Performance evaluation .edu



BA 453 – International Investments

Prof. Cam Harvey

Assignment 1

February 26, 1999

Performance Evaluation

Traditional measures versus Graham-Harvey measures

Universal Investments:

Christian Delay

Noppaporn Supmonchai

Tassanee Ratanaruangrai

Juan Sandoval

Introduction 2

Issue 2

Methodology 2

Mutual funds 2

Traditional measures 3

Captial Asset Pricing Model (CAPM) 4

Jensen’s alpha 4

Sharpe ratio 4

Treynor Index 4

Graham-Harvey measures 5

International Fund analysis 5

US Mutual Funds analysis 7

Conclusion 8

Introduction

An investor seeks high returns for his risk profile. Asset management is a multi-billion dollar industry, but according to Cam Harvey the “state of asset management is not very good in terms of performance.” Performance is the ultimate, objective judge in how to assess asset management. However, most fund mangers underperform the benchmarks. The essence of fund investing is beating the benchmark. Why is it so difficult to beat the benchmark? In addition, the investor must pay high transaction costs (management fees, loads, trading costs) that further deteriorate returns. If this is the case, why do institutions and individuals purchase mutual funds when they can achieve higher returns by purchasing a risk-free asset and S&P 500 futures?

Universal Investments chose this topic for two main reasons: 1) to assess international mutual funds performance and 2) to analyze different measures to determine which ones make the most sense.

Issue

There are many different ways to evaluate performance and each of the ways offers differing perspectives. We considered mean-variance analysis, the Capital Asset Pricing Model (CAPM), which includes the alpha and beta components, the Sharpe ratio, Treynor’s index as traditional measures. We wanted compare/contrast these to new measures developed by Graham & Harvey, GH1 and GH2, to provide deeper insight to evaluating performance.

Methodology

In the context of international investments, we wanted to analyze mutual funds that invested mainly in international stocks to assess performance using different quantitative measures. We gathered international mutual fund data from Morningstar to assess performance over 5 and 3-year periods. We established our benchmark as the MSCI World Index to evaluate mutual fund performance. Then, we calculated traditional measures and discussed the results. Afterwards, we used Graham-Harvey measures and commented on our results. At this juncture, we assessed the differences between the traditional and new measures and concluded the study.

Mutual funds

We selected the following 14 international mutual funds for analysis purposes:

|Fund Name | |

|Columbia International Stock |Fidelity International Growth & Income |

|BT Investment Intl Equity |Tweedy, Browne Global Value |

|Goldman Sachs International Equity |Janus Worldwide |

|Smith Barney International Equity |Dreyfus Global Growth |

|EuroPacific Growth |USAA World Growth |

|Schroder International |Capital World Growth & Income |

|Idex Global |Putnam Global Growth |

The funds varied in regional and industry exposure and from $77 million to $13.7 billion. All the funds are reported in US Dollars, therefore, we felt the range in exposure justified our decision to use the MSCI World Index as our benchmark portfolio. For more information on that index, see msci.html.

The mutual funds mainly invested in international stocks as shown in the following chart:

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Traditional measures

Our first step in analyzing the fund’s performance was to construct an efficient frontier, calculate a mean-variance analysis and plot the results. The mean-variance analysis allows us to figure out how funds are performing against the MSCI benchmark. The mutual fund data was taken from January 1994 to December 1998.

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The results are obviously dismal. Only 2 (Janus and Idex) out of the 14 funds lie directly above the frontier. We also looked at 3 year international mutual fund returns and achieved similar results:

|[pic] |

Again, most fund managers are not able to achieve the MSCI benchmark.

Capital Asset Pricing Model (CAPM)

The CAPM equation suggests a higher beta will generate higher expected returns at a level of systematic risk. The risk of the beta is the average level of market exposure. The residual in the CAPM represents the idiosyncratic risk that can be diversified. From January 1994 to December 1998, the average beta was 0.89.

Jensen’s alpha

Alpha measures the unexplainable performance relative to CAPM meaning the intercept of the alpha should be zero when using CAPM. The alpha is the intercept from a regression of a fund’s excess return (of the risk-free return) on the market’s excess returns. We ran regression on the 14 funds to determine the alphas. The average alpha in our analysis was 0.47.

