Monday, March 3, 2008 Session 9 – 2:30 PM to 3:20 PM Michael Crowley and Wayne G. Bogosian Monday, March 3, 2008 Session 9 – 2:30 PM to 3:20 PM Michael

Monday, March 3, 2008

Session 9 – 2:30 PM to 3:20 PM

Michael Crowley and Wayne G. Bogosian

Monday, March 3, 2008

Session 9 – 2:30 PM to 3:20 PM

Michael Crowley and Wayne G. Bogosian

401(k) Plan Fees … How does your Plan compare?

2008 Benefits New YorkNew York, NY

401(k) Plan Fees … How Does Your Plan Compare? | | 3

Workshop Objectives

Current Events in Fee Disclosure

Revenue Sharing – Good, Bad or Illegal?

Case Study: Benchmarking 401(k) Plan Fees

What is a “reasonable” fee?

Getting ready for “full fee disclosure”?


Current Events in Fee Disclosure

2004 Department of Labor ERISA Advisory Council to Review 401(k) Plan Fees (12/9/2004)– 15-member council appointed by the Secretary of Labor (union, employer, provider and "public" representatives)– Result of Council/Congressional Action/Litigation is three-step initiative (1) Revised Form 5500 Schedule C (confirm that all fees have been disclosed to sponsor;

(2) ERISA §408(b)(2) prohibited transaction exemption for fiduciaries who get written service agreements showing all provider fees;

(3) Disclosing plan fees to participants, thereby confirming fees are reasonable

401(k) Fee Lawsuits (9/2006)– Claims by Plaintiffs: Fiduciaries were “unaware” of plan expenses

2006 GAO Report Recommendations (11/2006)– Findings: Few participants understand plan fees– Recommendations: Report all fees paid from plan assets and paid by participants provide easy comparison

between funds 401(k) Congress Holds Fee-Related Hearings (3/6/2007) DOL (EBSA) Requests Comment on 401(k) Fee Disclosures (4/20/2007)

– Question: What information do participants require to make investment decisions? Miller (D-CA) Introduces “401(k) Fair Disclosure for Retirement Security Act of 2007” (7/26/2007) DOL Issues Proposed Regulation on Fee Disclosure (12/12/2007)

– ERISA §408(b)(2) requires plan fees to be “reasonable”– Plan sponsors require “full disclosure” of fees to make reasonableness assessment – Requires ALL plan service providers to disclose all methods of compensation (direct and indirect), conflicts of

interest, etc. – Plan fiduciaries receive prohibited transaction exemption if FULL disclosure is requested from all service providers


Current Events in Fee Disclosure (continued)

Court Decisions– Exelon (2/21/2007): US District Court of Northern District of IL granted motion to

exclude investment losses from plaintiff’s suit. No connection was drawn between participant investment losses and defendant’s failure to disclose administration fees.

– John Deere (6/29/2007): US District Court of Western District of WI dismissed “excessive fee” fiduciary breach case.

– United Technologies (8/9/2007): US District Court of CT granted motion to dismiss claim of fiduciary breach for failure to disclose revenue share arrangements but allowed it to proceed on a misrepresentation theory.

– Phones Plus v. Hartford FSG (10/23/2007): US District Court denies motion to dismiss “revenue sharing as plan assets” case. Plaintiff claimed: (1) Hartford was plan fiduciary and therefore receipt of revenue sharing was a prohibited transaction, and (2) Investment Adviser, as a fiduciary, had a duty to investigate, discover and inform plaintiff of Hartford’s use of revenue sharing dollars.


Current Events in Fee Disclosure (continued)

Court Decisions– Tullis v. UMB Bank (1/28/2008): Appeals Court allows an individual to seek

recovery of plan assets without resorting to a class action.

– Tussey v. UBB, Inc. (2/11/2008): US District Court of Western District of MO rules that plan sponsor and Fidelity had no fiduciary duty to disclose revenue sharing fees. However, the court denies motion to dismiss, declining to adopt the Deere decision’s rationale. Rather, the court rules that the failure to disclose revenue share arrangements is relevant to a 404(c) defense because that defense requires that plan losses be caused by a plan participant exercising control over investments. A jury could find that plan losses related to revenue sharing fees were not caused by a plan participant who was ignorant of the revenue sharing fees when choosing investments.

