CPS Performance Measurement and Evaluation 2 — Questions and Answers
Question 1: The Information Ratio is calculated as:
- Portfolio return divided by portfolio standard deviation
- Active return divided by tracking error (Correct answer)
- Alpha divided by beta
- Excess return divided by total portfolio risk
Correct answer: Active return divided by tracking error
The Information Ratio divides active return (portfolio return minus benchmark return) by tracking error (standard deviation of active returns), measuring the consistency and efficiency of active management.
Question 2: Tracking error in portfolio performance measurement is defined as:
- The total cumulative return difference between a portfolio and its benchmark
- The standard deviation of a portfolio's excess returns relative to its benchmark (Correct answer)
- The portfolio's beta multiplied by the market's standard deviation
- The average monthly deviation of the portfolio from its benchmark
Correct answer: The standard deviation of a portfolio's excess returns relative to its benchmark
Tracking error is the standard deviation of the difference between a portfolio's periodic returns and its benchmark's returns, measuring the consistency of active management.
Question 3: The Sortino Ratio improves upon the Sharpe Ratio by:
- Using beta instead of standard deviation as the risk measure
- Using only downside deviation rather than total standard deviation (Correct answer)
- Incorporating alpha to adjust for manager skill in the numerator
- Using geometric mean returns instead of arithmetic mean returns
Correct answer: Using only downside deviation rather than total standard deviation
The Sortino Ratio uses downside deviation (only below-target return variability) in the denominator, capturing the risk investors actually care about—losing money—rather than penalizing upside volatility.
Question 4: Maximum drawdown is best defined as:
- The average monthly loss of a portfolio over a given period
- The largest peak-to-trough decline in portfolio value during a specified period (Correct answer)
- The standard deviation of all negative monthly returns in the period
- The single worst one-month return recorded in the portfolio's history
Correct answer: The largest peak-to-trough decline in portfolio value during a specified period
Maximum drawdown measures the largest loss from a historical peak to a subsequent trough before a new peak is reached, representing the worst-case scenario an investor could have experienced.
Question 5: The Calmar Ratio is particularly useful for evaluating which type of investment strategy?
- Passive index funds with low tracking error
- Hedge funds and managed futures programs with non-normal return distributions (Correct answer)
- Large-cap equity portfolios relative to the S&P 500
- Fixed income portfolios managed against an aggregate bond index
Correct answer: Hedge funds and managed futures programs with non-normal return distributions
The Calmar Ratio, calculated as compound annual growth rate divided by maximum drawdown, is especially useful for hedge funds and managed futures where tail risk and drawdown are key concerns.
Question 6: In the Brinson performance attribution model, the 'allocation effect' specifically measures the value added by:
- Selecting individual securities that outperform within each sector
- Overweighting or underweighting sectors relative to the benchmark (Correct answer)
- Correctly timing market entry and exit points
- Using derivatives to hedge systematic portfolio risk
Correct answer: Overweighting or underweighting sectors relative to the benchmark
The allocation effect in the Brinson model captures the contribution from the manager's decision to overweight or underweight specific sectors relative to the benchmark allocation.
Question 7: Under GIPS (Global Investment Performance Standards), firms must present a minimum of how many years of compliant performance history?
- 3 years
- 5 years (Correct answer)
- 7 years
- 10 years
Correct answer: 5 years
GIPS requires firms to present a minimum of 5 years of compliant performance (or since inception if less), building toward a required 10-year record to ensure sufficient comparability.
CPS Performance Measurement and Evaluation 2
The Information Ratio is calculated as: