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Performance measure (2) (Risk-adjusted return on capital (RAROC) (problems…
Performance measure (2)
Portfolio risk and return analysis
aim
to assess whether superior performance has been obtained by simply taking more risk or by superior stock selection and timing,
steps
plot overall TWRR from portfolio over period against riskiness of portfolio
compare to peer group and simulated portfolios
riskiness measured by looking at standard deviation of returns over historical sub-periods or implied volatilities.
problems
creeping change in portfolio composition
successful investment manager may be treated unfairly by measurement system
manager may disagree with market view
assessing share performance using market price
advantages
objective
generally quick, cheap and easy to obtain
easy to understand/justify
disadvantages
volatile
need to allow for income
unavailable for unquoted shares
may be more than one quoted price e.g. bid price and offer price
assessing share price using NPV
advantages
can be made consistent with basis used to value liabilities
useful for unquoted shares
yields stable results (if assumptions don't change)
disadvantages
depends on subjective assumptions
results will reflect any changes in assumptions
differs from actual market price, at which shares actually traded
difficult to understand/justify
NAV
advantages
yields stable results
available for unquoted shares
useful for investment and property companies
disadvantages
based on accounting values, not true, economic value
depends on subjective accounting standards
results will reflect any changes in accounting standards
may exclude intangibles/goodwill
difficult to compare companies in different sectors
Risk-adjusted return on capital (RAROC)
RAROC= R - β (Rm - rf)
R= profits/divided by capital employed
If RAROC> rf company has out-performed after allowing for cost and risk involved in using its capital to generate its profits.
problems
difficult to estimate β
difficult to estimate company profits