and high-frequency traders.
How to calculate return due to active management?
A = Manager Return - Manager Benchmark Return
What is the Carhart model?
A four factor model used in performance attribution. The four factors are: market (RMRF), size (SMB), value (HML), and momentum (WML).
What are arrival price algorithms?
A type of execution algorithm. - seek to trade close to current market prices at the time the order is received for execution - will trade more aggressively at the beginning of trading to execute more shares nearer to the arrival price, known as a front-loaded strategy - tend to be time schedule based but can also be volume participation based Arrival price algorithms are used for: - orders in which the trader believes prices are likely to move unfavorably during the trade horizon - traders who are risk averse and wish to trade more quickly to reduce the execution risk associated with trading more passively over longer time horizons - cases where security is relatively liquid or the order is not outsized such that a participatory strategy is not expected to result in significant market impact from order execution
What are dark price/liquidity aggregator algorithms?
A type of execution algorithm. Dark aggregator algorithms execute shares away from "lit" markets, such as exchanges and other displayed venues that provide pre- and post-trade transparency regarding prices, volumes, market spreads, and depth. Instead, these algorithms execute in opaque, or less transparent, trade venues, such as dark pools. Dark aggregator algorithms are used for: - cases where traders are concerned with information leakage that may occur from posting limit orders in lit venues with pre- and post-trade transparency - cases where order size is large relative to the market and when trading in the open market using arrival price or VWAP strategies would lead to significant market impact - for trading securities that are relatively illiquid or have relatively wide bid-ask spreads. - trades in which the trader or portfolio manager does not need to execute the order in its entirety (since there is less certainty of execution)
What are liquidity seeking algorithms?
A type of execution algorithm. Liquidity-seeking algorithms, also referred to as opportunistic algorithms, take advantage of market liquidity across multiple venues by trading faster when liquidity exists at a favorable price. - may trade aggressively with offsetting orders when sufficient liquidity is posted on exchanges and alternative trading systems at prices the algorithms deem favorable (a practice called "liquidity sweeping" or "sweeping the book") - may use dark pools and trade large quantities of shares in dark venues when sufficient liquidity is present - if liquidity is not present in the market at favorable prices, these algorithms may trade only a small number of shares - these algorithms will often make greater use of market order types than limit order types Liquidity-seeking algorithms are appropriate for: - large orders that the portfolio manager or trader would like to execute quickly without having a substantial impact on the security price - cases where displaying sizable liquidity via limit orders could lead to unwanted information leakage and adverse security price movement - for trading securities that are relatively less liquid and thinly traded or when liquidity is episodic
What are smart order routers?
A type of execution algorithm. Smart order routers (SORs) determine how best to route an order given prevailing market conditions. The SOR will determine the destination with the highest probability of executing the limit order and the venue with the best market price—known in the United States as the National Best Bid and Offer (NBBO)—for market orders. The SOR continuously monitors real-time data from exchanges and venues and also assesses ongoing activity in dark pools. SORs are used when a portfolio manager or trader wishes to execute a small order by routing the order into the market as either a market(able) or non-marketable (limit) order.
What are POV algorithms?
A type of scheduled algorithm. Percentage of volume (POV) algorithms send order following a volume participation schedule (e.g. as trading volume increases, they will trade more shares). While POV algorithms incorporate real-time volume, by following (or chasing) volumes, they may incur higher trading costs by continuing to buy as prices move higher and to sell as prices move lower. An additional disadvantage of these algorithms is that they may not complete the order within the time period specified.
What are VWAP and TWAP algorithms?
