Business School

ACTL4303 AND ACTL5303

ASSET LIABILITY MANAGEMENT

Week 12
Currency and International Diversification
Performance Measurement and Attribution

Revision (1)
Market efficiency, anomalies, and behavioral finance
Fundamental law and transfer coefficient
The three hurdles for active management:
1. Are there anomalies to market efficiency?
2. Can some managers translate anomalies into consistent
outperformance?
3. Can funds reliably appoint and retain successful managers?
Secured Loans how secure? Spread duration. Secondary market
liquidity. The cycle of default rates.
FCFF versus DDM. CAPM beta adjustments.
Hedge funds. Alpha reliability net of fees versus market risk premiums.

Revision (2)
Economic indicators. What leads, what lags? How foes the market move
relative to the economy?
APRA SPG-530 and asset allocation, constant mix rebalancing
Black-Litterman
The asset-liability modeling framework and interest rate sensitivity

Australian Equity Manager Performance

Mercer Survey Rolling 3 Year Quartiles and Median

Past performance is not a reliable indicator of future performance. You should not rely on
past performance to make investment decisions

Australian Equity Manager versus Fund Performance

- periods ending June 2015

Sources: S&P/ASX, Mercer, FTSE/ASFA, SuperRatings

Active Management contribution is Mercer survey median minus S&P/ASX 200
Tax Effect is FTSE ASFA Superannuation Index less non-tax adjusted index
Super Fund Fees are estimated from a survey of Fund Product Disclosure Statements
Median Super Fund is from SuperRatings (SR50) Australian Share Options Survey.

Past performance is not a reliable indicator of future performance. You should not rely on
past performance to make investment decisions

Practical Beta Estimation (3)

Thin trading can lead to low beta estimates trade to
trade estimation, Dimson and Marsh (1983)
Direct Leverage Adjustment

bL = bU (1+ (1- t) ( D / E ))
if a stock has the same unlevered beta as the market its
beta can still be different to one due to leverage

Multifactor Model Example

Ri = E(Ri) + BetaGDP (GDP) + BetaIR (IR) + ei
Ri = Excess return for security i
GDP = GDP deviation from expected
BetaGDP= Factor sensitivity to GDP deviation
IR = Interest rate deviation from expected
BetaIR = Factor sensitivity for Interest Rate deviation
ei = return due to firm specific events

US Leading Economic Indicator

- Conference Board

Note the equity market is a leading economic indicator. Economic

indicators dont lead the market
8

US Coincident, Lagging Indices

The market cycle leads the business cycle

The market cycle is more ahead of the business cycle at the peak than the
trough
The market cycle transpires in phases, often starting abruptly
10

Firm Valuation Model

t=

ValueofFirm =
t=1

FCFF t

(1+WACC )

The current value of equity is obtained by deducting the

value of outstanding debt from the value of the firm
The FCFF is a pre debt cash flow and is independent of
the current capital structure
However some assumption about an optimal capital
structure needs to made to determine the WACC
As with the DDM the cash flows can be summarised in
phases

11

Free Cash Flow to the Firm (FCFF)

FCFF = EBIT x (1 Tax rate)
+ Depreciation
- Capital Expenditure
- (Working Capital)
If statements comply with US GAAP (Generally Accepted
Accounting Principles):
FCFF = Cash flow from operations
+ Interest expense x (1 Tax rate)
- Capital Expenditure
FCFE = FCFF Interest expense x (1 Tax rate)
12

Decomposition of ROE

ROE =

Net Profit

Pretax Profit
(1)

Tax
Burden

Pretax Profit

(2)

Sales

EBIT
x

EBIT

(3)

Sales

Assets
x

(4)

Assets
Equity

(5)

Interest
Burden

Margin x Turnover x Leverage

When forecasting ROE or ROA and trending towards stable

assumptions, a margin/turnover decomposition can be useful
13

Managing asset allocation around the Strategic

Asset Allocation (1)
Perold and Sharpe, Dynamic Strategies for Asset Allocation, FAJ Jan-Feb
1988
How to respond as market movements change the asset allocation
Constant mix rebalancing (CMR) sells the outperforming asset class and
buys the underperforming asset class
CMR is effective, and enhances performance, when markets oscillate
without trend
Usually operates after a threshold of drift is breached
However if an asset class trends (equities in a bull market) CRM will
underperform buy and hold