– LaRue v. Dewolff (2/20/2008): Supreme Court ruling allows individuals to recover (vs. entire plan) from fiduciaries.


Fiduciary and Participant Responsibility

Participant Responsibility

• Understand benefits & costs of plan participation

• Select investments • Monitor account performance• Make changes when appropriate

Fiduciary Responsibility

• Design/operate plan according to “rules”• Select, negotiate and monitor service

providers and agreements• Develop “Investment Structure”• Select, monitor, hire/fire managers• Communicate plan performance and

fees to participants

“What information do plan participants need to make confident decisions?”


Fiduciary and Participant Responsibility (continued)

Required Statutory Disclosures(Enrollment Form, SPD, Form 5500, SAR)

• Investment Fees (prospectus) Fund expense ratios Contingent redemption fees

• Administration Fees Paid from Plan Recordkeeping Loans, distributions, QDRO Transactions Compliance, Legal, Inv. Advisory, Audit

“Will more information make participants better investors or plan sponsors better fiduciaries?”

Desired Statutory Disclosures(New Notice Requirements)

• Participant Investments – Name, objective, risks,

OER, CRF, performance Administration – All fees paid by

participants or plan• Plan Sponsor

Written service agreements w/all service providers

Disclose all provider revenue sources Disclose all conflicts of interest Document fees on Form 5500 Sch. C


Your Personalized Expense Ratio

InvestmentCategory

Investment Option

CurrentAllocation

to Fund

Expense Ratio(bp)*

WeightedAverage Expense

(bp)*

Industry AverageExpense

(bp)*

Industry Average

Weighted Expense

(bp)*

Cash Equivalent Schwab Stable Vale 5% 50 2.50 65 3.25

Fixed Income PIMCO Total Return (Ins) 21% 43 9.00 102 21.42

Fixed Income PIMCO Real Return 14% 45 6.30 99 13.86

Real Estate Morgan Stanley Ins U.S. RE (A) 5% 89 4.50 154 7.70

Large Cap Value MainStay ICAP (I) 14% 80 11.20 134 18.76

Large Cap Growth Growth Fund of America (R5) 11% 36 3.96 142 15.62

Mid Cap Value Janus Adviser Mid Cap Value (I) 7% 75 5.25 141 9.87

Mid Cap Growth MainStay Mid Cap Growth (I) 5% 110 5.50 154 7.70

Small Cap Value Third Avenue Small-Cap Value 4% 113 4.52 155 6.20

Small Cap Growth Baron Small Cap 3% 133 3.99 166 4.98

International AF EuroPacific Growth A 9% 80 7.20 153 13.77

Emerging Markets Lazard Emerging Markets 2% 127 2.54 190 3.80

YOUR INVESTMENT EXPENSE 66.44 126.93

YOUR ADMINISTRATION EXPENSE 5.00 0.00

YOUR TOTAL EXPENSE 71.44 126.93

WHAT IS MY TOTAL COST FOR PLAN ADMINISTRATION AND INVESTMENT

MANAGEMENT?

You pay $0.71

out of every $100 you invest in your plan

The average investor would pay $1.27

out of every $100 they invest

*A basis point (bp) is a unit that is equal to 1/100th of 1% (i.e., 0.01% = .0001 = 1 basis point or $0.01 on $100 invested), and is used to denote the change in a financial instrument.