A type of scheduled algorithms. Volume-weighted average price (VWAP) slice the order into smaller amounts to send to the market following a time slicing schedule based on historical intraday volume profiles. These algorithms typically trade a higher percentage of the order at the open and close and a smaller percentage of the order during midday. Because of this, the VWAP curve is said to resemble a U-shaped curve. Portfolio managers who are rebalancing their portfolios over the day and have both buy and sell orders would likely select the VWAP as a price benchmark. In these situations, the preference is to participate with market volume. Following a fixed schedule as VWAP algorithms do may not be optimal for illiquid stocks because such algorithms may not complete the order in cases where volumes are low. Time-weighted average price (TWAP) slice the order into smaller amounts to send to the market following an equal-weighted time schedule. TWAP algorithms will send the same number of shares and the same percentage of the order to be traded in each time period. Excluding potential trade outliers used in market environments that are potentially volatile throughout the day would suggest that time-weighted average price (TWAP) would be applicable as opposed to VWAP.
What is alpha decay?
Alpha decay reflects the speed at which information is discounted by the market. Investors trading off daily news flow must react immediately to the news before others to capture alpha from the new information. In contrast, fundamental equity strategies can take months or years to reflect projected values and cash flow need-based trading is a non-urgent strategy.
What is an absolute benchmark?
An absolute benchmark is best for investors who aim to exceed a minimum target return. In this example, the investor needs to earn a minimum absolute return of $100,000 to fund expenses.
What are guidelines for good governance as far as maintaining a list of pre-approved brokers?
Asset managers should have a list of approved brokers and execution venues for trading and the criteria used to create this list. Creating and maintaining the list should be a collaborative effort shared by portfolio execution, compliance, and risk management. A best practices approach is to create a Best Execution Monitoring Committee within an investment management firm that is responsible for maintaining and updating the list regularly, or as circumstances require, and for distributing the list to all parties involved in trade execution.
How long lived are behavioral inefficiencies in the market?
Behavioral inefficiencies, which are mispricings due to investors adhering to behavioral biases, tend to be temporary in duration: after some time the market price and perceived intrinsic value will converge. In general, these inefficiencies exist independent of regulatory regime changes.
How to calculate fixed fees?
Fixed fees are equal to total explicit fees paid (e.g. if commission is 0.02 per share, and trader purchase 10,000 shares, then fixed fees would equal to 0.02*10,000 = 200).
How to determine market impact of a trade?
By examining the trade size as % of average daily volume. The permanent component of price change associated with trading an order is the market price impact caused by the information content of the trade. The larger the size of the trade expressed as a percentage of ADV, the larger the expected market impact cost.
What is the interpretation of capture ratio as far as manager return profile?
Capture ratio = UC / DC Capture ratio measures the asymmetry of return and is like bond convexity and option gamma. CR > 1 indicates positive asymmetry, or convex return profile: as BM returns increase, portfolio returns increase at an increasing rate CR < 1 indicated negative asymmetry, or concave return profile: as BM return increases, portfolio return increases at a decreasing rate
What are capture ratios?
Capture ratios measure the manager's participation in up and down markets—that is, the manager's percentage return relative to that of the benchmark. The upside capture ratio, or upside capture (UC), measures capture when the benchmark return is positive. The downside capture ratio, or downside capture (DC), measures capture when the benchmark return is negative. Upside capture greater (less) than 100% generally suggests outperformance (underperformance) relative to the benchmark, and downside capture less (greater) than 100% generally suggests outperformance (underperformance) relative to the benchmark.
What are some of the reasons for cash drag in the portfolio?
Cash drag can result from timing delays or disruption to active manager portfolios in the cash market, including timing delays when liquidating investments to rebalance between asset classes (e.g., rebalancing from private equity managers to fixed income managers would likely not happen simultaneously). Rebalancing with cash is more desirable with larger, not smaller, rebalancing transactions despite the associated cash drag because the transactions are likely to be more permanent.
What are the different types of trades?
Cash received from new clients must be invested. These trades are said to be cash flow driven. Risk rebalance refers to trades made to hedge risk exposure. Long-term alpha trades are made primarily for profiting from the changes in fundamental conditions in securities.
What is Treynor ratio?
