Now that we can effectively calculate performance on an absolute basis, we can begin to analyze the performance compared to relevant bench- marks. A benchmark is a group of financial instruments that are pooled to- gether to represent a particular element within an asset class, an entire asset class, or the entire market. For example, the Frank Russell 2000 In- dex (Russell 2000) is designed to represent the returns of the U.S. small cap
PDR EMV BMV CF
BMV CF PDR
PDR PDR PDR
3= − −
+
= − −
+
=
=
=
3
3
3 3
2 000 000 1 575 000 350 000 1 575 000 350 000 75 000
1 925 000 0 039 3 90
$ , , $ , , $ ,
$ , , $ ,
$ ,
$ , , .
. %
PDR EMV BMV CF
BMV CF PDR
PDR PDR PDR
2= − −
+
= − −
+
=
=
=
2
2
2 2
1 575 000 1 050 000 450 000 1 050 000 450 000 75 000
1 500 000 0 05
5 00
$ , , $ , , $ ,
$ , , $ ,
$ ,
$ , , .
. %
Performance Analysis 55
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market. The Russell 2000 is further subdivided into growth and value in- dexes for accurate style comparisons.
Equity Benchmarks
Benchmark selection is a critical element of the analytical process because it effectively allows us to compare apples to apples. Exhibit 4.8 provides a list of some of the more popular U.S. equity benchmarks along with de- scriptions and some factual data. This exhibit breaks the range of bench- marks into categories based on market capitalization and investment style.
Exhibit 4.9 is similar to the previous exhibit, only it illustrates the range of non-U.S. equity benchmarks and breaks the list out by geographical region and investment style.
56 EQUITY AND FIXED INCOME MANAGER ANALYSIS
EXHIBIT 4.8 U.S. Equity Benchmarks
Market Investment Style
Capitalization Value Core Growth
All-Cap Russell 3000 Value Wilshire 5000 Russell 3000 Russell 3000 Growth Large-Cap Barra/S&P 500 Value S&P 500 Barra/S&P 500
Russell 1000 Value Dow Jones Growth Wilshire Large Value Russell 1000 Russell 1000
Wilshire 5000 Growth Wilshire Large
Growth Mid-Cap Barra/S&P Mid Value S&P MidCap Barra/S&P Mid
Russell 2500 Value Russell 2500 Growth Wilshire Midcap Value Wilshire MidCap Russell 2500
Growth Wilshire
MidCap Growth Small-Cap Barra/S&P Small Value S&P SmallCap Barra/S&P
Russell 2000 Value Russell 2000 Small Growth Wilshire Small Value Wilshire Smallcap Russell 2000
Growth Wilshire Small
Growth
Micro-Cap DFA 9-10
Wilshire Microcap Callan Microcap ccc_travers_ch04_39-76.qxd 6/2/04 4:07 PM Page 56
Now that we have discussed how to calculate performance and have identified a wide variety of potential benchmarks, we can start to apply them to the case study. Using the data from the CAM Investment Manager report shown in Exhibit 4.1, we can target some of the U.S. small-cap benchmarks identified in Exhibit 4.8.
You may remember from the RFI that we did not ask the manager to provide annualized returns or to make any benchmark comparisons, but CAM did this anyway. Note that CAM uses the S&P 600 SmallCap Index for comparative purposes. However, our discussion on investment bench- marks identified several small-cap “value” benchmarks that might be a more appropriate comparison than the broad or “core” S&P 600 index.
In any case, we will take the historical monthly returns that CAM pro- vided and calculate the product’s performance utilizing the performance formulas covered earlier in this chapter. Using the chain-linking and annu- alizing formulas, we calculate returns for CAM and compare those returns to the S&P 600 SmallCap Value Index as well as the style neutral S&P 600 SmallCap Index (see Exhibit 4.10).
