LOS r: Demonstrate the use of performance quality control charts in performance appraisal.

Q1. 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 manager’s added value returns are more or less random.

Q2. When constructing a quality control chart which of the following is an important assumption that is made about the distribution of the manager’s value added returns?

A)   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.

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

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

Q3. 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)   statistically significant excess returns.

B)   strayed from their stated style.

C)   substantial excess returns.

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Q1. 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 manager’s added value returns are more or less random.

Correct answer is B)

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. Both of the other conclusions are correct.

Q2. When constructing a quality control chart which of the following is an important assumption that is made about the distribution of the manager’s value added returns?

A)   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.

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

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

Correct answer is B)

The null hypothesis states that the expected value-added return is zero. We are testing the manager’s ability to generate positive expected value added returns. 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.

Q3. 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)   statistically significant excess returns.

B)   strayed from their stated style.

C)   substantial excess returns.

Correct answer is A)

In portfolio management, quality control charts are used to determine if a manager has statistically significant excess returns. The manager’s 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 manager’s returns plot outside the confidence interval, we conclude that the manager has generated statistically significant excess returns.