I can see by LOS that market, currency, and security allocation are fair game. When looking at EOC questions they will talk about comparing to world benchmark (ie q 2c and 5d) First, do you think we are responsible for this? And if so, can someone explain to me how the world index return in base currency is calculated? I understand the total, but seem to not comprehend how they attribute to each country. I ask only because you need this number to get the other allocations Thanks for your input, always helpful
EOC questions are fair game.
I kind of got lost at 5d as well!!
Can anyone explain why they’re using portfolio weights and index returns for the market component in question 5, part C? Or what’s going in the currency allocation in part D? I’m lost too…
c’mon dark, you’re the attribution pro…
Take the world index value at time 0 divided it by the exchange rate at time 0. Then take the worl index value at 1 divided by the exchange rate at 1. Finally take the difference of these calculation. It is the return of your index.
darkstar Wrote: ------------------------------------------------------- > Can anyone explain why they’re using portfolio > weights and index returns for the market component > in question 5, part C? > > Or what’s going in the currency allocation in part > D? > > I’m lost too… i think the point in C is to find the weighted (portfolio weights) market return so you can use this to find the security selection contribution.
I guess one of the purposes of index return is to find out whether the manager was taking extra currency risk or not. The other one is to find out how much would have been the return if the manager just followed the benchmark weights (that is our starting point).
ozzy609 Wrote: ------------------------------------------------------- > c’mon dark, you’re the attribution pro… OK, yesterday was a bad day (trying to get them out of my system before Saturday!) I was misreading the question, it makes sense now. Anyone want me to explain it?
darkstar Wrote: ------------------------------------------------------- > ozzy609 Wrote: > -------------------------------------------------- > ----- > > c’mon dark, you’re the attribution pro… > > OK, yesterday was a bad day (trying to get them > out of my system before Saturday!) > > I was misreading the question, it makes sense now. > Anyone want me to explain it? Absolutely!
Here we go… Reading 48, question 5: a) Calculate Local and Base (USD) portfolio returns Step 1: Calculate the weight of each country component within the portfolio =(US Dollar value of each country as of 2006) / SUM(Total US Dollar value of portfolio as of 2006) Step 2: Calculate the portfolio returns in local currency for each country =(2007 portfolio value in local currency)/(2006 portfolio value in local currency)-1 Step 3: Calculate the portfolio returns in USD for each country First, convert the 2006 and 2007 Sterling and Euro portfolio values into USD using the 2006 and 2007 exchange rates. Then, apply the same concept as Step 3. =(2007 portfolio value in US Dollar)/(2006 portfolio value in US Dollar)-1 Step 4: Calculate the total portfolio return in US Dollar and local currency =SUM(portfolio return in local currency * portfolio weight) and =SUM(portfolio return in US Dollar * portfolio weight) Are we good so far? Excellent, let’s continue! b) Decompose the portfolio return into local currency capital gains and currency returns The objective here is to determine what portion of the portfolio’s return came from capital gains in local currency and what portion of the portfolio’s return came from currency returns. For example, you could buy a stock in Yen that drops in value, but the Yen itself could gain, which in theory could actually leave you with a gain depending on the difference between the loss on on the stock and gain on the Yen. We’ve actually already calculated the local currency capital gains in part A, step 2. Now, we have to calculate the currency returns for each country: =(local return - US Dollar return) *** Note that this is where I begin to disagree with their mathematics. They are assuming that the local return and currency return can just be added together to get the US Dollar return, which isn’t strictly true - ideally, you’d want to use this formula: (1 + local return) * (1 + currency return) - 1 = US Dollar return but their method is a reasonable (and simpler) approximation, although not entirely correct. End rant #1 *** Next, we need to calculate the total portfolio level currency return: =SUM(currency return * portfolio weight) c) Decompose the portfolio total return into the market, security selection and currency components. This is contribution. It is NOT relative to a benchmark, since it is decomposing the sources of the portfolio return. In this question, we’re trying to explain the sources of the total return of the portfolio. *** This is where it starts to get a bit murky due to the poor wording of the CFA material. I also think they’re combining “contribution” (sources of TOTAL return) with “attribution” (sources of ACTIVE return) due to the inclusion of the selection component. End rant #2 *** So we need to find the following: Market Component Security Selection Component Currency Component Portfolio Total Return = Market + Selection + Currency We already found the Currency Component in part B. Market Component: =SUM(Index local return * portfolio weight) Security Selection Component: =SUM[(Portfolio local return - Index local return) * portfolio weight] See page 191 in the CFA materials. The main difference between between the formulas above and page 191 is that they’re including the security selection in the formula above, but not on page 191. Note that by combining the Market Component and Security Selection Component above, you’d get the same result as if you had used the formula on page 191. See rant #2 above… d) Perform global performance attribution, using benchmark return, market allocation, currency allocation, and security selection The goal here is attribution, which defines the sources of active return, and answers the question, “how and why did we underperform/outperform the benchmark?” Total return = benchmark return + active return Active return = allocation + selection + currency Attribution is relative to a benchmark, since the goal is determining where the active return came from. Market allocation - How well did we underweight or overweight certain markets? Currency allocation - How well did we underweight or overweight certain currencies? Security selection - How well did we pick stocks? Depending on the fund, they are going to care