Active management

Portfolio selection
process designed to produce higher returns than are purely available from a
passive strategy aiming to replicate benchmark performance.

Active risk (or
Relative risk)

The risk of performance
deviating from the benchmark due to active management.

Absolute risk

The risk of a large
fall in capital value (or absolute performance) of an investment portfolio.

Average shortfall

The average level of
underperformance relative to the benchmark (or target).

Backward looking risk
measure

An approach to
measuring portfolio risk based on historical analysis (aka retrospective,
expost analysis.

Benchmark

A notional portfolio of
assets normally comprising three components:
(i) Asset class mix
(ii) Market
indices/peer group average returns within those asset classes
(iii) A rebalancing
regime
Benchmarks can be set
by explicitly applying fixed percentage weights to various asset classes and
index returns within those asset classes, or indirectly by reference to peer
group performance, or by a combination of peer group performance within each
asset class and fixed asset class weights.
The rebalancing regime
defines the rules for resetting the benchmark asset class weights which
change due to relative market movements.

Beta

A measure of the extent
to which a portfolio’s return moves in line with the market return. A beta of
1 means that each upward or downward movement of 1% in the market should, all
other things being equal, generate a 1% upward or downward movement in the
portfolio. A beta of less than 1 (or greater than 1) implies that a 1% market
movement should, all other things being equal, generate a less than (or
greater than) 1% movement in the portfolio

Downside risk

The risk of portfolio
performance falling below the benchmark (or target) return.

Downside target

A maximum
underperformance level relative to the benchmark return, e.g. 3.0% in any
single calendar year.

Duration

The weighted average
time to payment of cashflows arising from the securities held within a bond
portfolio. Changes in economic conditions usually affect bonds of similar
durations in similar ways, and often affect the price of bonds of longer
duration more than the price of bonds of shorter duration. Hence, how the
average duration of a bond portfolio differs from the duration of its
benchmark is a very important component of the risk of such a portfolio.

Expected Worst Loss (in
T realisations, say)

This is the expected
value of the worst outcome in a sample. As the sample size gets larger, the
expected worst outcome usually gets worse. See also Analysis of
Expected Worst Loss for Normal random variables

Forward looking risk
measure

An approach to
measuring portfolio risk based on forecast analysis (aka prospective, exante
analysis)

GIPS

Global Investment
Performance Standards. Ethical standards for the presentation and calculation
of performance. Designed to ensure fair representation and full disclosure of
an investment organisation’s performance history. A voluntary standard
effective from 1 January 2000.

Information ratio

Portfolio return in
excess of a benchmark divided by the standard deviation of return relative to
the same benchmark. The benchmark is fund specific, e.g. cash, a market index
or a peer group average.

Jensen’s alpha

Portfolio return in
excess of the betaadjusted benchmark return.

Market risk

The exposure to loss
due to market movements.

Normal distribution

A probability
distribution commonly used within statistics to represent the likelihood of
certain events occurring, with a familiar bellshape.

Performance attribution

The process of
allocating a portfolio’s return (absolute or relative to the benchmark) to
the various components in the investment decisionmaking process, e.g. to
asset allocation, industry exposures and to individual stock positions.

Performance measurement

The calculation of a
portfolio’s investment return over a given period to determine the growth in
asset values and to facilitate comparison with funds that have similar investment
objectives.

Portfolio risk

The risk that a fund’s
investment objectives are not achieved due to poor performance, excessive
volatility etc.

Relative return

The performance of a
fund compared to the return on the benchmark

Risk constraints

Formal control ranges
or limits on asset mixes, sector or individual stock positions, or on
portfolio risk measures such as tracking errors and ValueatRisk measures,
which are intended to act as a limit on the amount of portfolio risk that can
be taken.

Risk/reward tradeoff

The preferred balance
between risk and return, specific to each investor. Determined with reference
to the point where incremental risk is justified by increased relative
performance.

Risk adjusted
performance measurement

The calculation of
investment return with explicit allowance for the level of risk incurred.
Commonly used measures include:
Sharpe ratio,
Information ratio, Treynor ratio, Jensen’s alpha and Sortino ratio.

Sharpe ratio

Portfolio return in
excess of a ‘riskfree’ rate divided by the standard deviation of return
relative to this same ‘riskfree’ rate. ‘Riskfree’ is usually taken to mean
cash or shortdated treasury bills, even though these may not be ‘riskfree’
in the context of the investor in question.

Shortfall risk

The probability of
failing to achieve the benchmark (or target) return.

Sortino ratio

Portfolio return in
excess of a benchmark rate divided by downside standard deviation of returns
relative to the same benchmark

Standard deviation

A statistical measure
of dispersion or volatility of performance returns (the square root of
variance).

Target return

An outperformance level
in excess of the benchmark performance, e.g. 2.5%pa over rolling three year
periods.

Tracking error

A measure of active
risk. The annualised standard deviation of the difference between portfolio
return and benchmark return. The measure can be used to substantiate past
performance or to predict future experience. Forecast tracking errors rely on
quantitative modelling techniques; historical tracking errors are based on
the observed relative performance.
For example, a forecast
tracking error of 4.0% implies that there is a c. 67% probability that the
portfolio performance will be within 4.0% of the benchmark return (plus or
minus) over the following 12 months (as long as relative returns are Normally
distributed).

Treynor ratio

Portfolio return in
excess of the riskfree rate divided by the portfolio beta.

ValueatRisk (VaR)

A statistical measure
of downside risk. The potential losses on a portfolio over a given future
time period with a given confidence. Measured in either absolute terms or
relative to a benchmark.
See ValueAtRisk for more
details. See also Tail
VaR (TVaR), Conditional
VaR (CVaR) and terms such as Expected Shortfall
and Expected Policyholder Deficit that have very similar meanings.

Variance

A statistical measure
of dispersion or volatility of performance returns (the square of the
standard deviation).

Volatility

A measure of an asset’s
propensity to rise/fall in value over a specified period of time.

Weight Overlap

A measure of the extent
to which the weights of holdings in a portfolio coincide with those in a benchmark.
See Weight
Overlap for more details.