The highlighted rows represent the value added, or the rate of return for the CAM portfolio in excess of the benchmark return over the same pe- riod of time. This exhibit clearly indicates that CAM has performed very well relative to both the small-cap index and the small-cap value index. In fact, the only period in which the CAM portfolio underperformed either benchmark was in the three-year annualized return versus the small-cap value benchmark—and it was only by a modest 0.1%. Since the portfolio’s inception, January 1998, it had outperformed the small-cap benchmark by 5.2% (520 basis points) and the small-cap value benchmark by 5.00%
Performance Analysis 57
EXHIBIT 4.9 Non-U.S. Equity Benchmarks
Geographical Investment Style
Region Value Core Growth
World MSCI World MSCI World MSCI World
FT World
EAFE MSCI EAFE MSCI EAFE MSCI EAFE
FT EAFE
Developing MSCI Individual MSCI Individual MSCI Individual
Markets Country Country Country
FT Individual Country
Emerging Markets MSCI Individual MSCI Emerging MSCI Individual
Country Markets Country
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(500 basis points) on an annualized basis. For future reference, make note that a “basis point” represents a 0.01% return and can be stated as either positive or negative. This exhibit clearly shows that CAM has performed well in the recent past (year-to-date, one-year periods) and over the longer term (five-year and inception periods).
However, the three-year comparative return is more subdued. We can deduce that something had a negative impact on relative performance roughly two to three years ago. To gain a better understanding of when this occurred, we review the calendar year performance in Exhibit 4.11.
The relative performance table in Exhibit 4.11 indicates what we had expected—that the CAM portfolio had experienced some performance problems in the middle of its track record relative to the small-cap value benchmark. Specifically, the CAM portfolio underperformed the small-cap value index in years 2000 and 2001.
Exhibit 4.12 breaks down the performance of the CAM portfolio and contrasts it to the performance of the benchmarks on a monthly basis. The table lists the monthly returns and calculates the value added in the columns to the right. The value added is simply the difference of the return of the CAM portfolio minus that of the benchmark. The highlighted num- bers represent negative relative performance. This table is simple in design, but tells plenty about the portfolio’s performance history and specifically about its performance consistency.
58 EQUITY AND FIXED INCOME MANAGER ANALYSIS
EXHIBIT 4.10 Relative Annualized Performance (Periods Ended June 2003) YTD 1 Year 3 Years 5 Years Inception
CAM 15.9% –2.7% 7.9% 8.6% 9.7%
S&P SmallCap Value Index 13.0% –8.4% 8.0% 3.8% 4.8%
Value added 2.9% 5.7% –0.1% 4.7% 5.0%
S&P SmallCap Index 12.9% –3.6% 2.4% 3.7% 4.5%
Value added 3.0% 0.8% 5.5% 4.8% 5.2%
EXHIBIT 4.11 Calendar Year Performance
2003
1998 1999 2000 2001 2002 (YTD)
CAM 0.9% 24.1% 14.8% 10.7% –9.6% 15.9%
S&P SmallCap Value Index –5.1% 3.0% 20.9% 13.1% –14.5% 13.0%
Value added 5.9% 21.0% –6.1% –2.4% 4.9% 2.9%
S&P SmallCap Index –1.3% 12.4% 11.8% 6.5% –14.6% 12.9%
Value added 2.2% 11.7% 3.0% 4.2% 5.0% 3.0%