more about one term versus another (generally). This will also affect their portfolio decision-making process (as well as the approach they apply to performance attribution- but that’s probably beyond the scope of what’s required for the CFA exam so I won’t go there). A fund that highlights it’s stock-picking ability might keep the same approximate sector/country weights as the benchmark, but would overweight on the stocks in each sector/country that they think will do the best (and their goal would be to have a very low allocation component and a high selection component. On the other hand, a more macro-level fund might emphasize it’s ability to pick given sectors/countries - so it would overweight or underweight countries/sectors depending on their expected return, but keep approximately the same weights within the country/sector for each stock (and their goal would be to have a very low selection component and a high allocation component). However, most funds probably do a combination of both. Security Selection: We found the selection already in part c. Market Allocation: =SUM[(Portfolio weight - index weight) * index return] Currency Allocation: =SUM[ (Portfolio weight * portfolio currency return) - (index weight * index currency return) *** I don’t agree with how they displayed their answer. Ideally, you’d want to see each term for each market, as well as the total level. As a portfolio manager, you’d most likely want to be able to look at how well you’d done for each term in each market, rather than just a brief summary of the total. That way you can see how you’d done in terms of allocating money to each market, or if you’re good at picking stocks in Japan but not France, etc. End rant #3 *** Also, notice that ALL the terms in your attribution are additive. That is, you can sum up all the terms for each country to get to the country level portfolio return, and then sum these up to get your total portfolio performance, or alternatively you can sum up each country level term to the total portfolio level, and then sum up the total terms to get to the total portfolio performance. That’s because we’re doing arithmetic attribution, as opposed to geometric attribution. See the example below: Arithmetic attribution: total portfolio return = benchmark return + active return Geometric attribution: total portfolio return = (1 + benchmark return) * (1 + active return) However, this is also beyond what we’ll need for the CFA exam… Does that help?
Don’t mean to bring this up again, but quick question. There are two ways of doing the calculations for Market, Currency and Security. Can anyone think of a rational for CFAI to insist on us using one over the other? I learned decomposition which makes sense to me, but worried about the nasty formulas they have for attribution. Anyone care to shed some light on this? Thanks in advance.
looking at the solution on A-27 for part D, i still get lost on the currency allocation to get the answer you take the currency contribution of the portfolio (in this case -0.87%) less currency contribution of benchmark. to get the currency contribution of benchmark: take the dollar return of each index less capital gain (found in part c) and find the weighted sum. but this is where is get lost: how do you get the dollar index return? they have the US, UK, and FR at 9.079%, 10.417%, and -2.64% respectively. I am trying to understand where they get these numbers from and then I will be done with this.
You need to convert the index prices to dollars using the Exchange rates effective at the time So 12/31/06 UK index is 1090 Exchange rate = 0.65/ 12/31/07 UK index is 1148 Exchange rate = 0.65/ So index at 12/31/06 = 1090/.65 = 1676.92 at 12/31/07 = 1148/.62 = 1851.61 $ return of UK index = (1851.61 - 1676.92) / 1676.92 = 0.10417
^ OMG. it was in front of me this whole time. thanks a lot!!
passthismofo Wrote: ------------------------------------------------------- > Don’t mean to bring this up again, but quick > question. There are two ways of doing the > calculations for Market, Currency and Security. > Can anyone think of a rational for CFAI to insist > on us using one over the other? > > I learned decomposition which makes sense to me, > but worried about the nasty formulas they have for > attribution. > > Anyone care to shed some light on this? Thanks in > advance. If the question just asks us to show the sources of the portfolio’s return and doesn’t have the necessary benchmark information, then I think we’ll need to go with the decomposition/contribution formulas. If it says something to the effect of “compare to a benchmark”, then I am going with attribution. If it’s just a domestic market, I am going with the formulas in reading 47, and if it’s a multicurrency portfolio, then I am going with the formulas in reading 48. I’m hoping the questions won’t be vague and poorly worded. If they are, I’m in trouble!
Thanks Darkstar. I like your logic. I guess I wil have to learn the attribution then. Problem is…once I learn that, something else is going to seep out of my limited brain cells.
eriqnoodle Wrote: ------------------------------------------------------- > looking at the solution on A-27 for part D, i > still get lost on the currency allocation > > to get the answer you take the currency > contribution of the portfolio (in this case > -0.87%) less currency contribution of benchmark. > > to get the currency contribution of benchmark: > take the dollar return of each index less capital > gain (found in part c) and find the weighted sum. > > but this is where is get lost: how do you get the > dollar index return? > > they have the US, UK, and FR at 9.079%, 10.417%, > and -2.64% respectively. > > I am trying to understand where they get these > numbers from and then I will be done with this. The currency allocation term tells you the effects of allocating to currencies in a different way than the benchmark. This example was actually pretty straightforward actually from a currency perspective, but it can get very, very messy if you start looking at multiple markets with the same currency (like if you’re investing in France and Germany), or if you’re looking at a single market where stocks are traded in multiple currencies. I HIGHLY doubt something like this will show up on the exam, though. There’s actually another way to get the return in US Dollar, which in my opinion is probably quicker and easier than sv’s method above. UK Index 2006: 1090 UK Index 2007: 1148 Local return: 1148/1090-1 = 5.321% FX Rate 2006: .65 FX Rate 2007: .62 FX Return: .65/.62 = 4.839% US Dollar index return = (1.04839) * (1.05321) -1 = 10.417%