Constant Mix Rebalancing

This weeks coverage

Bodie et al
Chapter 24
Chapter 25
Revision

Portfolio performance evaluation

International diversification

16

Portfolio and asset returns

- income recognition
When an asset pays income, the price falls and the income is no longer
embedded in the price
An asset return calculation therefore adds income to change in price
At the portfolio level the valuation retains the income generated by
assets, because it is not typically payed out of the portfolio
A portfolio return calculation does not add income to change in
valuation because the change in valuation already includes asset
income

-P
P
Asset Return =
P
t

t-1

+It

t-1

17

Time Weighted (TWR) and Money Weighted

Returns (MWR)
Benchmark returns are time weighted so portfolio return calculations
need to be time weighted for comparison
Time weighted returns for a period (eg 3 years) are calculated as the
product of sub-period returns (eg monthly)
Sub-period returns should ideally also be calculated time weighted
In practice sub-period returns are sometimes money weighted
because of legacy custodian practices
Money weighted sub-period returns should be avoided where possible,
particularly where cash flows are significant and/or intra-period market
behaviour is uneven

18

The sub-period portfolio return

When cash flows occur there are two choices:

1. Adjust for the cash flows using a Modified Dietz calculation
MWR =

V1 -V0 - CFt
V0 + Wt CFt

2. Revalue the portfolio on the date of cashflow

Vt - CFt V1
TWR =

V0
Vt
19

Calculation of sub-period returns (1)

Example
A portfolio is valued at $100m at the end of August
A cash flow of $20m into the portfolio occurs on 20 September
The underlying return is +5% for the first 20 days of September then 10% in the final 10 days
The value of the portfolio at c.o.b 20 September is $125m ($100m x
1.05 + $20m)
The value of the portfolio at c.o.b 30 September is $112.5m ($125m x
(1 0.10))
MWR = (112.5 100 20)/(100+ 20 x 1/3) = -7.03%
TWR = ((125-20)/100) x (112.5/125) = -5.50%
The cash flow has created more exposure to the negative performance
in the final ten days, lowering the MWR below the TWR

20

Calculation of sub-period returns (2)

Recall a fund employs a custodian to maintain the records of their
portfolio, and manage custody.
The investment management agreement (IMA) will also stipulate that
the investment manager maintain comparable records
Custodians routinely reconcile their valuations to a managers portfolio
valuation at month end
This ensures agreement about portfolio holdings and accruals
(outstanding trades, income due but not received)
In the event of significant cashflow (eg 10% of the portfolio) the
custodian should be requested to value the portfolio so that a proper
TWR can be calculated
The MWR in the event of cashflows is a second best option
Where performance fees are involved accurate return calculation is
even more important

21

Net and gross of management fees

Investment management fees are normally payed directly from the
portfolio
A managers performance is normally measured gross of fees
Payments of fees should be recognised as a cash outflow and the
portfolio valuation should be gross of any fee accrual
Example: a portfolio has a gross valueation of $100m at c.o.b 30 June
and a fee accrual of $150,000 for a net valuation of $99.85m
The custodian valuation at 31 July shows a gross valuation of $105m
and a fee accrual of $50,000 for a net valuation of $104.95m
A quarterly management fee of $150,000 is payed on 20 July
The gross MWR = (105 100 (-0.15))/(100 + (-0.15)x11/31) = 5.15%
Note gross valuations are used, and the fee is treated as cash out
If the fee was the only cash flow the MWR calculation would be
reasonable in this instance because the cash flow is small

22

After tax performance

Comparing manager performance to benchmarks after tax is
complicated.
The benchmark portfolio in theory should have a cost inventory affected
by inception date, and cash flows in the same way as the managers
portfolio.
For example if the manager is forced to realise gains to meet a cash
outflow, the benchmark portfolio should be impacted similarly
After tax benchmarks are available (eg FTSE/ASFA) but these are
generic and not matched to a particular portfolios cash flow history
In practice funds can monitor tax inefficient behaviour (losing franking
entitlement by breaching the 45 day rule, realising gains after 11
months instead of 12 months)
After tax return calculations are more relevant at the overall fund level,
rather than for individual managers within a fund. A sale might realise a
short gain for the manager (15% tax) but the total fund inventory may
enable it to be a long gain (10% tax) with parcel selection.