Difference between Treynor and Sharpe ratio is attributed to company-specific, unsystematic risk. Treynor ratio is most appropriate for portfolios that are well diversified, such that most of their risk comes from systematic risk or beta and is tied to the general level of overall risk in the market
What is delay cost?
Difference between paper return (using the share price when decision was made) and estimated return if execution entirely occurred at the price that was prevailing when the order was released (NOT the actual price at which the order was executed).
What is direct market access approach and when is it used?
Direct market access (DMA) refers to access to the electronic facilities and order books of financial market exchanges that facilitate daily securities transactions. Direct market access requires a sophisticated technology infrastructure and is often owned by sell-side firms. Rather than relying on market-making firms and broker-dealers to execute trades, some buy-side firms use direct market access to place trades themselves. Small currency trades are usually implemented using direct market access (DMA). Buy-side traders generally use DMA for exchange-traded derivatives, particularly for smaller trades.
What is drawdown and drawdown duration?
Drawdown is cumulative peak-to-trough loss during a continuous period. Drawdown duration is the total time from the start of the drawdown until the cumulative drawdown recovers to zero. Drawdown duration can be segmented into the - drawdown phase (start to trough) - recovery phase (trough to zero)
How to calculate effective spread?
Effective Spread = 2 x (Actual execution price - Midpoint of market quote at time of order entry)
What is equitization?
Equitization is a strategy employed to minimize cash drag on a portfolio, or fund underperformance from holding uninvested cash in a rising market. In this case, equitization refers to temporarily investing cash using futures or ETFs to gain the desired equity exposure before investing in the underlying securities longer term. Equitization may be required if large inflows into a portfolio are hindered by lack of liquidity in the underlying securities. So, if the large inflow cannot be invested immediately, the investor can equitize the cash using equity futures or ETFs and then gradually trade into the underlying positions and trade out of the futures/ETF position.
What are trading specifics of derivatives markets?
Exchange traded derivatives: - the market is very large, trading volume exceeds several trillion USD per day - most trading concentrated in futures, but number of options outstanding is higher - market transparency is high, all data is publicly available - electronic trading is widespread, but algorithmic trading is not as evolved OTC derivatives: - opaque markets, little public price discovery data - trading is through dealers - trade sizes are large
How to calculate execution cost?
Execution cost is calculated as the difference between the costs of the real portfolio and the paper portfolio. It reflects the execution price(s) paid for the amount of shares in the order that were actually filled, or executed. Execution cost doesn't include commission or fees. Suppose the decision price was $40 for 90,000 shares, but the trades were executed in 4 batches at 4 different prices. Then the execution cost would be $127,500.
What is execution risk?
Execution risk is the risk of an adverse price movement occurring over the trading horizon owing to a change in the fundamental value of the security or because of trading-induced volatility. Execution risk is often proxied by price volatility. Securities with higher levels of price volatility have greater exposure to execution risk than securities with lower price volatility.
True or false: Securities with high rates of alpha decay require less aggressive trading to realize alpha.
False.
True or false: Trading larger size orders with higher trade urgency reduces market impact.
False.
What are the key components of a policy for the treatment of trade errors?
Firms should have a policy in place for the treatment of trade errors. Errors from trading and any resulting gains/losses need to be disclosed to a firm's compliance department and documented in a trade error log. The trade error log should include any related documentation and evidence that trade errors are resolved in a way that avoids adverse impact to the client.
What is high-touch agency approach and when is it used?
High-touch indicates a close relationship with the broker, dealer or counterparty performing the trade. Large, urgent trades, particularly in less liquid small-cap stocks, are generally executed as high-touch broker risk trades, where the broker acts as dealer and counterparty. Large, non-urgent trades may be executed using trading algorithms (particularly for more liquid large-cap stocks) or, for less liquid securities, a high-touch agency approach where the broker attempts to match buyers and sellers directly. For small trades in liquid securities, most buy-side traders use electronic trading.
