# CHAPTER 24: PERFORMANCE EVALUATION

– r ABC = 10% – r XYZ = 10%

1.

a. b. c.

Arithmetic average:

Dispersion: σABC = 7.07%, σXYZ = 13.91%. XYZ has greater dispersion. (We used 5 degrees of freedom to calculate standard deviations.) Geometric average: rABC = (1.2 × 1.12 × 1.14 × 1.03 × 1.01)1/5 – 1 = .0977 = 9.77% rXYZ = (1.3 × 1.12 × 1.18 × 1.0 × .90)1/5 – 1 = .0911 = 9.11% Despite the equal arithmetic averages, XYZ has a lower geometric average. The reason is that the greater variance of XYZ drives the geometric average further below the arithmetic average.

d.

In terms of "forward looking" statistics, the arithmetic average is the better estimate of expected return. Therefore, if the data reflect the probabilities of future returns, 10% is the expected return of both stocks. Time-weighted average returns are based on year-by-year rates of return. Year 1998-1999 1999-2000 2000-2001 Return [(capital gains + dividend)/price] [(120 – 100) + 4]/100 = 24.00% [(90 – 120) + 4]/120 = –21.67% [(100 – 90) + 4]/90 = 15.56%

2.

a.

Arithmetic mean: (24 – 21.67 + 15.56)/3 = 5.96% Geometric mean: (1.24 × .7833 × 1.1556)1/3 – 1 = .0392 = 3.92% b. Date 1/1/98 1/1/99 1/1/00 1/1/01 Cash flow –300 –228 110 416 Explanation Purchase of three shares at \$100 each. Purchase of two shares at \$120 less dividend income on three shares held. Dividends on five shares plus sale of one share at \$90. Dividends on four shares plus sale of four shares at \$100 each.

24-1

Time 0 1 2 3 a.7(13% – 5%)] = 1. 3. Portfolio A Portfolio B Market index Risk-free asset The alphas for the two portfolios are: αA = 12% – [5% + 0.] The IRR exceeds the other averages because the investment fund was the largest when the highest return occurred.1607%. E(r) 12 16 13 5 σ 12 31 18 0 β .46%.0 0.7 1.0)1/3 – 1 = .416 110 Date: 1/1/98 1/1/99 1/1/00 1/1/01 −228 −300 Dollar-weighted return = Internal rate of return = –. b.0357 = 3. 4. Dollar-weighted average rate of return = IRR = 5.70%.0 c. a.4% 24-2 . [You can find this using a financial calculator by setting n = 3. the greater the dispersion.1111 × 1.57% Time-weighted arithmetic average rate of return = (11.11% 0 0 Time-weighted geometric average rate of return = (1.0 × 1. and solving for the interest rate.4 1. the greater the difference. PMT = 100. The arithmetic average is always greater than or equal to the geometric average. FV = 0. Cash flow (\$) 3(–90) = –270 100 100 100 Holding period return (100–90)/90 = 11.11 + 0 + 0)/3 = 3. PV = (–)270.

5. so it is preferred. If you will hold only one of the two portfolios.1047 . The standard deviation of each stock's returns is given in the problem.500 To compute the Sharpe measure.3373 10. then the Sharpe measure is the appropriate criterion: SA = SB = 12 – 5 = . (i) Alpha is the intercept of the regression (ii) Appraisal ratio = αp/σ(ep) (iii) Sharpe measure* = (rp – rf)/σp (iv) Treynor measure** = (rp – rf)/βp * Stock A 1% . A’s is higher.αB = 16% – [5% + 1. b. using the assumed parameters rM = 14% and rf = 6%. then Treynor’s measure counts.4907 8.4(13% – 5%)] = – 0. and B is preferred.0971 . then Sharpe’s measure is the one to use. ** The beta to use for the Treynor measure is the slope coefficient of the regression equation presented in the problem. you would want to take a long position in A and a short position in B. If the stock is mixed with the index fund.2% Ideally.583 12 16 – 5 31 = . rp – rf can be computed from the right-hand side of the regression equation. a. (i) (ii) If this is the only risky asset. B is preferred. therefore.355 Portfolio A is preferred using the Sharpe criterion. the contribution to the overall Sharpe measure is determined by the appraisal ratio. (iii) If it is one of many stocks. 24-3 . b. note that for each stock.833 Stock B 2% .

