1 Fin 2802, Spring 09 - Tang

Chapter 24: Performance Evaluation
Risk Adjustments
•Sharpe measure

•Treynor measure

•Jensen measure
2 Fin 2802, Spring 09 - Tang
Chapter 24: Performance Evaluation
Sharpe Method
Sharpe measure:
r r
p f
p
÷
o
_ _
Reward-to-volatility ratio:
Appropriate for measuring the relative
performance of an entire portfolio.
3
M
2
Measure
• Developed by Modigliani and Modigliani
• Equates the volatility of the managed portfolio with the
market by creating a hypothetical portfolio made up of T-
bills and the managed portfolio
• If the risk is lower than the market, leverage is used and the
hypothetical portfolio is compared to the market
4
Figure 24.2 M
2
of Portfolio P
5
M
2
Measure: Example
Managed Portfolio: return = 35% standard deviation = 42%
Market Portfolio: return = 28% standard deviation = 30%
T-bill return = 6%
Hypothetical Portfolio:
30/42 = .714 in P (1-.714) or .286 in T-bills
(.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed
portfolio underperformed

Fin 2802, Spring 09 - Tang
Chapter 24: Performance Evaluation
6
Treynor Measure
Treynor measure:
r r
p f
p
÷
|
_ _
Excess return to beta ratio:
Appropriate for measuring the relative
performance of parts of a portfolio.
7
Chapter 24: Performance Evaluation
Jensen Measure
( )
| |
Jensen measure:
o |
p p f p M f
r r r r = ÷ + ÷
Appropriate for measuring the absolute
performance of a portfolio.
Alpha of an investment (from CAPM):
8
Information Ratio
Information Ratio = o
p
/ o(e
p
)
Information Ratio divides the alpha of the
portfolio by the nonsystematic risk
Nonsystematic risk could, in theory, be
eliminated by diversification
9
Which one to use?
• Sharpe measure:
Useful when assets are concentrated within a
single portfolio managers

• Treynor and Jensen measures:
Useful when assets are spread across many
portfolio managers.
10
Figure 24.3 Treynor’s Measure