When is holdings-based attribution most appropriate?
Holdings-based attribution does not make any adjustments for portfolio changes. Hence, it is most widely applied when analyzing portfolios with low turnover, such as passive index funds. The accuracy of holdings-based attribution improves when using data with shorter time intervals. (When transactions are made during the measurement period, holdings-based attribution may not reconcile to actual portfolio return.)
What is the difference between returns-based and holdings-based analysis?
Holdings-based style analysis estimates the portfolio's risk exposures using the securities held in the portfolio (a bottom-up approach), whereas returns-based style analysis uses portfolio returns to estimate a portfolio's sensitivities to security market indexes (a top-down approach).
Is it appropriate for a broker to pool funds to execute transactions?
If several accounts follow the same or a similar investment strategy and have similar trading needs, then pooling the trades for trade execution may make sense in some situations. If a pooled trade is not fully executed, the order amount that is executed generally needs to be allocated to accounts on a pro-rata basis so that no account is disadvantaged relative to the others.
Do management fees and incentive fees reduce the volatility of portfolio's realized returns?
Incentive fees do, but mgmt fees don't. Because incentive fees are fees charged as a percentage of returns (reducing net gains in positive months and reducing net losses in negative months), its use lowers the standard deviation of realized returns. Charging a management fee (a fixed percentage based on assets) lowers the level of realized return without affecting the standard deviation of the return series.
What is macro vs micro attribution?
Macro attribution analyzes investment decisions at the fund sponsor's level (e.g., a pension fund). Macro attribution quantifies the fund sponsor's decision to deviate from their strategic allocation and the timing of when they made those decisions. Quantifying decisions at the portfolio manager's level is micro attribution.
What is the decomposition of manager's portfolio return?
Manager Return = Style Return + Active Mgmt Return + Market Return S = Manager Benchmark Return - Market Index Return A = Manager Return - Manager Benchmark Return
What is Sortino ratio?
Measure of risk/reward - the higher, the better.
What is Sharpe ratio?
Measure of risk/reward - the higher, the better. Difference between Treynor and Sharpe ratio is attributed to company-specific, unsystematic risk.
Is manager universe an appropriate benchmark?
No. Manager universes are not a valid benchmark because they are: - not investable - are not specified in advance - are not unambiguous. It is also impossible to determine if they are appropriate due to the ambiguity of the median manager. Furthermore, the performance records of poor managers are dropped from manager universes so there is an upward bias (i.e., survivorship bias) where the median manager's return is inflated. The only property of a valid benchmark that manager universes fulfill is that they are measurable.
How to calculate opportunity cost?
Opportunity cost is based on the amount of shares left unexecuted in the order and reflects the cost of not being able to execute all shares at the decision price. We use the closing price in this calculation.
What are the categories of liquidity in time-to-cash methodology?
Over one year: illiquid Less than one year: semi-liquid Less than one quarter: liquid Less than one week: very liquid The time-to-cash table includes time-to-cash periods, liquidity classifications, and liquidity budgets. The liquidity budget provides minimum or maximum percentage allocations for the different periods, including minimum allocations for the three more liquid groups and maximum allocation for the illiquid group.
What is arrival cost?
P_bar - average execution price P_o - arrival price at the time the order was submitted to the market
What is performance appraisal?
Performance appraisal involves the interpretation of performance attribution. A judgment is made about manager's decisions and skill, in an effort to differentiate between returns attributable to luck and those attributable to skill.
How to decompose portfolio return vs benchmark?
Portfolio return = Market index return + Style return + active mgmt return
What are the risks for most families in the peak accumulation phase?
Premature death risk, unemployment risk, and disability risk.
Which reference price is used by profit-seeking managers aiming to earn short-term alpha?
Price target benchmarks provide an explicit value for a portfolio manager's view of fair value. If there is a difference in the price of a security and an investor's price target, there may be an opportunity to profit by buying or selling the security. Pre-trade and post-trade benchmarks do not provide a signal for profitable short-term trades.
