Performance Measurement — CFA Level III practice questions

An equity manager's portfolio outperformed the benchmark by 200 bps. Attribution shows allocation contributed +150 bps and selection contributed +50 bps. The MOST appropriate inference about manager skill is:

1. The 200 bps of outperformance is entirely attributable to random noise and provides no information
2. The manager's outperformance was driven primarily by individual stock selection rather than sector allocation
3. The manager's outperformance was driven primarily by sector allocation decisions rather than individual stock selection
4. The attribution results confirm skill only if selection exceeds allocation in every period

Answer: C — The manager's outperformance was driven primarily by sector allocation decisions rather than individual stock selection

A) A single period of positive attribution isn't proof of skill, but it is not entirely noise either; attribution is informative about where returns originated even if it doesn't confirm persistence. B) This reverses the relative magnitudes shown in the attribution — selection contributed less than allocation, not more. C) Correct — With allocation (+150 bps) contributing three times as much as selection (+50 bps), the single-period attribution indicates the outperformance was concentrated in sector/asset-allocation decisions rather than security picking, though further multi-period analysis is needed to confirm persistence. D) There is no rule requiring selection to dominate allocation for skill to exist; both are legitimate sources of value added.

Brinson-style performance attribution decomposes a portfolio's active return relative to its benchmark into which THREE effects?

1. Currency, duration, and convexity effects
2. Allocation, selection, and interaction effects
3. Alpha, beta, and tracking-error effects
4. Timing, sizing, and cost effects

Answer: B — Allocation, selection, and interaction effects

A) These are fixed-income risk factors, not the Brinson attribution decomposition. B) Correct — Brinson attribution splits active return into sector/asset allocation, security selection, and their interaction. C) Alpha, beta, and tracking error are risk/return statistics, not attribution components. D) A plausible-sounding but fabricated grouping — not the standard framework.

A large sell order causes the market price to move against the trader before the full order is filled. This cost component of implementation shortfall is known as:

1. Explicit commission cost
2. Opportunity cost (the unfilled portion)
3. Delay cost (the decision-to-order lag)
4. Market impact cost

Answer: D — Market impact cost

A) Commissions are a separate, explicit trading cost unrelated to price movement caused by the order itself. B) Opportunity cost captures the return foregone on shares never executed, not price slippage during execution. C) Delay cost reflects price drift between the investment decision and order placement, before trading begins. D) Correct — market impact is the adverse price movement caused by the order's own presence in the market as it executes.

Operational due diligence on a hedge fund manager is BEST viewed as:

1. A subset of investment due diligence focused solely on historical returns
2. A regulatory filing requirement that substitutes for investor-level due diligence
3. A one-time check performed only at initial fund launch and never repeated
4. An assessment of non-investment risks such as valuation controls, custody, and business continuity that complements investment due diligence

Answer: D — An assessment of non-investment risks such as valuation controls, custody, and business continuity that complements investment due diligence

A) Operational due diligence is distinct from, not a subset of, investment/return-based due diligence; it focuses on non-investment risk. B) There is no regulatory filing that substitutes for investor-conducted operational due diligence. C) Operational due diligence should be an ongoing, periodic process, not a one-time initial check, since operational risk can change over time. D) Correct — Operational due diligence separately evaluates the manager's back-office, valuation, custody, compliance, and business-continuity controls to detect fraud and operational risk that return analysis alone cannot reveal.

An institutional investor selecting a passive equity benchmark should PRIMARILY consider:

1. The index's average dividend yield over the trailing twelve months
2. Whether the index is investable, unambiguous, and representative of the intended market segment
3. The index's absolute total return over the prior five years
4. The tax efficiency of the underlying constituent securities

Answer: B — Whether the index is investable, unambiguous, and representative of the intended market segment

A) Dividend yield alone doesn't establish benchmark validity. B) Correct — a valid benchmark must be rules-based, investable, unambiguous, and representative of the targeted segment (per CFA Institute benchmark-quality criteria). C) Past absolute performance doesn't determine benchmark appropriateness. D) Tax efficiency is a portfolio-implementation concern, not a benchmark-selection criterion.