23

Global Investment Performance Standards (GIPS)

First version 1998 by the CFA Institute
Goal is to have managers calculate and present their investment
performance consistently
All of a managers client portfolios should be grouped into composites
(eg Australian equity broad cap, Australian equity small cap etc)
If a client portfolio has the same mandate specifications as the
composite it must be included in that composite
Managers should present results for the relevant composite in
marketing presentations, rather than selecting the best performing
portfolio(s)
Returns should be presented annually, rather than concealed in multiyear averages
Returns for periods less than a year should not be annualised

24

Sharpe, Treynor, Jensen, M2 or Information Ratio?

The decision about market exposure (beta) normally rests with the
superannuation fund, not external managers
An equity manager is expected to have a beta close to one and
performance is measured in excess of index typically without beta
adjustment
It is worthwhile validating that beta is close to one for risk management
The information ratio is therefore the common measure in practice
In a multi-manager configuration tracking error still matters, and does not
diversify away
The exception to the information ratio is absolute return managers (eg
hedge funds) where the Sharpe measure is more appropriate

ap
IR=
s (ep )

SharpeMeasure =
25

(rp - rf )

sp

Information Ratio
The numerator, p , is normally taken as the simple excess of portfolio
return over the market, without explicit beta adjustment
This is equivalent to assuming that the underlying beta is 1
Similarly, (ep) , is the volatility of portfolio returns in excess of the market
(rP rB)
In practice calculations are made on monthly excess returns and the ratio
is annualised by sqrt(12)
A cleaner approach mathematically is to work with ln((1+rP)/(1+rB)) so that
the sqrt(12) annualisation is mathematically appropriate
Even then the underlying assumption is that monthly active returns are
independent
Where there is serial correlation of active returns due to style bias the
annualised volatility via this simple approach is understated
Bear this in mind in manager configuration (risk budgeting)

26

Performance Attribution (1)

An investment option within a superannuation fund will usually have a
strategic asset allocation (SAA) giving benchmark weights for each
asset class
A passive index, not always replicable (eg property), can be established
for most asset classes
Benchmarks for private equity and absolute return strategies are less
obvious. In practice you might use public market indices and cash
respectively.
The objective of attribution analysis is to analyse the incremental
performance relative to benchmark by the activities which contribute to it
asset allocation and security selection

RP - RB = AA + SS

27

Performance Attribution (2)

The framework is based on representing portfolio and benchmark returns as
the sum of products of asset class weights and asset class returns
n

i=1

i=1

t=1

RP - RB = wPi rPi - wBi rBi = (wPi rPi - wBi rBi )

n

i=1

i=1

= (wPi - wBi ) rBi + wPi (rPi - rBi )

n

i=1

i=1

= (wPi - wBi ) (rBi - RB ) + wPi (rPi - rBi )

Note the last step works because the sum of difference in weights must
be zero

28

Performance Attribution (3)

Asset
Security
Asset Portfolio
Portfolio Benchmark Benchmark Allocation
Selection
Class Allocation Return
Allocation Return
Contribution Contribution
Equities
50%
3.00%
60%
2.00%
-0.045%
0.500%
Bonds
50%
0.50%
30%
1.00%
-0.110%
-0.250%
Property
0% NA
10%
0.50%
0.105%
0.000%
100%
1.75%
100%
1.55%
-0.050%
0.250%

The asset allocation contribution for bonds is (50%-30%)x(1.0%-1.55%)=0.110%

The benchmark bond return, while positive, is less than the benchmark
portfolio return
Allocating more to bonds makes a negative contribution
There is no portfolio return for property but the security selection item is
multiplied by the portfolio allocation of 0%, so the table is complete

29

Multi-Period Performance Attribution(1)

The attribution elements need to be converted to a multiplicative
structure for multi-period attribution
n