What are principal trades vs agency trades?
Principal trade - a trade in which the market maker or dealer becomes a disclosed counterparty and assumes risk for the trade by transacting the security for their own account. Also called broker risk trades. Agency trade - a trade in which the broker is engaged to find the other side of the trade, acting as an agent. In doing so, the broker does not assume any risk for the trade.
What are reference prices and how are they categorized?
Reference prices, also referred to as price benchmarks, are specified prices, price-based calculations, or price targets used to select and execute a trade strategy. Reference prices are categorized as follows: - pre-trade benchmarks, where the reference price for the benchmark is known before trading begins (decision price - price at the time buying decision is made; arrival price - price at which order is placed; previous close; opening price). A pre-trade benchmark is often specified by portfolio managers who are buying or selling securities seeking short-term alpha by buying undervalued or selling overvalued securities in the market. - intraday benchmarks, where the reference price for the benchmark is computed on the basis of market prices that occur during the trading period (VWAP - volume weighted average price; TWAP - time weighted average price, used when trade outliers are wished to be excluded) - post-trade benchmarks, where the reference price for the benchmark is established after trading is completed (closing price) - price target benchmarks, where the reference price for the benchmark is specified as a price to meet or beat (transact more favorably)
Which measurement of performance is least appropriate for hedge funds?
Relative performance using traditional benchmarks is the least appropriate given hedge funds concentration on absolute returns and the lack of reliable traditional benchmarks.
Which one of the three attribution approaches is the least accurate?
Return-based attribution is the least accurate of the three approaches (the return-based, holdings-based, transaction-based approaches). Return-based attribution uses only the total portfolio returns over a period to identify the components of the investment process that have generated the returns.
When does risk enter the performance evaluation process?
Risk is part of all phases of performance evaluation - performance measurement, attribution and appraisal.
How to calculate return due to style?
S = Manager Benchmark Return - Market Index Return
What is the most efficient way to generate required cash without selling portfolio assets?
Selling options generates cash immediately through the premium income. A futures overlay position rebalances exposures with no allocation changes to external managers but does not generate immediate cash. A short futures position generates cash at maturity (selling the asset) but does not generate cash today.
What are the different trading strategies?
Short-term alpha: short-term alpha-driven equity trade (high trade urgency) Long-term alpha: long-term alpha-driven fixed-income trade (low trade urgency) Risk rebalance: buy/sell basket trade to rebalance a fund's risk exposure Cash flow driven: client redemption trade to raise proceeds Cash flow driven: cash equitization (derivatives) trade to invest a new client mandate
How to express implementation shortfall in basis points?
The denominator is based off the target decision price and share amount, i.e. as if the whole order ideally was executed at the decision price.
What is implementation shortfall trading execution strategy?
The implementation shortfall algorithm is a front- loaded strategy that can be adjusted to aggressively execute an order when the order has a high urgency.
What is market-adjusted cost?
The market-adjusted cost is a performance metric used by managers and traders to help separate the trading cost due to trading the order from the general market movement in the security price (i.e., the price movement that would have occurred in the security even if the order was not executed in the market) Market-adjusted cost (bps) = Arrival cost (bps) - β × Index cost (bps) The market-adjusted cost removes the impact of market movements on trading costs so that a trader is not penalized or rewarded for general market movements over the trade horizon. A negative result represents a savings, while positive result represents a cost.
Why holdings-based attribution generates a residual term between the portfolio performance and benchmark performance?
The residual term cannot be explained by a fund manager's actions. The residual can be the result of measuring a fund's holdings less frequently than the frequency of fund transactions.
When setting a limit order, what price is considered decision price?
The target price is the decision price. It is the price at which it would be ideal to execute the transaction. Limit price is not the decision price.
What is return unsmoothing?