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59 EXHIBIT 4.12Monthly Performance Comparison Value Added Monthly Performance HistoryCAM Portfolio Versus CAMSmall CapSmall CapSmall CapSmall Cap PortfolioIndexValue IndexIndexValue Index Jan-98–1.23%–2.0%–2.1%0.72%0.84% Feb-988.34%9.1%8.4%–0.77%–0.03% Mar-985.67%3.8%5.0%1.85%0.71% Apr-981.21%0.6%0.7%0.62%0.56% May-98–5.21%–5.3%–4.4%0.08%–0.84% Jun-981.89%0.3%–0.1%1.60%1.94% Jul-98–8.34%–7.7%–9.2%–0.69%0.91% Aug-98–19.45%–19.3%–18.0%–0.15%–1.41% Sep-986.45%6.1%5.3%0.33%1.15% Oct-984.89%4.6%4.4%0.25%0.52% Nov-985.42%5.6%4.3%–0.21%1.15% Dec-984.99%6.4%3.9%–1.40%1.06% Jan-99–0.70%–1.3%–1.1%0.56%0.45% Feb-99–7.21%–9.0%–8.1%1.80%0.93% Mar-99–0.20%1.3%–0.4%–1.49%0.19% Apr-997.21%6.6%8.7%0.60%–1.50% May-994.51%2.4%4.0%2.08%0.52% (Continued) ccc_travers_ch04_39-76.qxd 6/2/04 4:07 PM Page 59
60
EXHIBIT 4.12(Continued) Value Added Monthly Performance HistoryCAM Portfolio Versus CAMSmall CapSmall CapSmall CapSmall Cap PortfolioIndexValue IndexIndexValue Index Jun-995.82%5.7%6.1%0.13%–0.25% Jul-990.20%–0.9%–1.6%1.08%1.76% Aug-99–5.12%–4.4%–4.2%–0.72%–0.93% Sep-991.90%0.4%–1.8%1.48%3.74% Oct-991.10%–0.3%–2.3%1.35%3.41%Outperformance Nov-995.20%4.2%2.2%1.02%2.96%Period Dec-9910.45%8.2%2.7%2.23%7.71% Jan-00–2.30%–3.1%–5.1%0.80%2.82% Feb-0015.34%13.4%4.5%1.95%10.82% Mar-00–6.54%–3.7%3.7%–2.84%–10.23% Apr-00–1.76%–1.7%0.7%–0.05%–2.46% May-00–2.11%–3.0%–1.6%0.85%–0.48% Jun-004.54%5.9%2.9%–1.37%1.67% Jul-00–2.17%–2.5%2.0%0.29%–4.14% Aug-008.26%8.9%5.8%–0.60%2.42%Underperformance Sep-00–1.16%–2.7%–0.2%1.56%–0.96%Period Oct-001.17%0.6%0.5%0.54%0.68% Nov-00–7.23%–10.4%–6.6%3.18%–0.62% Dec-0010.34%12.3%14.1%–1.98%–3.78% Jan-016.79%4.3%7.9%2.50%–1.13% Feb-01–4.56%–6.1%–4.2%1.54%–0.34%
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Mar-01–3.21%–4.6%–4.2%1.38%0.94% Apr-017.54%7.6%6.0%–0.08%1.52% May-013.45%1.9%2.5%1.54%0.90% Jun-011.24%3.7%3.8%–2.43%–2.58% Jul-01–1.45%–1.7%–0.9%0.22%–0.51% Aug-01–0.65%–2.3%–1.6%1.63%0.96% Sep-01–15.55%–13.5%–14.3%–2.03%–1.24% Oct-015.21%5.3%4.6%–0.12%0.64% Nov-017.54%7.3%8.0%0.22%–0.46% Dec-016.54%6.8%7.2%–0.23%–0.68% Jan-022.32%0.9%1.9%1.45%0.45% Feb-02–1.34%–1.7%–0.4%0.38%–0.91% Mar-0210.89%7.9%8.7%2.99%2.20% Apr-025.11%2.8%4.1%2.28%1.02% May-02–5.21%–4.1%–3.8%–1.07%–1.42% Jun-02–3.43%–5.2%–4.5%1.74%1.04% Jul-02–15.87%–14.1%–16.3%–1.75%0.39% Aug-020.02%1.0%–0.1%–0.93%0.15% Sep-02–6.50%–6.1%–7.4%–0.38%0.86% Oct-023.45%3.2%2.0%0.25%1.44% Nov-026.54%5.2%5.4%1.34%1.14% Dec-02–3.21%–3.4%–2.6%0.16%–0.57% Jan-03–3.45%–3.4%–4.1%–0.01%0.68% Feb-03–3.21%–3.2%–3.7%–0.01%0.49% Mar-030.23%0.8%–0.3%–0.56%0.54% Apr-039.17%8.1%9.0%1.05%0.13% May-038.76%8.1%9.3%0.70%–0.56% Jun-034.21%2.6%3.0%1.61%1.24%
61
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The CAM portfolio significantly outperformed the small-cap value benchmark in the period beginning July 1999 and ending February 2000.
This is significant because it coincides with the end of the bull run in the eq- uity market, particularly the final stages of the technology bubble. This infor- mation is contrary to what we would normally expect a value manager to show for this period, as value was generally out of favor. Investment man- agers and products that had a growthphilosophy or style largely dominated over this period. Over that eight-month period, the CAM portfolio returned 28.2% versus a –5.8% return for the small-cap value benchmark and a 17.6% return for the broad small-cap benchmark. These comparisons are ex- traordinary and very unusual for a value manager over that period of time.
