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Article in Financial Risk Management

Paradoxes of Portfolio Performance Calculation for Wealth Management: Avoiding Reporting Pitfalls

 This year, we have worked on a paper with Prof. Emmanuel Fragnière that has been published in the Journal of Financial Risk Management.

 Abstract:

 Clients of wealth management banks are usually informed about their portfolio through regular reporting. To maintain client trust, it is important that this reporting be both comprehensive and comprehensible. This reporting is grounded on complex mathematics in order to calculate myriads of profit and loss, performance and risk indicators. As the amount of information provided to clients increases so does the chance that certain elements will be confusing to them, at the risk of undermining their confidence in their wealth management bank. This risk is compounded by the general increase in portfolios of complex financial products involving different time horizons. The reporting is typically a decision aid tool for the client to monitor and control and make investment decisions. One example of such risk is that the calculated risk and performance indicators are delivered to the client with no explanation and can, in some cases, lead to incorrect perception due to misunderstanding of these numbers, even if calculations are correct. A typical example could be that the client is informed that the performance of the portfolio is 7% and in reality, the portfolio is losing money. In this paper, we want to address this kind of problem. As such we have identified a set of typical pitfalls that we are faced within the profession. Then, based on a rigorous reference to the scientific literature we have popularized these pitfalls and employed a series of simple and didactic illustrations to provide an appropriate toolbox in order to reduce the risk of financial reporting misunderstanding. In order to maintain client confidence, we highlight the importance of identifying areas of potential misunderstanding prior to providing reports to clients and of offering clear explanations for unusual numbers. We address the following themes: Profit and Loss Analysis, Performance Calculation, Performance Contribution, Realized and Unrealized Profits and Losses, and Bond Yields.

Download the paper here.

 Journal of Financial Risk Management

 
Exuberance and Gloom - Q2 2018

Exuberance and Gloom is a global financial markets analysis made by Stephen Rufino Ph.D, CIIA, Galeo's financial analyst.

 We look at four US market indicators (equity valuation, 10y bonds, corporate bonds and options) and determine whether these reflect rational expectations of market participants or excessively optimistic (Exuberance) or pessimistic (Gloom) ones. Similarly we look at two indicators affecting companies, corporate earnings and new jobless claims. For each indicator the Exuberance and Gloom zones are defined on the basis of its historical behaviour. To facilitate reading of the various charts we have constructed them to ensure that observations in the upper part of the chart indicate Exuberance and those in the lower part Gloom.

 When several indicators are in the Exuberance zone it is a strong indication that investors are allocating their capital based on irrationally optimistic assumptions and that markets are susceptible in the midterm to considerable downside. Conversely when several indicators are in the Gloom zone there is potential for substantial upside.

 After an edgy first quarter, investors regained their composure in the second quarter leading to a 2.9% rise of the SP 500. With SP 500 prices and 10-year earnings rising in parallel, its cyclically adjusted P/E ratio remained at 30.4 just below the exuberance zone. Implied volatility fell from 20 to 16 pushing sentiment, which had been in the gloom zone in February, to above average levels. The slope of the US sovereign bond curve flattened slightly returning sentiment to its upward trend. High-yield spreads and sentiment were unchanged. In the corporate arena, initial claims remain very low maintaining employment sentiment in the exuberance zone. SP500 earnings remain close to their historical trend keeping sentiment close to its average level.

Download the full study here.

 Exuberance and Gloom - Q2 2018

 
Exuberance and Gloom - Q1 2018

Exuberance and Gloom is a global financial markets analysis made by Stephen Rufino Ph.D, CIIA, Galeo's financial analyst.

 After a strong 2017, investors lost their resolve in early February. Spooked by fears of higher inflation, fed rate hikes and trade wars they dumped their equity holdings resulting in a roller-coaster ride for US equity markets with the SP500 experiencing a 10% intra-quarter drawdown.

 In the first quarter, with the SP500 up a paltry 0.2% and 10-year historical earnings rising, equity valuations were down and sentiment retreated from exuberant levels. The market turmoil drove implied volatility up to 33.5 at close of February 8th to finish the quarter at 20, resulting in sentiment swinging from exuberant to gloomy and back up to average levels. Credit spreads widening marginally pushing sentiment down towards its historical average. US sovereign short and long-term rates rose in parallel leaving the curve’s slope unchanged and bond sentiment slightly above its historical average.

 In the corporate arena, initial claims decreased maintaining employment sentiment in the exuberance zone. Earnings edge slightly higher but not sufficiently to keep sentiment rising.

Download the full study here.

 Exuberance and Gloom - Q1 2018