INSTITUTE OF ACTUARIES OF INDIA

EXAMINATIONS

21st November 2020

Subject CP3 – Communication Practice

Time allowed: 3 Hours 30 Minutes (09.30 – 13.00 Hours)

Total Marks: 100

IAI CP3-1120

Background information

You are an Actuary heading the Investment Department of a Life Insurance Company. Over the
years your Company has been specialising in management of funds for employers who wish to
have their fund based group Superannuation schemes administered externally. The contributions
are determined by the Employer or the Scheme Trustees and could be regular or could be one-off
contributions based on the financial position of the Employer. The employer can make claims to
meet benefit payments as per the scheme rules.

The Company is in the process of designing a performance-linked bonus scheme for its fund
managers. You are assisting with the drawing up of the framework. There have been some
discussions on how the performance should be assessed.

Fund managers are allowed to take positions on individual stocks with an objective that they beat
the benchmark index returns. It is possible that individual fund managers deviate from the
benchmark as well as the weights of each stock in the benchmark. There is no other specification
which is provided to the fund managers. The fund managers have no control over when the
contributions are made into the fund or when the funds are withdrawn. However, Employers and
Trustees do interact with the fund managers and inform them of any large contributions or
withdrawals.

It is being debated whether performance should be assessed based on absolute returns or returns
achieved on the funds in excess of benchmark returns and how should the performance be
evaluated allowing for the risks the fund manager assumes. There have also been questions as to
how the return itself should be measured. As the fund managers do not have control over the
external cash flows you have proposed that the return be calculated using the Time Weighted Rate
of Return. An alternative view is that fund managers can at least partially influence the timing of
the cashflows and therefore performance should be measured calculating the Money Weighted
Rate of Return (MWRR). The MWRR is also what the clients see and compare it with the earning
rates that they would have assumed for calculating their pension liabilities.

The head of Human Resources who has also been part of these discussions has written to you as
follows.

“Dear Lata,
I agree that a fund manager’s performance-linked bonus should depend on the investment
performance of the fund. But I can see that arriving at what is the return and whether that return
is good enough is not quite straightforward. Could you please summarise for me with the help of
some examples the different measures which are being talked about, why would they differ and
how we would assess whether these returns are good enough so that we can draw up a framework
which addresses all the parameters? Please also provide your recommendations.

Thanks
Geetha”

The returns on the different funds have been computed and a note on performance evaluation of
different managers has been prepared.

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IAI CP3-1120

Note on measurement of performance of investment portfolios

Measures of performance
Returns over the year of the funds would be calculated by using the following measures.

Money- Weighted Rate of Return (MWRR) or the Internal rate of return is the rate of return
that would produce the total ending value of a portfolio given the amounts and timing of the cash
flows. It gives greater weight to time periods where the portfolio has greater value than to periods
where the portfolio has less value.

V0 (1+i)^T+ ∑ Ct (1+i)^(T-t) = VT
t
V0 is the market value of the fund at the beginning of the period
VT is the market value of the fund at the end of the period
Ct is the net cashflow into the fund (excluding investment proceeds) at time t
i is the money-weighted rate of return

Time Weighted Rate of Return (TWRR) measures the compound rate of growth of the money
initially invested in the portfolio over a stated measurement period.

(1+i) ^T= Vt1 x Vt2 x---------x VT

---- ---------- ----------
Vo (Vt1 + Ct1) (Vtn +Ctn)

V0 is the market value of the fund at the beginning of the period

VT is the market value of the fund at the end of the period of T
Ctr is the net cash inflow, excluding investment proceeds, at time tr
Vtr is the market value of the fund at time tr just before the cashflow

The contributions into and withdrawals from the fund are not under the control of the investment
manager. Those inflows and outflows may significantly influence the money- weighted rate of
return. To isolate the effects of the fund manager’s decisions, the measure of return should
therefore not depend on the external cash flows. The TWRR is therefore a better measure of
performance of the fund manager.

The fund managers though cannot control the inflows and outflows can be informed of significant
contributions beforehand. Considering the fact that clients use the MWRR to plan for their
liabilities the MWRR cannot be ignored completely. Therefore some weight can be assigned to
the performance using this measure.

While the above measures are for assessing absolute returns it also needs to be seen how the fund
managers perform considering the risk which has been taken on by the fund managers in order to
maximize returns. The Employers and Scheme Trustees, all other things being equal, would prefer
lower risk (less variability of returns) to higher risk (more variability of returns). They would be
keen on maximising the return on their investments while simultaneously trying to minimise the
risks. Therefore it is proposed to calculate a reward to risk ratio like the Sharpe Ratio which is the
portfolio return divided by the portfolio standard deviation over the period. The higher the value
of the reward-to-risk ratio, the better the risk-adjusted return—that is, the higher the return per
unit of risk.

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IAI CP3-1120

The Employers and Trustees would also like to compare the returns against the benchmark returns.
Returns in excess of benchmark returns should be calculated and assigned a weight in the
performance evaluation.

The calculations of the above metrics have been done for two portfolios for the previous year and
a brief explanation of how the performance of the two fund managers stacks up against the metrics
defined above has been provided in the following sections.

