Reading 43: Evaluating Portfol....rmance－LOS r control

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 16: Performance Evaluation and Attribution
Reading 43: Evaluating Portfolio Performance
LOS r: Demonstrate the use of performance quality control charts in performance appraisal.

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When constructing a quality control chart which of the following is an important assumption that is made about the distribution of the managers value added returns?

A) The null hypothesis states that the expected value-added return is the risk free rate of return.

B) Due to the likely presence of skewness in the returns, a Chi-squared distribution is assumed.

C) Value-added returns are independent and normally distributed.

D) The investment process is consistent thus ensuring that a high degree of the error term in one period can be explained by the error term in the previous period.

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Answer and Explanation

The null hypothesis states that the expected value-added return is zero. We are testing the managers ability to generate positive expected value added returns. There is no reason why skewness in the distribution should exist and thus a Chisquared distribution is inappropriate in this case. We want a consistent process to ensure that the distribution of value added returns about their mean is constant. We do indeed assume that value-added returns are independent and normally distributed.

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Which of the following is NOT a conclusion that could be derived from plotting a manager's value-added returns relative to the benchmark on a quality control chart?

A) If returns are consistently above the horizontal axis this could indicate superior performance on the part of the manager under review.

B) The chart can be used to determine whether or not the potential superior performance is statistically significant.

C) If value added returns are distributed randomly around the horizontal axis then managers added value returns are more or less random.

D) If returns are consistently below the horizontal axis this could indicate underperformance on the part of the manager under review.

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Answer and Explanation

In order to determine statistical significance or otherwise, confidence intervals will need to be constructed using the standard deviation of the returns, this is not observable from plotting the manager's value added returns alone and would need to be separately calculated. All the other conclusions are correct.

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Which of the following best describes the use of quality control charts in portfolio management? Quality control charts are used to determine if a manager has:

A) strayed from their stated style.

B) economically significant excess returns.

C) substantial excess returns.

D) statistically significant excess returns.

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Answer and Explanation

In portfolio management, quality control charts are used to determine if a manager has statistically significant excess returns. The managers returns versus a benchmark are plotted on a graph where time is on the x-axis and value-added (excess) return is plotted on the y-axis. A confidence interval is formed around the x-axis of zero. If the managers returns plot outside the confidence interval, we conclude that the manager has generated statistically significant excess returns.