Reading 43: Evaluating Portfol....rmance－LOS t manager, errors

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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 t: Contrast Type I and Type II errors in manager continuation decisions.

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Which of the following is NOT a conclusion regarding quality control charts and how they are typically used to evaluate manager performance?

A) Keeping a manager who generates no value added would be a Type I error.

B) H0 will be that the manager adds no value; Ha is that the manager adds positive value.

C) This is a two-tailed test.

D) Firing a manager who is returning positive value added is a Type II error.

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Answer and Explanation

The test is set up as null, the manager generates no added value and the alternative is that the manager adds value. So we are looking for positive added value which is a one-tailed test. Therefore, the alternative will be that the manager generates positive value added.

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Jack Jensen is the president of Jensen Management. Jensen prides himself on the care of his employees. He states that in 30 years of portfolio management, he has only had to fire two employees. Tom Mercer is president of Analytical Investors. His policy has been to replace poorly performing managers, where poor performance equals underperforming their benchmark for two successive quarters. Which of the following best describes these managers continuation decisions?

A) Jensen is likely committing Type II error and Mercer is likely committing Type I error.

B) Jensen is not likely to be committing any error and Mercer is likely committing Type II error.

C) Jensen is not likely to be committing any error and Mercer is not likely to be committing any error.

D) Jensen is likely committing Type I error and Mercer is likely committing Type II error.

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Answer and Explanation

Type I error is retaining (or hiring) a poorly performing manager. Jensen is likely committing Type I error because he rarely fires anyone. Type II error is firing (or not hiring) a superior manager. Jensen is likely committing Type II error because he fires managers after only two quarters of underperformance. Two quarters is not enough time to properly evaluate a manager.

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Suppose that all a firms 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?

A) Type I error would become more likely and Type II error would become less likely.

B) Type I error would become more likely and Type II error would become more likely.

C) Type I error would become less likely and Type II error would become less likely.

D) Type I error would become less likely and Type II error would become more likely.

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Answer and Explanation

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.