AAt = (wtPi - wtBi ) (r tBi - RtB )

i=1

SS t = wtPi (r tPi - r tBi )

i=1

t
t
1+
R
+
AA
B
1+ AA*t =
1+ RtB

1+ SS =
t
*

1+ RtB + AAt + SS t
1+ RBt + AAt

30

1+ RPt
=
1+ RBt + AAt

Multi-Period Performance Attribution(2)

The attribution ratios are then multiplied through time to
calculate full period attribution
p

t=1

t=1

AA = ( (1+ RBt )) ( (1+ AA*t ) -1)

p

t=1

t=1

SS = ( (1+ RBt ) (1+ AA*t )) ( (1+ SS*t ) -1)

p

t
(1+
R
)
-1
=
(
(1+
R

B ) -1) + AA + SS
t
P

t=1

t=1

31

Performance attribution in practice

It is more straightforward to attribute gross performance rather than
after tax/fees performance
The impact of tax and fees can be summarised at the total portfolio
level
A portfolio return may not exactly equal the sum of products of sector
weights and sector returns due to cashflow distortions etc
At the calculation stage any discrepancy should be isolated in subperiod and multi-period attribution not obscured by arbitrarily merging
with other elements
If the discrepancy accumulates significantly over time then there could
be something structurally wrong with the attribution framework (eg the
portfolio returns have been assumed gross of fees when in fact they
have been calculated net)
Random unbiased discrepancies should not accumulate significantly

32

Australian companies investing overseas (1)

NABs US adventure
NAB sells off HomeSide (Money Management 12/12/01)

National Australia Bank (NAB) has rid itself of its troubled

American mortgage business, HomeSide, after offloading it to
Washington Mutual Inc for $3.7b
The Florida-based business , acquired by NAB in 1997 for
$1.7b , made spectacular losses of more than $3b as a result
of bungled interest-rate calculations
NAB chief executive Frank Cicutto vowed .. That NAB would
never again revisit mortgage products in foreign markets

33

Australian companies investing overseas (2)

NABs UK adventure
NAB committed to UK despite Clydesdale downgrade (AFR
29/9/11)
NABs Clydesdale on credit watch in Britain (AFR 2/6/13)
Brokers urge NAB to move on Clydesdale sale (AFR
21/1/14)
RBS fallout casts shadow over NAB UK (AFR 29/1/14)
Cameron Clyne confident NAB will get out of UK (AFR
10/9/14)
NAB flags profit drop on $1b UK write-downs (AFR 9/10/14)
34

Australian companies investing overseas (3)

QBEs ill-fated global acquisition strategy
QBE buys into Argentina, Hong Kong (AFR 7/3/12)

QBE playing catch-up after aggressive expansion (AFR

21/1/13)
Profit warning tipped for QBE after US strife (AFR 9/12/13)
QBE should sell Winterthur, take write-down (AFR 15/4/14)
Argentinian woes cause yet another QBE downgrade (AFR
30/7/14)

35

Australian companies investing overseas (4)

Rio takes massive loss on Mozambique sale (paid $3.9b,
sold for $50m) (AFR 31/7/14)
We were a company with $500 million in cash, rail, port,
wagons, the mine was already developed, the wash plant
was going and they still managed to screw it, he said.
And I dont want to talk publicly about how that happened,
but thats just an example of how these things work.
They just think they are sending people from here to there
and think, Oh yeah, how hard can that be?
And its bloody hard. You have to manage it and you have to
manage it well. vendor who initially sold asset to RIO
36

Australian companies investing overseas (5)

Some companies have unique products that generate strong demand
overseas (eg Cochlear hearing implants, Computershare registry
services)
But generally Australian companies tend to acquire smaller overseas
operations that are cheap often because they are in compromised
competitive positions
At the outset there is hope that the talents of Australian management
can turn these frogs into princes (why hasnt a local acquirer tried?)
In practice that is often a steeper challenge than it first appears
Overseas diversification via the overseas subsidiaries of Australian
companies is a constrained alternative
Buying overseas companies gives access to stronger global companies
Are these available at good prices?