Market Equity –0.20 × 1.10 × 0. The intercept of the scatter diagram is a measure of stock selection ability.2% Cash 0.5% = 1.91% Actual: .65% Underperformance: . a. Timing ability is indicated by the curvature of the plotted line. Bogey: .20 ..35% –0.e. Stock selection must be the source of the positive excess returns.26% Security Selection: (1) Differential return within market (Manager – index) (2) Manager's portfolio weight .10 × 0. This ability to choose more market-sensitive securities in anticipation of market upturns is the essence of good timing. This indicates poor timing.04 0 –0. C. We need to distinguish between market timing and security selection abilities.2% + .70 . Bad Good Good Bad Good Good Bad Bad 7.6. If the manager tends to have a positive excess return even when the market’s performance is merely “neutral” (i.60 × 2. a higher beta) in periods when the market performed well. The steeper slope shows that the manager maintained higher portfolio sensitivity to market swings (i.0% + . a declining slope as you move to the right means that the portfolio was more sensitive to the market when the market did poorly and less sensitive when the market did well.39% b.0% + .5% = 1.0 Contribution of security selection 24-4 .e.. has zero excess return) then we conclude that the manager has on average made good stock picks. B.10 (3) = (1) × (2) Contribution to performance –0. D.5% + .70 × 2. We can therefore classify performance for the four managers as follows: Selection Ability Timing Ability A. Lines that become steeper as you move to the right of the graph show good timing ability. In contrast.5% Bonds –0.30 × 1.

4% 0.S.27% –.13% (1) Excess weight: Market Manager – benchmark Equity .15 –.6% Market UK Japan U.30 × 20 + .30% Country UK Japan U.2 –1.2 0.30 .4 –0.15 × 12 + .10 Bonds –.26% Manager return = .0 –1.c.39% .70% Contribution of country allocation c. a. Total value added – .80% – 1.10 .25% –.18 –.10 × 12 Added value = b.2 0.8 = 12. Added value from stock selection (1) Differential return within country (Manager – index) 8% 0 –4 –7 (2) Manager's country weight .8% 1. Asset Allocation (2) Index return 2.5 (3) = (1) × (2) Contribution to performance .13% – .6 –1.01 –.45 × 14 + .05 .20 –.50% = 13.10 Cash 0 Contribution of asset allocation Summary Security selection Asset allocation Excess performance 8. Germany (3) = (1) × (2) Contribution to performance –.20 (3) = (1) × (2) Contribution to performance 2.12 .40 × 10 + .10 (2) Index return minus bogey –1.0__ . Germany Contribution of stock selection 24-5 .20 × 5 Benchmark (bogey) = .24 –.5% 1.30 × 15 + .10 × 15 + .40 . Added value from country allocation (1) Excess weight: Manager – benchmark .S.

we know that.0 percent versus –5. to some degree.5(14% – 6%)] = 0 From Black-Jensen-Scholes and others. 12. portfolios with low beta have had positive alphas. (The slope of the empirical security market line is shallower than predicted by the CAPM -. we should observe performance over an entire cycle.2 percent return for the international index. then market performance should not affect the relative performance of individual managers.e. It is therefore not necessary to wait for an entire market cycle to pass before you evaluate a manager. this manager apparently has some country/security return expertise..see Chapter 13. a. 24-6 . Manager A has an obvious weakness in the currency management area. Therefore. This large local market return advantage of 2. a manager who does no timing. 10. b. Although Manager A’s one-year total return was slightly below the international index return (–6. to the extent that observing a manager over an entire cycle increases the number of observations.9.0 percent. This manager experienced a marked currency return shortfall. but simply maintains a high beta. Also. respectively). The manager’s alpha is 10% – [6% + . 1.) Therefore. a.2 percent for the index. on average. The following briefly describes one strength and one weakness of each manager. For example. Contradict: If we adequately control for exposure to the market (i. It does. given the manager's low beta. adust for beta).0 percent versus –5. Weakness. Support: A manager could be a better performer in one type of circumstance.0 percent exceeds the 0. 11. Manager A Strength. performance could be sub-par despite the estimated alpha of zero. it would improve the reliability of the measurement. if those manager groups can be made sufficiently homogeneous with respect to style. with a return of –8. will do better in up markets and worse in down markets.

