# Level III Review | Portfolio Evaluation

Study session 17 in the Level III CFA Program curriculum concludes the portfolio management topic area with two readings (41-42) on performance evaluation and attribution.
Evaluating Portfolio Performance
The curriculum gives several ways to calculate the rate of return on an account depending on if and when cash flows occur. Don’t try to memorize each individual method, instead think about it intuitively to work through the problem. If cash flows happen at the beginning of the period, then they should be included in the return metrics because it is money that was/wasn’t in the account for the entire period. If cash flows happen at the end of the period, they should not be included.
Understand the difference between time-weighted and money-weighted returns. The money-weighted return is the IRR and is only appropriate when the manager has discretion over deposits/withdrawals.
The material on benchmarks is fairly testable, make sure you know the types of benchmarks and advantages/limitations.

• Absolute is the return objective or a minimum return target on the portfolio. It is simple and straightforward but not investable.
• Manager universe  is usually the median manager or fund from a broad list. It is measureable but not investable, specified in advance, and is ambiguous.
• Broad market is the comparison to a market index like the S&P500. The benchmark method is easy to understand, widely available and unambiguous, investable and measurable but there may not be an index appropriate for the manager’s investment style.
• Factor model based uses models to relate systematic sources of returns to the account through  a regression model. It can be modeled to the manager’s specific style but may be difficult to use, ambiguous, and may not be investable.
• Returns based benchmarks are constructed using the series of account returns and the series of style index returns over a period to make allocation weights. The method is intuitive and simple, unambiguous, investable and specified in advance but may not be matched to the manager’s actual style and require detailed data points.

Understand the basic steps to creating a custom security-based benchmark and its advantages/limitations.
Question #9 in the morning section of the 2010 and 2011 Level 3 exams was an attribution problem. I highly recommend that you download the test and the guideline answers to work through the problems. You need to be able to do both a macro-attribution and a micro-attribution analysis. The past three years of essay questions and guideline answers are available here.
Understand the objectives and basic process for a manager continuation policy.
Global Performance Evaluation
The reading revolves around breaking a total return out into its three components: capital gain (in the local currency), yield, and currency return.
Example: If you invest \$100 in the Mexico index on January 1 2013 and by the end of the year the index has increased by 10% with a depreciation of 3% in the peso against the dollar, what is the return of the investment in dollars? (no dividends paid)
The return to currency is (% change in currency)(1+return +yield) = -.03(1+0.10+0)= -0.033
The return in the domestic currency is (cap gain)+(yield)+(currency)= 0.10+0+-0.033 = 6.7%
**Note it isn’t as simple as reducing the overall gain by the 3% depreciation
You will also need to be able to break the total portfolio return down further to its returns from market selection, security selection, yield and currency. The market selection return is that which would have been achieved with a passive investment in the local market index. The security selection component is made by the manager’s individual selections, in the local currency and compared to the market index.
Beyond the two types of global attribution analysis, the material on active and passive currency management is fairly testable. Passive currency management can be fully hedged to the exposure or selectively hedging some currencies but not others. Active currency management is a strategy that differs from the benchmark and creates different exposures. Currency management is usually done by futures or forwards as seen in the prior topic area.
Be sure to catch Friday’s post where we’ll look at what topics typically show up in the Level 3 morning essay section. We’ll cover study session 18 in the Level III CFA Program curriculum next week, which consists of one reading on the Global Investment Performance Standards (GIPS).
‘til next time, happy studyin,
Joseph Hogue, CFA

#### Poem

If it’s your desire to be the best
Please take the CFA Program Test.