A 'risk-adjusted' performance measure that uses BETA (systematic risk) rather than total volatility in the denominator is MOST APPROPRIATE when:

1. The portfolio being evaluated represents the investor's entire, undiversified wealth
2. The portfolio has no correlation whatsoever with any broad market index
3. The evaluator wants to capture both systematic and unsystematic risk in a single measure
4. The portfolio is one of several holdings within a well-diversified total portfolio, so its unsystematic (diversifiable) risk is largely irrelevant to the investor's overall risk and only its contribution to systematic risk matters

Answer: D — The portfolio is one of several holdings within a well-diversified total portfolio, so its unsystematic (diversifiable) risk is largely irrelevant to the investor's overall risk and only its contribution to systematic risk matters

A) When a portfolio is an investor's entire wealth, unsystematic risk still matters because it is not diversified away elsewhere, making a total-risk measure (like the Sharpe ratio) more appropriate than a beta-based measure. B) A beta-based measure is precisely designed to describe co-movement with the market; a portfolio with no market correlation would have a beta of approximately zero, which is a special case, not the general justification for using beta. C) A beta-only measure by design excludes unsystematic risk, the opposite of capturing both types in one figure. D) Correct — when a portfolio is only one piece of a larger diversified whole, its idiosyncratic risk is diversified away at the total-portfolio level, so a beta-based (systematic-risk) measure like the Treynor ratio better reflects its true contribution to overall risk than a total-volatility measure.

All of the following are appropriate risk-adjusted performance measures for a diversified portfolio held as an investor's entire wealth EXCEPT the:

1. Sharpe ratio
2. Treynor ratio
3. Sortino ratio
4. M-squared measure

Answer: B — Treynor ratio

A) Sharpe ratio uses total risk (standard deviation), appropriate when the portfolio represents the investor's entire wealth. B) Correct — the Treynor ratio uses beta (systematic risk only), which is appropriate for a portfolio that is one holding among several, not for total wealth where unsystematic risk still matters. C) Sortino uses downside deviation of total returns, valid for a full-wealth portfolio. D) M-squared restates Sharpe-ratio information in return terms and shares the same total-risk basis.

Dispersion analysis across managers in a US large-cap composite shows very low cross-sectional return dispersion. This MOST LIKELY indicates:

1. High market efficiency and correlated returns, leaving limited scope for managers to add idiosyncratic alpha
2. Managers are taking unusually large, differentiated active bets against the benchmark
3. The composite was constructed using an invalid or inconsistent benchmark
4. Dispersion is mechanically high whenever markets are trending upward

Answer: A — High market efficiency and correlated returns, leaving limited scope for managers to add idiosyncratic alpha

A) Correct — low cross-sectional dispersion signals that stock returns are moving together, so active managers have little idiosyncratic opportunity to differentiate results. B) Large differentiated bets would produce HIGH, not low, dispersion. C) A construction flaw isn't implied by dispersion alone. D) Dispersion isn't tied mechanically to market direction — it reflects return correlation, not trend.

Proponents of passive management cite which finding as their PRIMARY empirical support for indexing over active management?

1. Active managers consistently outperform gross of fees but never net of fees
2. Passive funds have zero tracking error to their benchmark by construction
3. On average, active managers underperform their benchmarks net of fees over long periods
4. Index funds are legally required to hold every security in the index at all times

Answer: C — On average, active managers underperform their benchmarks net of fees over long periods

A) A half-true claim — gross outperformance is inconsistent and not universal, so this overstates the case. B) True of well-run index funds but irrelevant to the active-vs-passive performance debate itself. C) Correct — the core empirical case for indexing is that the average active manager fails to beat the benchmark after fees over long horizons. D) Many index funds use sampling/optimization rather than full replication, so this is a misconception.

M-squared (M²) restates a portfolio's Sharpe-equivalent return at the BENCHMARK's volatility, by:

1. Treynor rescaled to alpha value in the standard framework
2. Beta rescaled to unit variance in the standard framework
3. Sharpe ratio rescaled to benchmark volatility
4. Standard deviation alone measure in the standard framework

Answer: C — Sharpe ratio rescaled to benchmark volatility

A) Not a valid rescaling. B) Not the M-squared definition. C) Correct — M-squared converts Sharpe into a comparable percentage return at benchmark risk. D) Ignores return.

Sharpe ratio?

(Return - Risk-free) / Standard deviation. Risk-adjusted return.

Tracking error?

Standard deviation of (portfolio - benchmark) returns.

Jensen's alpha?

Return - CAPM expected return. Excess return adjusted for systematic risk.

In an implementation shortfall calculation, what are the four component costs, and which two typically move in opposite directions as execution speed changes?

Explicit costs (commissions, fees, taxes), delay/decision cost, execution (market-impact) cost, and opportunity (missed-trade) cost. Execution cost rises with trading speed while opportunity cost falls, creating the classic urgency tradeoff.