This period of extreme outperformance was followed immediately by a longer period of underperformance that began the following month, March 2000, and ended a year later in February 2001. Over this period of relative underperformance, the CAM portfolio gained a modest 3.8% ver- sus a gain of 26.0% for the small-cap value benchmark and a loss of –0.4% for the broad small-cap benchmark. In addition, the CAM portfolio experienced some choppy performance in the period beginning June 2001 and ending in February 2002. The examination of the performance num- bers relative to the benchmarks on a monthly basis has graphically illus- trated that the CAM portfolio needs to be examined more closely over specific periods if we are going to gain a thorough understanding of the portfolio and, ultimately, make an accurate assessment of the portfolio manager’s skill.
Because the CAM portfolio returns have several performance periods that seem out of line with the small-cap value benchmark and possibly more in line with the small-cap growth benchmark, Exhibit 4.13 takes the monthly comparison table and adds the small-cap growth benchmark for comparative purposes. The exhibit also focuses exclusively on the two pe- riods of out/underperformance previously identified.
The highlighted numbers in the “value added versus” columns repre- sent months of negative relative performance. A quick glance at this table indicates that the CAM portfolio acted more like the growth index during the first period under review (7/99–2/00), as the relative performance num- bers are smaller when compared to the growth index versus the value in- dex. The table further indicates that the CAM portfolio achieved returns somewhere in between the value and growth benchmarks over the subse- quent period (3/00–2/01). In summary, the table shows that the CAM port- folio performed in exactly the opposite manner in each period, as it outperformed the value index and underperformed the growth index in pe- riod one, which reversed in the following period. The summary perfor- mance statistics can be found in Exhibit 4.14.
62 EQUITY AND FIXED INCOME MANAGER ANALYSIS
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Performance Analysis 63
EXHIBIT 4.13 Monthly Performance Comparison versus Small-Cap Value and Growth Indexes for Outlier Periods
Monthly Performance History Value Added Versus Small Cap Small Cap Small Cap Small Cap
CAM Value Growth Value Growth
Portfolio Index Index Index Index
Jul-99 0.20% –1.6% –0.2% 1.76% 0.44%
Aug-99 –5.12% –4.2% –4.6% –0.93% –0.53%
Sep-99 1.90% –1.8% 2.4% 3.74% –0.47%
Oct-99 1.10% –2.3% 1.5% 3.41% –0.41%
Nov-99 5.20% 2.2% 5.8% 2.96% –0.57%
Dec-99 10.45% 2.7% 12.4% 7.71% –1.97%
Jan-00 –2.30% –5.1% –1.4% 2.82% –0.92%
Feb-00 15.34% 4.5% 20.9% 10.82% –5.52%
Mar-00 –6.54% 3.7% –9.1% –10.23% 2.58%
Apr-00 –1.76% 0.7% –3.8% –2.46% 2.05%
May-00 –2.11% –1.6% –4.3% –0.48% 2.17%
Jun-00 4.54% 2.9% 9.1% 1.67% –4.55%
Jul-00 –2.17% 2.0% –6.8% –4.14% 4.67%
Aug-00 8.26% 5.8% 12.1% 2.42% –3.79%
Sep-00 –1.16% –0.2% –5.3% –0.96% 4.16%
Oct-00 1.17% 0.5% 0.8% 0.68% 0.39%
Nov-00 –7.23% –6.6% –15.0% –0.62% 7.77%
Dec-00 10.34% 14.1% 9.2% –3.78% 1.15%
Jan-01 6.79% 7.9% 0.1% –1.13% 6.71%
Feb-01 –4.56% –4.2% –8.5% –0.34% 3.93%
EXHIBIT 4.14 Cumulative Performance in Outlier Periods
Benchmarks
CAM Small Cap Small Cap
Out/Underperformance Periods Portfolio Small Cap Value Growth July 1999 to February 2000 28.2% 17.6% –5.8% 40.2%
Value added 10.6% 34.0% –12.0%
March 2000 to February 2001 3.8% –0.4% 26.0% –22.7%
Value added 4.2% –22.2% 26.5%
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Up/Down Market Analysis
Another very effective type of performance analysis takes into account the movement in the overall market. The up/down chart uses a benchmark’s returns as a starting point and compares the returns of the benchmark for each negative period (in our case, months) to the corresponding return for the portfolio under review (the down part of the analysis). The same is done for months where the benchmark experiences positive returns (the up part of the analysis). We then simply calculate a cumulative return for all the negative and positive months respectively for the benchmark and the portfolio under review.
