PM Qbank: Matthew Spencer Case Scenario

David Moore, a new committee member, asks Spencer how to interpret value added statistics. Spencer responds with the following statements.

Statement 1 : The measurement is derived from the various sources that make up the contribution from active management decisions, including asset allocation and security selection.

Statement 2 : It appraises active management decisions and further compares the portfolio’s return in excess of the benchmark with the risk-free rate and relative to the standard deviation of returns.

Statement 3 : The statistic is a useful tool for comparing relative returns, but it is most applicable in comparing active management decisions of equity portfolios.

Q. Which of Spencer’s statements responding to Moore’s question is most likely correct?

A) Statement 1

B) Statement 3

C) Statement 2

Solution: A is correct. Value added is determined by deviations from benchmark performance and arises from deviation from portfolio benchmark weights. This calculation can be further broken down into the various sources that make up the contribution from active management decision, including asset allocation and security selection. If every asset in the managed portfolio is held at its benchmark weight, there would be no value added relative to the benchmark.

B is incorrect because the use of value added is applicable to the evaluation of relative return of most asset classes.

C is incorrect because the determination of value added does not include either the risk-free rate or the standard deviation of returns.

IMO the answer should be C - Statement 2. Reasoning: exptected V added=E(RA)∗=IC√BRσA

The IC√BR part is IR which = (Port r - BM r)/std (r Port-r BM), we also know that BM r is in excess of risk free rate, so putting all of this together, wouldn’t statement 2 be a more complete definition of Value Added?

Imho, Statement A is the most concise and accurate definition. Remember, value added = active return = active portfolio return - benchmark return.

I would not choose C because active management, and the measures of active return, are not only applicable to equity portfolios, but to investments in debt and other asset classes as well.