Sources of Provider Revenues (“Economic Benefit”)

Proprietary Product Placement– Fully “bundled” using ALL/MOSTLY proprietary product is MOST profitable– Internal “revenue crediting rates” (for proprietary funds) differ by fund company– Default fund option (Life Cycle, Managed Accounts)– Spreads (fixed income products)

Non-Proprietary Product Revenues– Revenue sharing arrangement & 12b-1 fees – Sales commission– Yield spread – Wrap fees– Sub Transfer Fees & Shareholder Service Fees– Brokerage “shelf-space” Fees– Preferred Provider or Placement Fees– “Soft-dollar” Brokerage (proprietary & third-party research)– Directed brokerage (for investment products other than mutual funds)– Other: Allowances, Subsidies, Conferences, Reciprocal Referrals, Directed

Brokerage, Rollovers upon Termination


Is “Revenue Sharing” Good, Bad or Illegal?

INVESTMENT CATEGORY

INVESTMENT OPTION

EXPENSE RATIO (Component Parts) (%)*

EXP. RATIO*

REVENUE SHARE TO SERVICE

PROVIDER

CATEGORY AVG EXP.

RATIO (%)*Inv. Mgt.

Distribution (12b-1)

Other

Cash Equivalent Proprietary Stable Value 6 bp 0 bp 44 bp 50 bp 44 bp N/A

Fixed Income PIMCO Total Return (Ins) 25 bp 0 bp 18 bp 43 bp 0 bp 102 bp

Allocation Strategy Moderate Allocation Strategy 40 bp 0 bp 18 bp 58 bp 16 bp 108 bp

Balanced Proprietary Balanced (Ins) 75bp 0 bp 11 bp 86 bp 75 bp 113 bp

Allocation Strategy Aggressive Allocation Strategy 63 bp 1 bp 11 bp 75 bp 22 bp 113 bp

Real Estate Morgan Stanley Ins U.S. RE (A) 76 bp 0 bp 13 bp 89 bp 10 bp 154 bp

Large Cap Value Proprietary Equity (I) 80 bp 0 bp 0 bp 80 bp 50 bp 134 bp

Large Cap Index BGI Equity Index (Q) 5 bp 0 bp 1 bp 6 bp 1 bp 115 bp

Large Cap Growth Growth Fund of America (R5) 28 bp 0 bp 8 bp 36 bp 5 bp 142 bp

Mid Cap Value Janus Adviser Mid Cap Value (I) 64 bp 0 bp 11 bp 75 bp 10 bp 141 bp

Mid Cap Index Vanguard Mid-Cap Index Adm 11 bp 0 bp 2 bp 13 bp 0 bp 143 bp

Small Cap Value Third Avenue Small-Cap Value 90 bp 0 bp 23 bp 113 bp 0 bp 155 bp

Small Cap Index Vanguard Small-Cap Index Adm 10 bp 0 bp 3 bp 13 bp 0 bp 144 bp

Small Cap Growth Baron Small Cap 100 bp 25 bp 8 bp 133 bp 35 bp 166 bp

International Proprietary International (I) 80 bp 0 bp 0 bp 80 bp 50 bp 153 bpSource: Morningstar 2007; Fund Prospectus


About NFA

• Founded 1982• Nationwide Self-Regulatory Org. for

US Futures Industry (not-for-profit)• 280 Employees• $58M 401(k)/Profit Sharing Plan• 99% Participation• 8.33% Avg. Deferral• Auto-enrollment @ 6%• QDIA – Balanced Fund • 20 Plan Funds

13 Active Managers 5 Index Managers 3 Risk-based Strategies

• Avg. participant uses 7 plan funds• Formal Plan Oversight


Fiduciary Committee – Plan Oversight

Retained Responsibilities (Non-Delegated)– Fiduciary Oversight (“Benefit Plan Trustees”)

– Committee Charter and Investment Policy

– Fund Manager Performance

– Fee Analysis (Total and Vendor-specific)

– Service Provider Oversight

Delegated Committee Responsibilities– Trust (directed-trustee)

– Plan Administration (day-to-day recordkeeping)

– Investment Advisory

– ERISA Counsel

– Communications and Education


“State-of-the-Plan” Report to Board of Directors

Purpose: Inform Board of the Actions of their Appointed Fiduciaries– Plan Amendments and Material Modifications

– Claims and Appeals

– Plan Administration

– Plan Demographics

– Plan Qualification

– Litigation

– Agents (ERISA Counsel, Inv. Advisor, Auditor)