The unsmoothing method is used for illiquid asset classes like private equity and private real estate, by making an upward volatility adjustment to better reflect their underlying risks. In essence, it removes the effects of positive serial correlation on risk estimates caused by stale prices.
What are the attribution components of Brinson Model?
The value added by the portfolio manager is decomposed in allocation, selection, and interaction effects. allocation = (w_p - w_b)R_b selection = w_b(R_p - R_b) interaction - effect resulting from the interaction of the allocation and selection decisions combined = (w_p - w_b)(R_p - R_b)
If the market-adjusted cost is significantly lower than total arrival cost, what does it indicate?
This indicates that most of the expense associated with buying LIM is due to the effect of buying it in a rising market as opposed to the buying pressure induced by the order itself.
What is the trader's dilemma?
Trading too fast results in too much market impact, but trading too slow results in too much market risk. The goal in selecting a trading strategy is to choose the best price-time trade-off given current market conditions and the unique characteristics of the order.
True or false: Trading with greater urgency results in lower execution risk.
True. Greater trade urgency results in lower execution risk because the order is executed over a shorter period of time, which decreases the time the trade is exposed to price volatility and changing market conditions. In contrast, lower trade urgency results in higher execution risk because the order is executed over a longer period of time, which increases the time the trade is exposed to price volatility and changing market conditions.
Suppose that all of a firm's managers are outperforming the benchmark, some by a little, some by a lot. If the confidence intervals for a quality control charts in portfolio management were widened, what would the most likely effect be on Type I and Type II errors?
Type I error would become less likely and Type II error would become more likely. Type I error is retaining a poorly performing manager. If the confidence intervals are widened and a poor manager is barely outperforming the benchmark, it is less likely that they will have statistically significant excess returns. We are thus more likely to fire them and hence less likely to commit Type I error. At the same time, we may be firing good managers who are outperforming the benchmark but yet do not have statistically significant excess returns. We are thus more likely to commit Type II error as Type II error is firing a superior manager.
What are the properties of an appropriate benchmark?
Unambiguous—The individual securities and their weights in a benchmark should be clearly identifiable. Investable—It must be possible to replicate and hold the benchmark to earn its return (at least gross of expenses). Measurable—It must be possible to measure the benchmark's return on a reasonably frequent and timely basis. Appropriate—The benchmark must be consistent with the manager's investment style or area of expertise. Reflective of current investment opinions—The manager should be familiar with the securities that constitute the benchmark and their factor exposures. Specified in advance—The benchmark must be constructed prior to the evaluation period so that the manager is not judged against benchmarks created after the fact. Accountable—The manager should accept ownership of the benchmark and its securities and be willing to be held accountable to the benchmark.
How to calculate trade costs?
Various prices can be used in place of P* - arrival price: measures difference between the market price at the time the order was released to the market and the actual transaction price for the fund - VWAP or TWAP: measure whether a fair price was received over the trading period - closing price: typically used by index and mutual fund managers
What are the challenges related to executing trades in a rising vs falling market?
When there is general price momentum in one direction, it is more difficult to execute trades. In rising markets, investors are unlikely to execute buy trades between the bid and offer prices, and in a declining market, the bids are likely to be softer and apply to fewer shares.
What is a market order?
a buy or sell order to be executed immediately at current market prices
What are type I and type II errors in manager selection?
null hypothesis = manager has no skill Type I: Hiring or retaining a manager who subsequently underperforms expectations. Rejecting the null hypothesis of no skill when it is correct. It is an error of commission. Type II: Not hiring or firing a manager who subsequently outperforms, or performs in line with, expectations. Not rejecting the null hypothesis when it is incorrect. It is an error of omission. Type I errors are more common, because they are more easily measured and may be tied to compensation of a decision maker. The wider the dispersion of returns between a weak and a strong fund manager, the easier to distinguish their relative skills. This will minimize both Type I and Type II errors.