This strategy would also mitigate Manager B’s weakness. this fund was told to adopt a long-term horizon. Yet Alpine was told to hold down risk. (Alpine’s beta was also somewhat defensive.2. with a marked positive increment apparent in the currency return. Manager B had a marked shortfall in local market return. b. Indeed. 1. The following strategies would enable the fund to take advantage of the strengths of the two managers and simultaneously minimize their weaknesses. Recommendation: Another strategy would be to combine the portfolios of Manager A and Manager B. investing at most 25% of its assets in common stocks. Moreover. Equities performed much better than bonds. Manager B appears to be weak in security/market selection ability. Recommendation: One strategy would be to direct Manager A to make no currency bets relative to the international index and to direct Manager B to make only currency decisions. and no active country or security selection bets. This would allow capture of Manager A’s country and stock selection skills while avoiding losses from poor currency management. Manager B’s total return exceeded that of the index.0 percent currency return versus a –5. Justification: This recommendation would capture the strengths of both Manager A and Manager B and would minimize their collective weaknesses.) Alpine should not be held responsible for an asset allocation policy dictated by the client. The Board specifically instructed the investment manager to give priority to long term results. The sample of pension funds had a much larger share in equities than did Alpine. with Manager A making country exposure and security selection decisions and Manager B managing the currency exposures created by Manager A’s decisions (providing a “currency overlay”). a. but one year is a poor statistical base on which to draw inferences. leaving an index-like portfolio construct and capitalizing on the apparent skill in currency management. Justification: This strategy would mitigate Manager A’s weakness by hedging all currency exposures into index-like weights. Manager B’s strength appears to be some expertise in the currency selection area. b. Based on this outcome. 24-7 .2 percent currency return on the international index. 2. Manager B had a –1. 13. Weakness. Manager B Strength. Therefore. the one year results were terrible.

but is the best of the three techniques. actually above zero.8% – 7.13%. Alpine did much better than the index fund.3% – [7. Treynor = (. Alpine outperformed both. which was the Board’s. choice. Within this asset class. 14. Method III uses net purchases of bonds as a signal of bond manager optimism. and not a neutral position.c. particularly the last one. Sharpe = (24 – 8)/18 = . It at least tries to focus on market timing by examining the returns on portfolios constructed from bond market indexes using actual weights in various indexes versus year-average weights. however. For example. Method II is not perfect. Note that the last 5 years. But such net purchases can be due to withdrawals from or contributions to the fund rather than the manager’s decisions. (Note that this is an open-ended mutual fund.1 = . despite the fact that the bond index underperformed both the actuarial return and T-bills. d. it is inappropriate to evaluate the manager based on whether net purchases turn out to be reliable bullish or bearish signals. but that return is more indicative of the manager’s performance. not Alpine’s.08)/1. 15. e. the asset class that Alpine had been encouraged to hold. Its overall disappointing returns were due to a heavy asset allocation weighting towards bonds. It also uses a very questionable “neutral position. have been bad for bonds.888 24-8 .5% + . The problem with the method is that the year-average weights need not correspond to a client’s “neutral” weights.) Therefore. Moreover. Alpine’s performance within each asset class has been superior on a risk-adjusted basis. Alpine’s alpha measures its risk-adjusted performance compared to the market’s.5%)] = . d. A trustee may not care about the time-weighted return.17 – .9(13.082 16.” the composition of the portfolio at the beginning of the year. Method I does nothing to separate the effects of market timing versus security selection decisions. a. After all. the manager has no control over the cash inflow of the fund. α = 13. what if the manager were optimistic over the whole year regarding long-term bonds? Her average weighting could reflect her optimism.

i. 27. Therefore. 18. 22. Treynor measures Market: (12 – 6)/1 = 6. b. but underperforms based on the Sharpe measure.00 Portfolio X: (10 – 6)/. a. a. the portfolio outperforms the market based on the Treynor measure but underperforms based on the Sharpe measure. 30. ii. b.17. c. b. a. 28. 25. 24.222 Portfolio X outperforms the market based on the Treynor measure. a. d. b. a. 19. Portfolio X has less systematic risk than the market based on its lower beta. 21. c.6 = 6.462 Portfolio X: (10 – 6)/18 = . b. 29. b.67 Sharpe measures Market: (12 – 6)/13 = . but more total risk (volatility) based on its higher standard deviation. The two measures of performance are in conflict because they use different measures of risk. b. 24-9 . 26. 23. 20. a.