Morningstar Advisor - August/September 2011 - (Page 60)

Gray Matters Statistical Analysis of Fund Performance The groundwork for the use of regression to analyze returns was laid by William Sharpe, in his 1964 paper that developed the Capital Asset Pricing Model. From this basic theory, sprung a number of risk-adjusted performance measures, such as the Sharpe ratio, which measures excess return relative to volatility, as well as Jensen’s Alpha and the Treynor Ratio, which adjust return for the level of systematic risk. A practitioner’s guide to the application of these theories can be found in the book Active Portfolio Management by Richard Grinold and Ronald Kahn. error using daily returns are often implausibly high. After long puzzling over these estimation errors, Morningstar’s research team ultimately identified the indexes themselves as the source of the difficulties. When to Trust the Index and noise versus the index while also separating long-term return drags from the short-term movements against the index. Estimated Holding Cost isolates the long-term return difference against the index over the past year and smooths the daily noise from stale prices in order to provide the most accurate possible value. We found our new estimates to be far more stable and, most important, far more predictive of future performance than traditional point-to-point estimates of tracking difference. Tracking Volatility measures the day-to-day return discrepancies versus the index. It uses a sophisticated statistical technique that accounts for stale prices in the index that take a day or two to catch up with the pricing in the NAV. This factor for lagging prices shows incredible statistical significance and results in improved annualized tracking error estimates for credit bond index funds and foreign equity index funds compared with naive measures based on the standard deviations of daily return discrepancies. This new tracking-error measurement not only provides a useful method for identifying the most efficient funds for short-term traders and hedgers but also allows longer-term investors to see how confident they can be in our estimated holding cost for each fund. A larger tracking error means that the fund has experienced far more random deviations against its index, and there is a greater chance that the estimated holding cost has picked up random movement rather than persisting drags on return. Although Estimated Holding Cost is statistically similar to alpha and Tracking Volatility is similar to tracking error, we have chosen to use distinct terminology to avoid confusion. The methodology is similar, and it will lead to identical results when stale pricing is not an issue and there is not predictive power in ETF price movements, such as when the ETF and the underlying asset trade in the same market during the same trading hours (as with S&P 500 funds). But for ETFs in which Financial indexes try to approximate a platonic ideal of market value at any given moment. In practice, index providers use local market closing prices for the underlying securities as the basis for nearly all index prices. However, fund NAVs try to capture the precise value of the portfolio at the time that the fund’s market, rather than the local market of the underlying securities, closes. For most funds, this difference is negligible. But in the case of stocks in the MSCI Japan Index held by the U.S.-domiciled iShares MSCI Japan Index ETF EWJ, the Tokyo closing prices used in the index value are more than 15 hours old by the time the NAV for the fund is set. Fair value pricing for the NAV may include after-hours trades, trades in cross-listed shares, pricing of Nikkei futures, and any other sources of more up-to-date information on the portfolio value. On days when major market news comes out after the Japanese market closes, the difference between index values set at 8 a.m. and NAVs set at 4 p.m. can be more than 1 percentage point. Measuring Performance Despite Stale Prices The Alpha and the Beta In finance, “beta” is widely used as a measure of an investment’s sensitivity to market movements, but its name is borrowed from the common Greek symbols used to express a regression formula. The positive “alpha” for which active portfolio managers are incentivized to achieve derives its name from the intercept of the regression of portfolio returns regressed on benchmark returns. The residual volatility, fund movements that cannot be explained by the market, is the tracking error. 4 3 tracking error 2 1 –4 –3 –2 –1 –1 –2 –3 –4 alpha 1 beta 2 3 4 A major problem with measuring passive fund performance relates to the issue of stale pricing in the index, which afflicts foreign securities and fixed-income funds most of all. Passive funds often incur costs and tracking errors of a few dozen basis points over a year, while day-to-day noise from stale prices can easily be as large as a percentage point. That level of noise means that the typical tracking-error or tracking-difference measurement is picking up far more noise than signal about management quality. Morningstar’s new measures of passive fund performance seek to address stale prices 60 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011