– Plan Expenses

– Plan Funds


Plan Fees Paid by Participants

EXPENSEANNUAL PARTICIPANT PAID FEES

(based upon Total Plan Assets of $57,000,000 as of 12/31/2007)

Fees for Plan Administration $125,000 or

$298/participant22 basis points

Fees for Investment Management, Shareholder,

Distribution and Other Services

$251,000 or $599/participant

44 basis points

Total Annual Fees Paid by Participants

$376,000 or $897/participant

66 basis points

NFA’s Average Account Balance is ~ $138,000


How Does NFA Compare to All Plans?Benchmark Comparison of Plan Fees to PFE 401(k) Database – ALL PLANS

DATABASE PROFILE

Mean Median NFA

Plan Assets $995 Million $451 Million $58 Million

Participants 20,684 10,326 419

Avg. Account Size $48,118 $43,709 $138,000

Inv. Expense (bp) 57 bp 54 bp 44 bp

Admin. Expense ($) $161 $140 $298

PFE 401(k) DATABASE PROFILE – ALL PLANS

The PFE 401(k) Plan Expense Database contains information from 242 defined contribution plans, ranging in size from $442,000 to $16 billion and from industries such as industrial, retail, professional services, financial services, non-profit, technology, consumer products, and entertainment. Total assets in the database are approximately $243 billion spread among more than 5 million accounts.

Plans in PFE’s expense database have been submitted by fee-only investment consultants and some service providers. It is highly likely these plans are among the most competitively priced 401(k) plans in the United States


$0

$100

$200

$300

$400

$500

How Does NFA Compare to All Plans? (Continued)

PERCENTILE INVESTMENTS* ADMINISTRATION* TOTAL COST*5 $59 $53 $139

25 $134 $101 $24650 $200 $157 $35175 $289 $233 $41795 $563 $491 $582

NFA Forecast $538 (41 bp) $384 (29 bp) $922 (70 bp)

NFA Actual $599 (44 bp) $298 (22 bp) $897 (66 bp)

401k Source Mid Plan Avg.** $584 (119 bp) $15 (2 bp) $599 (122 bp)

*This table ranks ACTUAL investment, administration and total expenses for 242 plans in the PFE database. Actual expenses are influenced by average account size and asset allocation. Figures for Total Cost, Investments and Administration are independent of each other (mutually exclusive). ** 401k Source Averages Book© 2007 8th edition Mid plan is defined as assets of $40 million and million w/approximately 1,000 participants

$600

$700

$800

$900


NFA vs. Comparable Plans by Plan Assets

Investment Expense Only

IndustryTotal Plan

AssetsCompany

Stock# of

AccountsAvg. Account

Size*Total Inv

Expense**

Inv Expense

(bp)**

Average Cost Per

Account**

Industrial $81,044,815 $7,292,497 1,686 $48,081 $99,620 14 $59

Professional Svcs $35,681,201 $0 498 $71,649 $56,739 16 $114

Industrial $54,260,731 $0 581 $93,392 $91,317 17 $157

Professional Svcs $70,294,370 $0 1,280 $54,917 $205,864 29 $161

Professional Svcs $81,139,048 $0 1,056 $76,836 $238,960 30 $226

Health Care $32,079,183 $0 419 $76,561 $109,971 34 $262

Financial $27,140,254 $0 574 $47,283 $100,540 38 $175

Industrial $23,015,306 $0 725 $31,745 $87,029 40 $120




Industrial $51,347,282 $0 378 $135,839 $223,498 44 $591

NFA $57,659,094 $0 419 $137,611 $251,486 44 $599

Entertainment $30,632,811 $0 550 $55,696 $153,401 50 $279

Non-Profit $47,447,000 $0 1,802 $26,330 $269,142 57 $149

Industrial $28,861,702 $0 1,580 $18,267 $166,074 59 $105

Health Care $53,041,345 $0 1,103 $48,081 $325,858 61 $295

Industrial $56,438,692 $0 1,058 $53,345 $311,375 63 $294

Consumer/Misc Prods $63,565,086 $0 2,000 $31,783 $478,315 75 $239

Industrial $67,600,000 $0 3,700 $18,270 $521,282 77 $141

Health Care/Med Svcs $75,907,292 $0 13,000 $5,839 $610,531 80 $47

* Includes Company Stock. ** Includes all funds-Life Cycle, Life Style and Company Stock funds