Exhibits 4.15 and 4.16 are examples of CAM’s up/down chart versus both the small-cap value index and the broad small-cap index.
Focusing on the down market aspect of each of these illustrations (the two bars on the left side of the charts), we note that the CAM portfolio managed to preserve some capital when the market moved into negative territory. In Exhibit 4.15, we can see that the CAM portfolio had declined a cumulative –72.6% versus –75.9% for the small-cap value index. This means that on a cumulative basis, the portfolio has proven to be a bit more defensive than the index. The numbers are similar when compared to the broad small-cap index in Exhibit 4.16 (at –76.3% versus –78.5% for the index). What the numbers do not tell is how the portfolio manager was able to achieve that relative performance or how much additional risk, if any, the manager took on to outperform the benchmark in down markets.
When we look at the performance of the CAM portfolio relative to ei- ther benchmark during positive periods (months), we see that the portfo-
64 EQUITY AND FIXED INCOME MANAGER ANALYSIS
EXHIBIT 4.15 Up/Down Chart: CAM versus Small-Cap Value Index Down Markets
508.8%
435.3%
Small-Cap Value Index CAM Small-Cap Value Index CAM
Cululative Gain/Loss
Up Markets
–75.9% –72.6%
–200%
–100%
0%
100%
200%
300%
400%
500%
600%
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lio had been a star when the market was moving up. On a cumulative ba- sis, the CAM portfolio outperformed the small-cap value index by 74%
(509% versus 435% for the index) and the broad small-cap index by 112% (604% versus 492% for the index) in positive periods. However, we have already discovered that the CAM portfolio experienced the largest component of its relative outperformance during a single eight- month period (7/99–2/00). Because we have already flagged this period as an outlier (as the returns appear to be more indicative of the growth style than the value style) and have agreed to perform more analytics to get to the bottom of things, we will exclude those months from this particular analysis and see what the CAM portfolio was able to do once the flagged period was removed.
Exhibits 4.17 and 4.18 represent the same up/down charts as before;
however, we have excluded the outlier period (July 1999 to February 2000) from review.
What a difference. The exclusion of the eight-month outlier period had a profound impact on the up market comparisons, particularly when we look at the performance of the CAM portfolio relative to the small-cap value index (Exhibit 4.17). The cumulative performance comparison in up months went from an outperformance in excess of 70% (including the outlier period) to an underperformance of –34% (excluding the outlier pe- riod). However, the CAM portfolio still managed to outperform the broad small-cap index significantly (55%) in the up (positive) months. When we review the down market comparisons in Exhibits 4.17 and 4.18, we can see that the CAM portfolio still managed to outperform each index during down (negative) months.
Performance Analysis 65
EXHIBIT 4.16 Up/Down Chart: CAM versus Broad Small-Cap Index
Down Markets Up Markets
–78.5% –76.3%
604.1%
491.6%
Small-Cap Index CAM Small-Cap Index CAM
Cululative Gain/Loss
–200%
–100%
0%
100%
200%
300%
400%
500%
600%
700%
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When I review a manager whose portfolio experiences a period of extreme outperformance or underperformance, I like to remove the pe- riod in question to see how the portfolio performs in normal circum- stances. It is essential to gain a full understanding of what happened during the outlier period before we can make an informed decision re- garding the product. These types of questions usually spark some inter- esting discussions during the interview phase of the investment manager analysis process.
66 EQUITY AND FIXED INCOME MANAGER ANALYSIS
EXHIBIT 4.17 Up/Down Chart versus Small-Cap Value Index—Excluding Outlier Period
Down Markets Up Markets
–73.5% –72.8%
354.3%
387.6%
Small-Cap Value Index CAM Small-Cap Value Index CAM
Cululative Gain/Loss
–200%
–100%
0%
100%
200%
300%
400%
500%
EXHIBIT 4.18 Up/Down Chart versus Broad Small-Cap Index—Excluding Outlier Period
Down Markets Up Markets
–77.7% –76.0%
415.6%
360.8%
Small-Cap Index CAM Small-Cap Index CAM
Cululative Gain/Loss
–200%
–100%
0%
100%
200%
300%
400%
500%
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Peer Group Comparison
In addition to analyzing an investment product against appropriate bench- marks, peer group comparisons are also a popular method of assessing rela- tive performance. A peer group is simply a group (also referred to as a universe) of investment products with similar investment objectives. Several consulting firms calculate peer group universes on a regular basis. In addition, most (if not all) of the third party databases discussed in Chapter 2 have peer universes built right into the software. Many of the third party databases available for purchase also give users the ability to create peer universes based on their own unique sets of criteria. However, a peer group analysis is simple to create in a spreadsheet if you have the underlying return data.