Sharpe ratio

Sharpe ratios measure the excess expected return over the standard deviation. So, higher Sharpe ratios are associated with superior performance per unit of standard deviation. An important concept with the Sharpe measure is ex-post. That is, the measure deals with actualized returns. The highest Sharpe ratios belong to the best performing mutual funds: BT Investment, Capital World, Janus and Idex.

Treynor Index

Another ex-post measure is the Treynor index. Since the index uses the mutual fund beta in the denominator, the index measures the excess return per unit of risk taken. Again, the higher index indicates a superior return. The top four performers are the same for the Treynor Index as for the Sharpe ratio.

|[pic] |

All of the above measures are used when evaluating fund performance. For example, Morningstar provides an Advanced Analytic page that includes most of these measures. However, the traditional measures fall short when considering predictability (ex-ante), risk, flexibility and economic intuition. It is also difficult to distinguish performance in terms of volatility, as traditional measures do not truly compare similar vehicles.

Graham-Harvey measures

A better way to compare mutual funds is to highlight risk-taking (volatility) and match it with expected returns. This is what the Graham-Harvey measures accomplish. There are two Graham-Harvey measures, GH1 and GH2. GH1 levers the benchmark to have the same volatility as the mutual fund whereas GH2 levers the mutual fund to have the same volatility as the benchmark. GH2 assumes that the investor is willing and/or able to lever an international mutual fund to have the same volatility as the MSCI.

International Fund analysis

Using the Graham-Harvey model, we evaluated the international mutual funds to determine performance. We ran these performance measures using both the model retrieved from Harvey's web site as well as using a simple quadratic equation in determining the results. The results from using the model and that derived from a simple quadratic equation are almost identical. Note that transaction costs is assumed to be zero for the simple quadratic calculations. We came up with the following results:

GH1

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GH2

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Again, we shortened the time frame to 3 years to determine if international mutual funds were outperforming the benchmark using GH1 and GH2. Our findings for the 3-year results are similar to the period from 1994 to 1998.

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Only 2 of the 14 international mutual funds outperform the benchmark. The GH1 and GH2 measures are telling in the table below. The average of all the international mutual funds is negative which translates into underperformance.

|[pic] |

US Mutual Funds analysis

We thought that international fund managers might be challenged due to various reasons, i.e. lack of information, complexity of international markets, risk factors, etc. So, we decided to do a similar analysis with United States Mutual funds. To our dismay, we found that the results were even worse for U.S. mutual funds.

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GH1

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GH2

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Conclusion

The mean-variance and the Graham-Harvey measures give results that are consistent with one another. The main advantage of Graham-Harvey measure as compared to the mean-variance measure is the intuition that comparisons are made on the same basis (i.e. volatility). In addition, the Graham-Harvey measure is more user-friendly in that performance evaluations can be interpreted simply by looking at the numerical results (positive is good and negative is bad).

Comparing the results between the randomly selected mutual funds that invested internationally and domestically, it is shown that some of the internationally invested portfolio, if chosen properly, will give a better performance than a comparable benchmark, in our case, the MSCI World. On the other hand, according to our results, none the domestically invested portfolio seems to be able to outperform its comparable benchmark, the MSCI US Equity.

An investor must understand his risk tolerance before investing in equity mutual funds. Once accomplished, the investor will attempt to achieve the highest expected returns for a level of risk he feels comfortable enduring. He can either invest in mutual funds or in a combination of a risk-free asset (one month T-bill and a benchmark index).

Based on our results, we suggest that an investor use Graham-Harvey metrics in order to evaluate mutual funds. The traditional measures do not highlight risk taking as effectively as GH1 or GH2. If an investor only looks at historical returns to determine future performance, he does not understand the complexities of the market.

In order to optimize an equity investment portfolio, we recommended that an investor invests in the index fund for domestic equity or utilize dynamic trading strategies to achieve superior results and carefully select international funds based upon the Graham-Harvey measures.

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