Investment Strategies and Performance Evaluation

Performance Evaluation

• The course is FIN 367: Investment Management at the University of Texas at Austin.
• The instructor is Shikhar Singla.
• There will be a guest speaker, Rodolfo Martell, on Monday, December 2nd from 5:00 PM to 6:30 PM.

Announcements

• There will be a comprehensive final exam covering 60% of the semester's topics and 40% since the last midterm.
• The final exam format will be similar to previous exams.
• Students may bring three note sheets (front and back) to the final exam; they do not need to be the ones used on previous exams.
• Additional practice problems are available on Canvas.

Lecture Agenda

• Topics include performance evaluation methodology, performance evidence, mutual funds, alternative investments, issues with alternatives, hedge funds, private equity, and venture capital.
• A pre-lecture video is available.

Thought Questions

• Investor perspective questions include how to evaluate fund performance, whether to invest in actively managed mutual funds, hedge funds, or alternative investments, and which funds to choose.
• Economist perspective questions include whether fund managers can outperform the market, and whether markets are efficient. A caveat is provided that manager outperformance is evidence against efficiency, but lack of outperformance doesn't confirm efficiency.

Evaluating Returns

• To evaluate high returns, ask three questions: risk adjustment, performance attribution, and luck vs skill.

Performance Evaluation Methods

• Methods include universe comparison, Sharpe Ratio, Treynor Measure, Jensen's alpha (with different factor models), and Information Ratio.

Universe Comparison

• This is the simplest and most common way to adjust returns.
• Compare returns to a benchmark or universe of similar funds.
• Examples include "fund beat its benchmark each of the past three years" or consistently performed in the top quartile.

Sharpe Ratio

• This ranks performance based on the portfolio's risk premium per unit of risk.
• The formula is (Rp - Rf) / σp, where Rp is the average portfolio return, Rf is the risk-free return, and σp is the volatility of the portfolio.

Treynor Ratio

• This ranks performance based on the portfolio's risk premium per unit of systematic risk (beta).
• The formula is (Rp - Rf) / βp, where Rp is the average portfolio return, Rf is the risk-free return, and βp is the portfolio's beta.

Information Ratio

• This measures a portfolio's excess return relative to a benchmark, adjusted for the volatility of those excess returns.
• The formula is (Rp - Rf) / σ(Rp-Rb) where Rp is average portfolio return, Rf is average benchmark return, and σ(Rp-Rb) is tracking error.

Which Approach is Preferred or Best?

• Alpha is often the most appealing approach because it adjusts excess returns for systematic risk and known factors and is flexible.

Jensen's Alpha

• Measures a portfolio's excess return relative to the expected return predicted by a risk model.
• The formula using CAPM: Rp - [Rf + βp(RM - Rf)].
• The formula using the Fama French 3 model: Rp - [Rf + βp(RM - Rf) + BSMBSMB + BHMLfHML].

Jensen's Alpha (Continued)

• Positive alpha indicates outperformance, negative indicates underperformance.
• It adjusts for risk and market performance and indicates the value added by the manager.
• Alpha estimates are frequently noisy and require a long time series to measure accurately.

Section Summary

• Alpha and performance relative to a benchmark are the most common ways to evaluate fund performance.
• Noise and selection bias make evaluating individual funds difficult, but it's possible to evaluate portfolios of funds with specific characteristics.

Mutual Fund Performance

• On average, mutual funds underperform the market by approximately 1% per year.
• Underperformance is largely due to fees.
• Past losers tend to continue underperforming.

Active Public Manager Snapshot

• Underperformance rates of various fund categories (e.g., large cap, small cap, high yield) increased over time.

Investor Behavior

• Outflows from domestic equity mutual funds occurred, while inflows into ETFs are observed.

What about during the bad times?

• Active funds tended to underperform the S&P 500 during the COVID-19 crisis.

Alternative Investments

• Discussion of challenges associated with alternative investments.

Private vs Public Performance

• Private investments show higher returns than public investments compared to their risk
• This is because of the common belief among industry, but the risk adjustment is not taken into account,

Private vs Public Reward vs Risk

• Private investments have a higher return per unit risk than public investments (higher Sharpe Ratio).
• This has driven the significant movement of Pensions into Alternatives.
• There are questions about why private investments have lower standard deviation / volatility.

Challenges with Alternative Indices

• Difficulties include valuation differences (infrequent pricing, vintage year, subjectivity), liquidity issues (illiquidity, limited data), structural diversity (varied investment structures, complexity), performance smoothing (appraisal smoothing, time lags), and benchmarking (lack of comparable benchmarks, subjective custom benchmarks, regulatory and compliance differences, varied regulations and disclosure requirements).

Estimating betas are harder with Alternative Investing

• Linear model may not work well with non-linear returns and low-probability events (e.g., options, liquidity issues).
• Illiquid assets may lack price information, which biases returns calculations).

Simple Smoothing Example

• Examples of how stale data may affect return estimates, even for periods with market downturns

Estimation errors in beta change alpha

• Estimating betas with alternative investments leads to potential errors, making it harder to accurately measure alpha.

Do Hedge funds generate alpha?

• Industry view generally supports hedge fund ability to generate alpha, but academic literature suggests a more skeptical view, with decreasing performance and growing evidence of subpar performance compared to factors like fees.

Bollen, Joenväärä & Kauppila (2021): Hedge Fund Performance

• Hedge fund performance has decreased since 2008 and has displayed evidence that regulatory changes and market condition changes explain the decline.

Does Private Equity Outperform?

• Private equity returns are not observable, creating difficulties in risk-adjusting returns.
• Industry common practice is to report IRR, but the appropriate benchmark selection, as well as reporting bias (downward volatility bias) remains a challenge

Kortweg (2019): Risk Adjustment in Private Equity Return

• Studies found that leveraged buyout investments have generally earned risk-adjusted profits before and after fees, compared to a levered stock portfolio, but alphas has been declining with better measures of risk and adjusted returns.

Kortweg (2019) Risk Adjustment in private equity return

• This study reviews the literature on risk-adjusted returns in private equity. Results show that risk-adjusted returns estimates vary by method, time period and data source.

Does VC outperform？

• VC funds do not outperform the market when considering beta and risk factors.

Boyer et al. (2019): VC does not outperform

• VC funds were not found to outperform when incorporating a new data source and considering previous issues in measuring beta.

Real estate is highly correlated with S&P 500

• Real estate has a high correlation with the S&P 500, and annualized Sharpe ratios for real estate are much lower.

Summary

• Mutual funds typically underperform the market by approximately 1% per year, with underperformance largely due to fees.
• Hedge funds and VC funds, similarly, have not exhibited consistent outperformance after accounting for risk.
• Alternative investments (like REITS) have correlations with market but do not routinely outpace the market either.
• Passive management strategies tend to yield better risk-adjusted returns.

Test your knowledge on the key concepts of investment strategies and performance evaluation methods. This quiz covers topics from the final exam materials, including alternative investments, mutual funds, and crucial findings in financial research. Understanding these areas is essential for mastering investment performance metrics.