Are managers delivering on investors’ expectations? Guest blog from Ralph Frank

Question

 

An investor appoints an active manager in the hope that this manager will outperform the agreed benchmark by a specified amount within an agreed risk tolerance.  Assessing whether the manager has delivered on this expectation should be relatively straightforward.  However, many investors want to be able to compare how their manager compares to other managers too.  This wider comparison is usually more challenging given the different benchmarks, performance targets, risk metrics and attaching tolerances that the managers run their portfolios against.  Charlton Frank has developed a practical approach to facilitating this wider comparison.

 

The ‘purchase’ decision when investing in an actively managed strategy, in most cases, involves the investor effectively being sold on the strategy’s benchmark, return target relative to the benchmark, definition of risk and corresponding risk budget.  Some larger investors might be able to negotiate these parameters in light of the investor’s specific requirements.  Ultimately, these parameters frame the investor’s assessment as to whether the expectations at purchase have been met.  Different strategies have different parameters but these differences should not render comparison of delivery on expectation impossible.

 

The first step in the process is to consider whether the manager has delivered on the excess return targeted relative to the benchmark.  Comparability across different strategies is achieved by considering what percentage of the excess return targeted has been achieved.  For example, if an excess return of 2% p.a. relative to the benchmark is being targeted and the strategy has delivered a return of 19% compared to a benchmark return of 18% then 50% of the target has been delivered.

 

The second step in the process is to assess how much of the risk budget has been utilised in delivering the performance outcome.  Different strategies will have different definitions of risk (e.g. volatility, drawdowns etc.) – there is no single ‘correct’ measure of risk.  Some strategies might have multiple risk metrics but a single metric, usually the one that binds first in most cases, needs to be ‘nominated’ for use in the assessment process.  The investor is effectively signing up to the risk metric used when investing in a particular strategy.  The investor is also indicating a comfort with the maximum level of risk that the strategy is being managed within.  This maximum level of risk is also referred to as the ‘risk budget’.  Comparability is achieved by assessing what percentage of the risk budget has been used in delivering the returns over the corresponding period (that the returns are calculated).  The percentage approach cancels out the bias created by the risk measure in question.  From a computational perspective, if the strategy is being run with a risk budget of 5% per annum but 2% of risk is realised then 40% of the risk budget has been utilised.

 

A simple ratio of: {the percentage of the excess return achieved compared to that targeted} divided by {the percentage of the risk budget utilised compared to the maximum anticipated} does give an indication of whether the strategy has met the investor’s expectations.  However, this ratio does not guide as to whether the manger has remained within the risk budget that the investor has signed up to.  A manager might achieve a multiple of the return target by taking a corresponding multiple of the risk – not what the investor was looking for, despite the risk taken having paid off in this instance.

 

The simple ratio above can be modified to control for whether the manager has remained within the risk budget by adding a term of: {1 – the percentage of the risk budget utilised compared to the maximum anticipated}.  If the risk budget is exceeded then this term detracts from the overall score.  For example, if the strategy is being run with a risk budget of 5% per annum but 7.5% of risk is realised then 150% of the risk budget has been utilised and this modification term has a value of -0.5.

 

Charlton Frank’s overall construct, referred to as the ‘Modified Risk-Adjusted Outcome’ (“MRAO”), is computed as follows: {{the percentage of the excess return achieved compared to that targeted} divided by {the percentage of the risk budget utilised compared to the maximum anticipated}} plus {1 – the percentage of the risk budget utilised compared to the maximum anticipated}.

 

No single metric can capture all aspects of the performance of an investment strategy.  For example, product providers might seek to game the MRAO by setting a low excess return target and/or a wide risk budget.  However, these factors will stand out in a side-by-side comparison of strategies.  The choice of benchmark and/or risk metrics might well have an impact too.

 

The comparison of actively managed strategies, whether traditional products or services such as fiduciary management, is seldom straightforward.  However, metrics can be computed to aid in this comparison.  The Modified Risk Adjusted Outcome, described above, gives an indication as to whether the risk and return expectations created by the manager and signed-up for by the investor have been met.  The MRAO facilitates comparison of strategies with different benchmarks, return targets relative to the benchmarks, definitions of risk and/or corresponding risk budgets.  Charlton Frank will be applying the MRAO in upcoming analyses, including an assessment of the UK Fiduciary Management market in conjunction with Spence Johnson.

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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1 Response to Are managers delivering on investors’ expectations? Guest blog from Ralph Frank

  1. Reblogged this on rennydiokno.com.

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