37

Sovereign Risk
Kingsgate Consolidated Limited (ASX: KCN) wishes to advise
that business is continuing as usual at its Chatree operations in
Thailand following the move by the army to take control of the
administration of the country on Wednesday 22 May. This
followed the imposition of martial law on Tuesday 20 May 2014
which was implemented after several months of anti-government
protests in Bangkok.

Company Announcement 27/5/14

38

Social Capital and Economic Development

Social capital is the set of institutions including the legal
framework, the financial system, the nature of corporate
governance, political practices and traditions, educational and
health levels, the structure of taxes, etc. that determine the
way individuals are given incentives to create value with the
tools and infrastructure that they have.
Michael Pettis, Peking University
The Pettis thesis is that a deficiency in social capital makes it
hard for developing economies to transition to developed
economies. The development of social capital conflicts with the
interests of entrenched rent-seeking elites.
39

Emerging markets (1)

Emerging markets currently represent around 11% of the MSCI All

Countries Index. Volatility of 24% compares to 18% for developed
markets

40

Emerging markets (2)

41

Does stronger economic growth mean higher

equity returns?
For 19 developed markets since 1900 the correlation is firmly negative
(-0.39 in local currency, -0.32 in $US)
For 22 developed markets over the period 1970-2011 the correlation is
virtually zero (-0.04 in local currency, 0.01 in $US)
For 15 emerging markets over the period 1988-2011 the correlation is
firmly negative (-0.41 in local currency and -0.47 in $US)
Equity returns depend on profitability per share
Economic growth can occur through expansion of the capital base (debt
and equity funded) without improvement in profitability per share
Scrutiny of how companies manage their capital (adequate returns on
retained capital) is an important prerequisite for equity performance
Capital management may be better scrutinised in developed markets

42

Exposure to non-$A currencies improves

diversification (to a point)

43

Asset and currency separation (1)

A portfolio has two layers of allocation
Asset class weights, divisible by country (eg US equity allocation) which
add to 100%
Currency allocation weights (eg to $A, $US, Euro, Yen etc) which add to
100%
For example it is possible to allocate to UK equities, but cross-hedge
the currency exposure to Euro
Separating assets and currencies allows allocation to strong markets in
local currency terms, but where the currency is weak
Without separation a perspective on the currency will influence the
allocation to the asset (eg avoid markets where currency is weak)
Asset returns should be considered in excess of the local interest rate,
and currency returns considered as including the local interest rate
In that way currency allocation creates forward premiums

44

Asset and currency separation (2)

Asset

Currency

Australian
Equities

50

$A

60

US Equities

25

$US

15

European Equities 10

Euro

20

Japanese Equities 15

Yen

100

100

Starting with the currency profile of the assets, this currency allocation
could be achieved by a 10% cross-hedge from Yen to Euro, and a
10% hedge from $US to $A. Currency hedging establishes a new
currency exposure and an interest rate differential (forward premium).

45

Currency and asset correlation - Australia

Asset returns in this illustration are a composite of 40% Australian

equities, 30% international shares (hedged), 15% Australian bonds
and 15% international bonds (hedged). R-squared is 21%.

46

Currency and asset correlation - Australia

International investors view Australia as a global cyclical exposure
When the global economy is strong, Australias terms of trade tend to be
strong (commodities) and the Australian dollar is well supported.
Overseas investors are attracted to Australian assets, especially
resource companies
When there are concerns about the global economy overseas investors
have less appetite for the Australian dollar, and Australian assets
In times of crisis overseas investors have a tendency to repatriate
capital, selling peripheral asset/currency exposures
For the above reasons the Australian dollar has a tendency to be weak
when assets returns are weak
But there is a silver lining - Australian dollar weakness buoys the returns
from overseas assets due to currency translation

47

Revision Focus
CAPM, market efficiency for and against
Modeling asset class returns equity trend stationarity, Nelson Siegel,
regime switching, historical context
Expectations of asset class returns Black-Litterman
Inflation and asset class returns, by type of inflation
Equity management styles value and growth
Property - valuation
Risk budgeting manager allocation

48

Thank you for your attention

Greg Vaughan
School of Risk and Actuarial Studies
University of New South Wales

49