Benchmarking Fees … Easier Said Than Done

No Benchmarking Survey Can Capture all Plan Expenses– Loan, Distribution, and Ad Hoc Fees can be substantial – Managed Account fees are often not counted – Expenses paid by plan sponsors are often not reported (as a result overall fee looks low for

these sponsors when compared to all-in expensing)

Not all Plans are created equal – What provider services do you use?– How complex is your plan design?– How “demanding” are you?

What services are of value to “your” plan and participants, but incur additional cost?– Independent Investment Advisor– ERISA Counsel– Demographic-specific communications– Financial education and one-on-one counseling

Index and ETF Plans vs. Active Manager Plans – Active Manager Plans tend to look expensive when compared to all-Index or ETF plans – Expenses alone do not tell the entire story; return and risk must also be included


Comparing Active Management vs. Index Management (Risk and Return)

*See “Interpreting Modern Portfolio Theory Statistics” at the end of this publication

COMPOSITION

Asset Class/Style Class FundModerate Allocation Aggressive Allocation

Naïve* Index Fund Naïve* Index Fund

Cash & Equivalent Schwab Stable Value 10% 10% 10% ------ ------ ------

Investment Grade Bonds PIMCO Total Return D 50% 30% 30% 20% 12% 12%

Inflation-Adjusted Bonds PIMCO Real Return Instl ------ 20% 20% ------ 8% 8%

Large Cap Value WHG Large Cap Value Inst ------ 11% 11% ------ 17% 17%

Large Cap Blend S&P 500 IndexSel 40% ------ ------ 80% ------ ------

Large Cap Growth Growth Fund of America R4 ------ 9% 9% ------ 13% 13%

Midcap Value JP Morgan Midcap Value Inst ------ 5% 5% ------ 8% 8%

Midcap Growth Alger Midcap Growth Instl ------ 4% 4% ------ 5% 5%

Small Cap Value Royce Low-Priced Stock ------ 3% 3% ------ 6% 6%

Small Cap Growth Schroeder US Opportunities ------ 2% 2% ------ 4% 4%

Real Estate Third Avenue Real Estate Val ------ 3% 3% ------ 8% 8%

International Equity Amer Funds EuroPac A ------ 3% 3% ------ 14% 14%

Emerging Markets Equity Oppenheimer Dev Markets A ------ ------ ------ ------ 5% 5%

SEVEN YEAR PERFORMANCE** (ending 12/31/2007)

Annualized Return 4.82% 6.65% 7.85% 4.00% 8.42% 10.33%

Alpha vs. Naïve 0.00 1.91 3.40 0.00 4.43 6.49

Beta vs. Naïve 1.00 0.97 0.89 1.00 0.94 0.86

R-Squared vs. Naïve 1.00 0.89 0.83 1.00 0.89 0.84

Standard Deviation 5.04 5.15 4.93 10.43 10.41 9.82

Sharpe Ratio 0.36 0.71 0.99 0.10 0.52 0.75

Tracking Error vs. Naïve 0.00 1.68 2.13 0.00 3.44 4.13

Information Ratio N/A 1.14 1.60 N/A 1.29 1.57

This table shows the seven-year risk and return characteristics for two optimally-constructed portfolios using plan funds. Naïve vs. Index shows the efficiencies of diversification. Index vs. Fund shows the added value (if any) of active management.


The Future for Plan Fees

Notice Requirements – add 2 new “Notices” to your current list (AE, AI, QDIA, Safe Harbor):

– Annual Fee Notice and Fund Change Notice

Comprehensive Fee Analysis and Benchmarking – by independent third party

Fee Restructuring – pro rata allocation of administration expense; per capita allocation of investment expense

More Competition – 2008 Form 5500 (Schedule C) will disclose all expenses paid by plan (w/o any context, of course)


Are You Ready for Full Fee Disclosure?

