Book Review: Performance Evaluation and Attribution of Security Portfolios
Performance Evaluation and Attribution of Security Portfolios. 2012. Bernd R. Fischer and Russ Wermers.
In the current environment of dwindling excess returns (alpha), Bernd R. Fischer and Russ Wermers give readers the necessary tools to tackle and overcome the challenges of adding value through the efforts of active managers. This well-detailed volume establishes an excellent framework for manager evaluation and selection by delving into portfolios and analyzing them with meticulous methodologies. At the same time, the authors highlight pitfalls and traps to avoid.
They begin with basic concepts of performance evaluation and a discussion of models for valuing traded financial securities, including the capital asset pricing model (CAPM). The importance of the CAPM is balanced with criticism of its impracticality in the real world, which is due to unrealistic assumptions. Fischer and Wermers then move on to the contemporary, “empirically inspired” multifactor model.
The authors explain that two analyses form the basis of manager evaluation: return-based analysis and holding-based analysis.
Numerous return-based metrics are used to evaluate portfolios across asset classes. Fischer and Wermers highlight two nonregression approaches (the Sharpe ratio and tracking error) and two regression-based approaches (Jensen’s alpha and the Treynor ratio). These measures rank managers in an effort to identify those with genuine skill. To inculcate a firm understanding of the concepts, the authors apply these techniques to several well-known funds across a variety of asset classes, including Fidelity Magellan, Legg Mason Value Trust, Janus Twenty, Vanguard 500 Index, and PIMCO Total Return.
In their discussion of the analysis of portfolio holdings, the authors apply the Grinblatt–Titman methodology (GT) to the Janus Twenty Fund’s stock positions with a lag of 12 months. This measure has statistical advantages over others, such as the Brinson–Hood–Beebower approach (BHB), because it does not rely on using a market index as a benchmark. Many portfolios have suboptimal benchmarks because available indices do not match their styles: Their product mandates involve niche or differentiated strategies, and the universe of stocks they invest in is different from the universe of stocks in the benchmark. Hence, GT is a better approach because it examines the holdings of the portfolio with a lag. For instance, a portfolio that invests in small-cap stocks will have the same style over time; using GT, one can calculate its performance measures on the basis of its historical holdings rather than its benchmark. Further, GT can be integrated into BHB to conduct performance attribution. In addition, the authors discuss the DGTW (Daniel, Grinblatt, Titman, and Wermers) measures — characteristic selectivity (CS), characteristic timing (CT), and average style (AS) — in detail. They argue that the DGTW measures are superior to factor-based regression approaches owing to a smaller standard error for CS and a more precise measure of the return attributable to AS. As a further benefit, the DGTW measures integrate the return-based approach to performance evaluation with the holding-based approach.
Fischer and Wermers also discuss the “bootstrap approach” to computing the statistical significance of a fund manager’s estimated performance. Useful in evaluating short-term persistence, this analysis shows more funds having significant alphas than the standard t-test does.
If there is one chapter that defines the book, it is Chapter 9 — “Does Active Management Add Value?” — in which the authors guide investors to find superior active managers, or SAMs, in “mostly efficient” markets using a combination of four approaches: past fund performance, macroeconomic correlations, fund characteristics, and analysis of fund holdings. The chapter summarizes findings from over two dozen studies, providing insights into persistence of fund performance, performance during recessions, characteristics of outperformers, and managers’ handling of risk.
The final section of the book covers performance analysis and reporting. It introduces basic performance evaluation models and addresses such implementation issues as missing net asset values at some points in time and multiple solutions to internal rate of return calculations. The authors also address the important issue of selecting an appropriate benchmark.
The book elaborates on the Brinson approach to performance attribution, taking into consideration the benchmark, security selection, currency management, and leverage. In particular, it examines the interpretation of interaction effects, separation of currency contribution, and use of the methodology for a prolonged, multi-period analysis. Fischer and Wermers delve into attribution methodologies for fixed-income portfolios, multi-asset-class portfolios, and hedge funds. The book concludes with a chapter on the Global Investment Performance Standards (GIPS®), which define ethical practices for asset managers.
In summary, Fischer and Wermers evaluate several methodologies and studies and provide appropriate criticisms. They use real-life examples in their analyses of the practicality of the various approaches. The exhaustiveness of their efforts makes this volume a comprehensive one-stop shop for fund manager evaluation and portfolio analytics. Highly recommended for professionals who evaluate portfolio managers (e.g., wealth managers, advisers, fund allocators), Performance Evaluation and Attribution of Security Portfolios blends traditional concepts of portfolio evaluation with the latest academic findings. Unlike books that are either concerned exclusively with nuts-and-bolts issues or unduly theoretical, it provides an optimal balance for the benefit of both practitioners and academicians.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.