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Portfolio Risk and Return Analysis

Discussion in 'SP5' started by Studystuff, Feb 26, 2021.

  1. Studystuff

    Studystuff Very Active Member

    Hi,

    I was hoping someone would be able to help me get my head around this topic which appears at the start of chapter 17.

    I understand all the info in chapter 16 on performance measurement on a fund in absolute and relative terms.
    Portfolio risk and return analysis appears to be an extension onto this which could be considered similar to risk adjusted performance measures.


    By plotting our funds TWRR and risk (from SD or implied volatility) vs that of peer group and a benchmark we can asses relative performance and also determine whether returns have stemmed from risk or skill. My confusion is with the rest of this section.

    Firstly - It states hirers of investment managers will not want excessive risk to be taken (is this just black and white they want lower absolute risk?). It then measures two risk controls used in practise. I am correct in thinking we ignore these risk controls for the rest of the section and only look at the half yearly meeting with investment manager as our risk control mechanism?

    As just mentioned, it then mentions through the process of meeting with Inv Manager to discuss the results of the analysis. From this we implicitly assume there is a level of risk control in place as (even only from dealing costs) its not likely the manager will not not have been able to alter the portfolio so much in 6 months.

    Finally it mentions 3 problems with this half yearly discussion of analysis results:

    1. Creeping change - I understand this, small changes each 6 months could cause big changes eventually
    2. DIfferent view of risk with Market - I also get this, Manager may disagree with the risk implied by the market
    3. This is my main confusion "A successful investment manager may be treated unfairly by the measurement system" (ActEd, 09/2020)
    Is this just saying that even skilled managers who achieve high excess returns over high risk taken on will not be rewarded by this system due to the fact hirers want low risk in absolute terms? I.e low risk levels on the x axis? So even though this person is skilled is picking performing stock the absolute risk levels taken on are likely too much?

    Eg would hirers prefer a return of 6% with risk of 2% vs our skilled manager in question who can get 12% return from risk of 6%? Even risk adjusted return is higher than the other manager, the higher levels of absolute risk will go against him/her?
     
    Studystuff, Feb 26, 2021
    #1
  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    Hi. This is quite an unusual chapter in the course. It is one of the least examined, as can be seen from the ASET cross reference grid which plots exam questions by chapter since 2010.

    Firstly - It states hirers of investment managers will not want excessive risk to be taken (is this just black and white they want lower absolute risk?). It then measures two risk controls used in practise. I am correct in thinking we ignore these risk controls for the rest of the section and only look at the half yearly meeting with investment manager as our risk control mechanism?

    I think the first bit is just the word "excessive". Most people are happy with some risk to obtain a return, but excessive suggests that there is too much. The risk controls you mention are load differences on stock weightings and sector weightings, which are commonly used. It is not ignored after that, but just does not impact the narrative. the load differences would be monitored and discussed at the 6 monthly meeting if the manager breached them.

    As just mentioned, it then mentions through the process of meeting with Inv Manager to discuss the results of the analysis. From this we implicitly assume there is a level of risk control in place as (even only from dealing costs) its not likely the manager will not not have been able to alter the portfolio so much in 6 months

    The regular meetings are important to discuss the risk outcome (tracking error, VaR) and the returns. the portolio may not change that much but the markets may.

    3. This is my main confusion "A successful investment manager may be treated unfairly by the measurement system" (ActEd, 09/2020)

    I think what this part is saying is that there will be managers who's skill lies in selecting the winners from the "dangerous" and volatile stocks in the market. If that is the manager's skill, and the performance is always rated on a risk-adjusted basis, the volatility will bring the Treynor or Sharpe measure down. The manager will look worse than other more boring managers even though the performance is consistently better. Is that fair? Possibly it is fair, if the manager has just taken the risk as a market bet to get extra performance by selecting some risky stocks. But possibly its not fair, if the manager simply finds his or her skill in stock selection of volatile stocks, and is not simply selecting volatile stocks just because they are volatile stocks (if you see what I mean).
     
    Colin McKee, Feb 26, 2021
    #2
  3. Studystuff

    Studystuff Very Active Member

    Hi Colin,

    Thanks for the reply I appreciate it. So just to confirm on my last point with an example.

    Manager A: Can consistently get 6% return while taking 2% risk
    Manager B: Can get 7% return from a 5% risk

    The measurement system may go against manager B (who can get high returns by picking out performing stocks in volatile sectors) because when looking at each manager on a risk adjusted basis manager A would yield better results?
     
    Studystuff, Feb 26, 2021
    #3
  4. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    Yes. If manager A gets (say) Rp - Rf = 4% and has vol = 2% then they have a sharpe of 2. If manager B gets Rp - Rf = 2% and has vol = 1% then this manager also has sharpe of 2, which is fair enough. If Manager A achieved the higher return by taking a punt on the market and moving the portfolio into high volatility share, then got lucky when the market rose, then giving them the same sharpe ratio seems fair. If Manager A always picks from exciting volatile stocks (this is where his or her skill lies) and has not done it as a market bet, then it seems unfair.
     
    Colin McKee, Feb 27, 2021
    #4

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