Relate these questions to your retirement plan? Yes NoDon’t Know

1. We have identified those services which are considered necessary to the effective and efficient operation of the plan?

2. We have identified all fees charged for necessary services and confirmed (a) who is currently paying the fee (participant or sponsor) and (b) how the fee is being assessed (pro-rata or per capita)?

3. We have identified all Plan Administration services (and fees) which

are currently paid through plan investments? 4. We offer less expensive share classes today (if possible) than we did

three years ago? 5. We have re-negotiated our plan fees (or moved our business) within

the past three years? 6. We have benchmarked our plan services and fees to similar plans in

the past three years? 7. Total plan expenses are reported to plan fiduciaries at least once

each year? 8. An independent investment advisor, who is a fiduciary of the plan,

regularly reviews our plan’s services, investments and fees? ERISA § 406(a)/408(b)…

“Prohibited transaction occurs if plan assets are used to pay service providers more than reasonable compensation for their services”


A Fiduciary’s “Fee-Related” To Do List …

Service provider revenue/service assessment

Comparing plan investments and plan costs to correct benchmarks

Share class selection and monitoring

Service provider revenue capitation ($ or bp)

Default fund selection (Who recommended? What were revenue implications?)

Pension plan vs. 401(k) due diligence

Reporting fiduciary actions to Board of DirectorsIf you don’t know what you are doing …

ERISA requires you to find someone who does.


Thanks for coming!

Michael CrowleyAssociate General CounselNational Futures Association300 South Riverside Plaza Suite 1800Chicago, IL 60606(312) [email protected]

Wayne G. BogosianPresident & Managing DirectorThe PFE Group144 Turnpike Road, Suite 360Southborough, MA 01772(508) 683-1400, ext. [email protected]


Disclaimers and Attributions

General Notes The information contained in this document is as of December 31, 2007 and is believed to be accurate. Data was gathered from a variety of sources believed to be reliable, including

Morningstar, eVestmentAlliance, Standard & Poor’s and other third-party administrators. Every attempt has been made to verify data; however, no guarantees or endorsements of accuracy are to be made. Any discrepancies between the numbers contained herein and other sources are unintentional.

Total returns include changes in share values and reinvestment of dividends and capital gains distributions, if any. Gross returns will be reduced by management fees and other expenses in an amount proportional to performance. For example, a fund with a gross return of 10% and an expense ratio of 1% will experience a reduction of 1.1%. Individual client performance numbers may differ from reported numbers for a fund due to contributions or withdrawals made during the performance measurement period. Past performance is no guarantee of future results.

All references to Company Plans reflect information that was available at the time of publication. Actual benefits will be based upon information and formulas contained in the appropriate Plan Document(s). The inclusion of non-plan funds in certain exhibits is for comparative purposes only, and does not imply an endorsement of those funds by PFE Advisors, Inc.

The information on specific investments contained in this document is not an offer to sell, nor a solicitation of an offer to buy, these securities. Plan sponsors should review fund prospectuses and other relevant information before making any investment decisions.

This presentation is for the exclusive use of PFE Advisors, Inc. and its respective clients, and is not authorized for public distribution.

Index Definitions The S&P 500 is an unmanaged index of 500 large-cap domestic stocks that is commonly used as a proxy for the large-cap stock market. Historically, the index has targeted a

composition of 400 industrial companies, 40 financial companies, 40 utility companies, and 20 transportation companies. The index does not contain real estate investment trusts. Changes in the index composition may be made at any time. Performance numbers for the index are a size-weighted average of the performance numbers for each index constituent.

The Russell 2000 is an unmanaged index consisting of the smallest 2000 stocks in the Russell 3000 universe, which in itself consists of the largest 3000 publicly-traded domestic companies. This index is commonly used as a proxy for the liquid small-cap stock market. The index is reconstructed on July 1 of each year. Performance numbers for the index are a size-weighted average of the performance numbers for each index constituent.