Benchmark returns
Nifty 100 Values Monthly returns
1-Jan-19 10198
31-Jan-19 10189 -0.1%
28-Feb-19 10567 3.7%
31-Mar-19 10678 1.1%
30-Apr-19 10700 0.2%
31-May-19 10678 -0.2%
30-Jun-19 10800 1.1%
31-Jul-19 10805 0.0%
31-Aug-19 10850 0.4%
30-Sep-19 10600 -2.3%
31-Oct-19 10800 1.9%
30-Nov-19 10723 -0.7%
31-Dec-19 10756 0.3%

Annual return 5.5%

Fund A Amounts in Rs. Million

Fund
Fund Fund
Contributio Withdrawa Value
Value Monthly Values for
Date ns to the ls from the before
after cash returns MWRR
fund fund cash
flows calculation
flows
1-Jan-19 15,988 15,988 (15,987)
31-Jan-19 16,000 16,000 0.08%
28-Feb-19 16,593 16,593 3.71%
31-Mar-19 16,804 16,804 1.27%
30-Apr-19 16,857 16,857 0.32%
31-May-19 17,233 17,233 2.23%
30-Jun-19 10 17,238 17,228 0.03% 10
31-Jul-19 90 17,403 17,313 1.02% 90
31-Aug-19 17,503 17,503 1.10%
30-Sep-19 17,553 17,553 0.29%
31-Oct-19 18,593 20,093 5.92%
30-Nov-19 1,500 19,503 19,503 -2.94% (1,500)
31-Dec-19 18,770 18,770 -3.76% 18,770
TWRR 9.3% MWRR 8.6%
Standard deviation of the portfolio (std.dev) 2.5%
Risk free return (RFR) 6%
Sharpe ratio=(TWRR-RFR)/std.dev 1.3
Return in excess of benchmark (TWRR-Nifty 100 return) 3.8%

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IAI CP3-1120

Fund B Amounts in Rs. Million

Fund
Fund
Withdraw Value Fund Values
Contributions to Value Monthly
als from before for MWRR
the fund after cash returns
the fund cash calculation
flows
flows
1-Jan-19 25,000 25,000 (25,000)
31-Jan-19 25,890 25,890 3.56% 0
28-Feb-19 5,000 27,000 22,000 4.29% 5,000
31-Mar-19 21,736 22,000 -1.20%
30-Apr-19 22,012 22,012 0.05%
31-May-19 22,134 22,134 0.55%
30-Jun-19 50 22,207 22,157 0.33% 50
31-Jul-19 22,189 22,189 0.14% 0
31-Aug-19 22,800 22,800 2.75%
30-Sep-19 22,845 22,845 0.20%
31-Oct-19 23,100 23,100 1.12% 0
30-Nov-19 22,750 22,750 -1.52%
31-Dec-19 22,356 22,356 -1.73% 22,356
TWRR 8.7% MWRR 11.6%

Standard deviation of the portfolio (std.dev) 1.8%

Risk free return (RFR) 6%
Sharpe ratio=(TWRR-RFR)/std.dev 1.4
Return in excess of benchmark (TWRR-Nifty 100 return) 3.2%

The risk free return is the yield Government bonds

Then fund managers have to beat the Nifty 100 returns.

Commentary

 Absolute performance of Fund A is higher than that of Fund B based on the TWRR.
 In Fund B there was a large withdrawal before returns fell in the February 2019. The
returns were relatively higher in the earlier months and therefore the money weighted
return is higher for Fund B as compared to Fund A.
 The Sharpe ratio which measures the excess of return over a risk free return per unit of
risk is higher for Fund B as compared to Fund A, though not very significantly. It can be
therefore said that the return which has been achieved by the Fund manager of Fund B is
better as the returns are more stable.
 The excess of return over the benchmark is higher for fund A than for Fund B. Currently
the benchmarks are the same.

Recommendations

 Fund or portfolio returns should be calculated using the time-weighted rate of return
method. Time-weighted rates of return are not distorted by cash flows, so they reflect the
true performance of the fund or portfolio.
 The money- weighted return gives greater weight to time periods where the portfolio has
greater value than to periods where the portfolio has less value. Considering that pension
funds have an expectation of investment return which is higher than the ones which they
have used for the valuation of their liabilities, and fund managers have some ability to
anticipate external cashflows, this metric can also be added to the performance evaluation
but with a lesser weight.

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 IAI CP3-1120

 Standard deviation is being used as the measure of investment return risk. The Sharpe ratio
is an important reward-to-risk ratios that can be used to compare a portfolio’s excess return
with a measure of portfolio risk. A reward to risk metric is important in order to ensure
that fund managers take reasonable risks and do not expose the funds to very risky
investments. This is especially important as the fund managers have been given a broadly
free mandate with no restrictions.
 Relative returns allow for the comparison of a fund’s return with the return on the
benchmark and is an important measure to understand relative performance.

Taking into these considerations it is recommended that performance relative to benchmark be

assigned a weight of 50%, the reward to risk ratio a weight of 40% and the MWRR a weight of
10%.

Instructions to candidates

You can base your answers on the performance evaluation note which has been prepared with
the proposed metrics computed for two of the bigger funds and the recommendation in answering
the questions. There is no need to perform any calculations. There is no word limit which has
been prescribed.

Questions

Q. 1) Draft an email to the head of HR answering her queries. Your email should give an overview of
the two measures of returns, the need for the two measures, how outperformance is measured and
how performance in evaluation allows for the risk taken and the recommendation. [90]

Q. 2) The email is to the head of HR. How did you ensure that the tone of the email is appropriate for a
senior colleague? [2]

Q. 3) Explain how you summarized some of the numerical data to provide the required clarity without
cluttering the email. [4]

Q. 4) Give two examples of jargon that you avoided or included but with appropriate explanations. [4]

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