CIC Performance Measurement and Reporting 1 — Questions and Answers
Question 1: What does the Time-Weighted Rate of Return (TWR) measure?
- The return generated per dollar invested by the client
- The compound growth rate of one unit of currency invested over a period, eliminating the effect of external cash flows (Correct answer)
- The average return weighted by the number of trading days in each period
- The return adjusted for inflation and taxes over the investment horizon
Correct answer: The compound growth rate of one unit of currency invested over a period, eliminating the effect of external cash flows
TWR measures the compound growth of one unit of currency and removes the distorting effect of client-driven cash flows, making it ideal for evaluating manager skill.
Question 2: Which of the following best describes the Sharpe Ratio?
- Excess return per unit of systematic risk (beta)
- Excess return per unit of total risk (standard deviation) (Correct answer)
- Annualized alpha divided by tracking error
- Portfolio return minus benchmark return divided by market variance
Correct answer: Excess return per unit of total risk (standard deviation)
The Sharpe Ratio divides a portfolio's excess return (above the risk-free rate) by its standard deviation, measuring reward per unit of total risk.
Question 3: The Global Investment Performance Standards (GIPS) are maintained by which organization?
- The Securities and Exchange Commission (SEC)
- The Financial Industry Regulatory Authority (FINRA)
- The CFA Institute (Correct answer)
- The Investment Adviser Association (IAA)
Correct answer: The CFA Institute
GIPS standards are developed and maintained by the CFA Institute to ensure fair, consistent, and transparent performance reporting by investment managers.
Question 4: What does 'alpha' represent in the context of portfolio performance measurement?
- The portfolio's sensitivity to interest rate changes
- The excess return of a portfolio relative to its expected return given its beta (Correct answer)
- The standard deviation of returns above the risk-free rate
- The percentage of variance explained by the benchmark
Correct answer: The excess return of a portfolio relative to its expected return given its beta
Alpha measures the value added (or destroyed) by the portfolio manager above what would be predicted by the portfolio's market exposure (beta).
Question 5: Which benchmark characteristic is most important when evaluating a domestic large-cap equity portfolio?
- The benchmark must be equally weighted across all constituents
- The benchmark should be investable, specified in advance, and appropriate to the manager's style (Correct answer)
- The benchmark should include international securities for diversification context
- The benchmark must be constructed by a government regulatory agency
Correct answer: The benchmark should be investable, specified in advance, and appropriate to the manager's style
A valid benchmark must be investable, measurable, specified in advance, and reflect the manager's investment universe and style to ensure meaningful performance comparison.
Question 6: Which method of return calculation is required under GIPS standards for portfolios with external cash flows?
- Simple Dietz Method
- Modified Dietz Method or daily valuation (Correct answer)
- Internal Rate of Return (IRR)
- Arithmetic mean of monthly sub-period returns
Correct answer: Modified Dietz Method or daily valuation
GIPS requires the Modified Dietz Method or daily portfolio valuation for periods with external cash flows to produce accurate time-weighted returns.
Question 7: What is 'tracking error' in the context of portfolio performance?
- The difference between a portfolio's return and the risk-free rate
- The standard deviation of the difference between portfolio returns and benchmark returns (Correct answer)
- The error introduced when using estimated rather than actual transaction costs
- The variance of alpha over a rolling 12-month period
Correct answer: The standard deviation of the difference between portfolio returns and benchmark returns
Tracking error (also called active risk) is the standard deviation of excess returns (portfolio minus benchmark), quantifying how consistently the manager deviates from the benchmark.
CIC Performance Measurement and Reporting 1
What does the Time-Weighted Rate of Return (TWR) measure?