The MSCI EAFE® Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US & Canada. The index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.

The NAREIT index is an unmanaged index of securities that meet the definition of Real Estate Investment Trust (REIT) and are traded on the NYSE, AMEX, or NASDAQ. REITs are investments in rental properties, and are required to pay out 95% of their earnings each year as dividends. Performance numbers for the index are a size-weighted average of the performance numbers for each index constituent.

The Lehman Aggregate Bond Index is an unmanaged index made up of the following fixed-income securities: all debt securities issues to the public by the US Government or its agencies, as well as quasi-federal corporations or corporate debt guaranteed by the US Government; all public obligations of the US Treasury except flower bonds and foreign-targeted issues; all 15-year and 30-year fixed-rate securities backed by mortgage pools of GNMA, FHLMC, and FNMA, with the exception of graduated payment mortgages, manufactured home mortgages, and graduated equity mortgages; and all publicly-issued, fixed-rate, non-convertible, investment-grade, dollar-denominated, SEC-registered corporate debt securities with at least one year to maturity and an outstanding par value of at least $100 million.


Interpreting Modern Portfolio Theory Statistics

Annualized Return – the constant one-year rate of return on an investment which would result in the same total return as the actual annual returns over the performance period being measured. Example: A three-year investment has three yearly returns of +5%, -4%, and +10%, for a total return of +10.9%. The annualized return on this investment is +3.5%, since a return of 3.5% for each of the three years would result in the same total return of +10.9% with compounding.

Alpha – the expected return of the actively managed portfolio when the return of the index is 0%; it is determined by comparing the monthly or quarterly returns of the portfolio and the index over a period of time. A positive alpha is always good, although it is not abnormal to have a low alpha accompanied by a high beta (see beta below)

Beta – a measure of the market-related risk of a portfolio, expressed as a multiple of its benchmark. A beta of 1.10 means that the portfolio is 10% riskier than its benchmark; a beta of 0.90 means that the portfolio is 10% less risky than its benchmark. Modern Portfolio Theory states that higher betas should be rewarded with proportionally higher returns over long investment periods.

R-Squared (R2) – a measure of the effectiveness of the alpha and beta statistics in estimating the expected risk and return levels of a portfolio. As a rule of thumb, an R2 statistic of 0.70 or higher means that there is a significant relationship between the performance of the portfolio and the performance of the index to which it is being compared. Lower numbers are acceptable if the measurement period is longer, and vice-versa

Standard Deviation – a measure of the consistency of periodic returns of a portfolio or index over time. For any given twelve-month period, the investment has a 68% probability of producing a return within the range defined by its long-term average return plus or minus its standard deviation. Similarly, it has a 95% chance of providing a return in the range defined by its long-term average return plus or minus two standard deviations.

Sharpe Ratio – a measure of the tradeoff between the value added through active management of a portfolio and the amount of risk incurred through the management process. There is no constant number that is considered “good” or “bad”; the only objective for an actively managed portfolio is to produce a Sharpe Ratio that is higher than its benchmark. The Sharpe Ratio uses standard deviation as its measure of risk. (Note: The Sharpe Ratio statistic has a slight bias in favor of more conservative portfolios.)

Tracking Error – A measure of the similarity between the periodic returns of a portfolio and its benchmark. A low tracking error indicates a high degree of similarity, and vice-versa. Like the standard deviation statistic, the interpretation of tracking error is that a portfolio has a 68% probability of performing in a range defined by its benchmark return plus or minus its tracking error over any twelve-month period. There is no “good” or “bad” tracking error – it is simply a reflection of the investment policy of the portfolio manager.

Information Ratio – a comparable measure to the Sharpe Ratio in that it measures the tradeoff between return and risk; however, the return used is the alpha, and the measure of risk is the tracking error.

Documents

Monday, March 3, 2008 Session 9 – 2:30 PM to 3:20 PM Michael Crowley and Wayne G. Bogosian Monday, March 3, 2008 Session 9 – 2:30 PM to 3:20 PM Michael