Question

Use the following information to answer Problems l2–16:

Primo Management Co. is looking at how best to evaluate the performance of its managers. Primo has been hearing more and more about benchmark portfolios and is interested in trying this approach. As such, the company hired Sally Jones, CFA, as a consultant to educate the managers on thebest methods for constructing a benchmark portfolio, how best to choose a benchmark, whether the style of the fund under management matters, and what they should do with their global funds in terms of benchmarking.

For the sake of discussion, Jones put together some comparative two-year performance numbers that relate to Primo’s current domestic funds under management and a potential benchmark.

As part of her analysis, Jones also takes a look at one of Primo’s global funds. In this particular portfolio, Primo is invested 75% in Dutch stocks and 25% in British stocks.

The benchmark invested 50% in each—Dutch and British stocks. On average, the British stocks outperformed the Dutch stocks. The euro appreciated 6% versus the U.S. dollar over the holding period, while the pound depreciated 2% versus the dollar. In terms of the local return, Primo outperformed the benchmark with the Dutch investments but underperformed the index with respect to the British stocks.

Question: Calculate the amount by which the Primo portfolio out- (or under-) performed the market over the period, as well as the contribution to performance of the pure sector allocation and security selection decisions.

Short answer

Primo underperformed the benchmark.

Primo’s pure sector allocation decision = -2.2 %

Primo’s pure security selection decision = 0.8%

Step-by-step solution

Calculation of Primo portfolio performance

Primo return = Primo weight x Primo return

=.06 x 17% + 0.15 x 24% + 0.25 x 25%

= 18.8%

Benchmark return = Bench mark weight x bench mark return

= 0.5 x 16% + 0.4 x 26% + 0.1 x 18%

= 20.2%

Performance calculation: Primo – Bench mark

= 18.8% - 20.2 %

= -1.4%

This implies that Primo underperformed the benchmark.

Calculation of Primo’s pure sector allocation decision

This can be calculated by multiplying the weight difference between Primo and benchmark portfolio in each sector by the benchmark sector returns:

Hence; (0.6 - 0.5) x (.16) + (0.15 – 0.4) x (.26) + (0.25 – 0.1) x (.18)

= -2.2 %

Calculation of Primo’s pure security selection decision

This can be calculated by multiplying the return differences between Primo and benchmark for each sector by Primo’s weightings:

Hence: (.17 - .16) x (.6) + (.24 - .26) x (.15) + (.2 – 0.18) x (.25)

= 0.8%