Exhibit 4.19 contains information about various breakpoints in the
Performance Analysis 67
EXHIBIT 4.19 Peer Group Comparison—Small-Cap Value Universe Peer Group Breakpoints
Performance Breakpoints (%)
Percentile YTD 1 Year 3 Years 5 Years
5th 19.7 –0.2 13.7 9.1
25th 16.3 –3.5 10.4 7.6
50th 14.2 –8.0 8.1 5.6
75th 12.7 –10.2 7.7 3.8
95th 9.3 –13.5 3.1 1.0
CAM and Small-Cap Indexes Performance
Performance (%)
YTD 1 Year 3 Years 5 Years
CAM 15.9 –2.7 7.9 8.6
Small-cap 12.9 –3.6 2.4 3.7
Small-cap value 13.0 –8.4 8.0 3.8
Small-cap growth 12.7 1.2 –4.5 2.0
Ranking within Peer Universe
Percentile Rankings
YTD 1 Year 3 Years 5 Years
CAM 30th 20th 61st 14th
Small-cap 70th 27th 98th 77th
Small-cap value 61st 55th 54th 75th
Small-cap growth 75th 1st 100th 89th
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small-cap value peer universe in the top part of the table and then lists CAM’s portfolio returns as well as the benchmark returns in both absolute format (under the heading “performance”) and in relation to the peer uni- verse (under the heading “percentile rankings”).
The data for the peer universe listed under the heading “performance breakpoints” is determined by calculating the percentile ranking of each product’s return in the peer universe for each period under review. A product that has a return in the first percentile of returns in the peer uni- verse has performed in the top 1 percent of the group—or another way of stating this is to say that a product that has first percentile performance has beaten 99 percent of the products in the peer universe. Conversely, a product that performs in the 100th percentile has performed worse than all the other products in the peer universe. A product that has returned in the 50th percentile has performed right in the middle of the peer group.
Note that in Exhibit 4.19 we do not show the 1st and 100th percentiles.
Instead, we start with the 5th percentile and end with the 95th percentile.
This is done to eliminate any outliers that may stretch the performance range beyond what is reasonable and to help avoid errors in percentile rankings due to the inclusion of products that don’t fit perfectly in the peer category (more on this later on). Looking at the YTD column as a point of reference, we see that the CAM portfolio’s 15.9% return places it at the 30th percentile in the peer universe. The percentile ranking im- proves to 20th over the one-year period, falls dramatically to 61st over three years, and increases, just as dramatically, to the 14th percentile over the five-year period. Exhibit 4.20 is a very popular way of graphically showing the data in Exhibit 4.19.
This graph is commonly referred to as a quartile chart because the breakpoints separate into four return ranges. The first quartile ranges from the 5th to 25th percentile, the second quartile ranges from the 25th to 50th percentile, the third quartile ranges from the 50th to the 75th quartile, and the fourth quartile ranges from the 75th to the 95th percentile. As the chart indicates, the top box represents the first quartile and the bottom box rep- resents the fourth quartile. The CAM portfolio, which is represented in this chart by a bold “c,” had been a consistent second-quartile performer over the YTD, one-year, and three-year periods. However, the portfolio moved firmly into the first quartile over the five-year period.
The five-year quartile distribution also indicates that more than half of the small-cap manager universe outperformed the small-cap benchmarks over that period of time. We can graphically see this in Exhibit 4.20 by looking at where the three benchmarks rank over the five-year period. The chart illustrates that all three benchmarks ranked in the 3rd or 4th quar- tiles. We should keep this in mind when making any assessment of CAM’s relative outperformance over historical periods.
68 EQUITY AND FIXED INCOME MANAGER ANALYSIS
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