MSc in Finance

EF5132: Advanced Portfolio Theory

Lecture Notes:
Evaluating Portfolio Performance

Relative Performance (Risk-adjusted basis)

Individual Funds
Market Portfolio

(i) Sharpe Measure (Excess Return to Variability Measure)

The CML has the greatest

Slope of portfolio possibility
Lines

Slope =

R pA R f

pA

Rp R f

>

= Sharpe Ratio

Rp R f

pB

The Sharpe Ratio provides a relative performance ranking of portfolios

(including the market portfolio).

Most mutual funds

Have a lower rewardto-variability index
than the Dow Jones
index.

The Sharpe measure looks at the decision from the point of view of an
investor choosing a mutual fund to represent the majority of his/her
investment.
An investor choosing a mutual fund to represent a large part of his/her
wealth would likely be concerned with the full risk of the fund, and
standard deviation is a measure of that risk.
If the investor desired a risk different from that offered by the fund,
he/she would modify the risk by lending and/or borrowing.

(ii) Differential Return

An alternative performance measure is to compare a fund manager
performance to the nave strategy of investing in the riskless asset and the
market portfolio to obtain the same risk ( ) as the fund.

CML:

Rm R f
Ri = R f +

m

For a given A

Rm R f
R A = R f +

m

The differential return is the difference in return between A and A

Actual average return on fund A is R A

Differential Return = R A R A

With this measure, funds are ranked by their differential return with the
best performing fund the one with the highest differential return.
Both Sharpe and Differential Return Performance Measures will list the
same mutual funds as performing better or worse than the market index.

(R

R A ) > (RB RB )

Yet,

RA R f

<

RB R f

Manager A was able to outperform a mixture of the market portfolio and

lending (with the same risk as A ) by more than manager B could
outperform a mixture of the market portfolio and lending (at the same risk
level as B ).

(iii) Treynor Measure

CAPM:

R p = R f + p (Rm R f
Rp R f

Treynor Measure =

Rm R f

Rp R f

m = 1.0

(iv) Jensens Alpha (Differential Return when risk is measured by beta)

R p = R f + (Rm R f ) p

(R

R f ) = (Rm R f ) p

Rewrite to include p (a move away from SML)

(R
If

p > 0
p < 0

R f ) = p + (Rm R f ) p

Superior Performance (relative to market)

Inferior Performance

where, p = R p R f p Rm R f

Treynor and Jensens Alpha rank the same funds that beat the market, and
conversely those that result in an inferior performance to the market.

Since, p = R p R f p Rm R f

R R f Rm R f
p
= p

p
p
m

m = 1

When,

Rp R f

>

Rm R f

p
>0
p

If p > 0

p > 0

An advantage of the Jensens Alpha measure is that through regression

analysis one can test the significance of p .
Note, a word of caution. In empirical studies, the CAPM has a higher
intercept and lower slope than the simple CAPM would suggest.

If the empirical line truly represents the risk-return opportunities

available in the marketplace, then viewing the Jensen measure as a
comparison to the CAPM line would imply that the differential returns
should be calculated relative to the Empirical Line. Utilising the

Empirical Line rather than the Theoretical Line would result in portfolios
with p < 1 having a smaller p (for positive p ) and for portfolios
with p > 1 having larger p .
Since most mutual funds have p < 1 , calculating p from the
Empirical Line would result in mutual funds being judged as having
inferior performance.
Also, using the Empirical CAPM might result in p < 0 even though
they were positive if the Theoretical Line is used.

Decomposition of Overall Evaluation (Famas Decomposition)

The Jensens Alpha draws on the CAPM and provides a measure of
selection ability since it measures the average deviation form the Security
Market Line (SML)

(R

Rf

= risk premium per unit of systematic risk ( = 1 ). If the

portfolios systematic risk is p , then the risk premium is AC. The

distance CD measures Jensens Alpha (the vertical distance from the
SML).

If the portfolio is not fuly diversified the underlying risk exceeds p , say
*

it is p . This would typically occur when the aggressive fund manager

overweights an under-priced stock and incurs some diversifiable risk.
In such cases the Gross Selectivity Return (=CD) incurs a component CE
which is attributed to the diversification risk incurred; DE is, accordingly,
termed Net Selectivity.

Selectivity deals with the capacity to select underpriced stocks and

Diversification deals with the capacity to diversify the portfolio
such that it is mean-variance efficient.

The Jensens Alpha measure may in fact underestimate the amount

of risk of the portfolio, and thus overestimate the performance of
the portfolio.

A measure to adjust for this is provided by Moses, Cheyney and Veit.

They suggest a performance measure that adjusts the Jensens Alpha in
cases where the manager does not maintain adequate diversification.

p =

p m pm
m2

If a portfolio is fully diversified pm = 1 p =

Let

Ip =

p
m

p
, which is an index of total portfolio risk
m

For an inefficient portfolio p < I p

*
( I p p in diagram)

Thus lack of diversification is captured by the expression

p
p
D = p = (1 pm )
m
m

If

If

pm = 1

pm 1

D = 0 (zero lack of Diversification)

Performance = p

D>0

Performance =

p
D

= GPp

If large and positive, the GPp implies a superior performance relative to

the additional diversification risk incurred.
Rankings on GPp provide a measure of relative performance. It is
possible to go a step further and identify funds that Beat the Market on
a risk-adjusted basis by relating GPp to a measure of excess return per
unit of systematic risk for the market portfolio

GPM =

[R

GPp

Rf m

[R

GPp

Rf

m = 1

*
Note, the distance p p represents lack of diversification risk D . This

is divided into CD (i.e., Jensens Alpha) to yield the GPp measure. If the
diversification risk, D , were compensated in line with market risk
premia it would yield a return CE.

Measuring Timing

Treynor and Mazuy Test

(R

R ft ) = a i + bi (Rmt R ft ) + ci (Rmt R ft ) + eit

2

it

ci > 0

Superior Market Timing

ci < 0

Inferior Market Timing

ci = 0

No Market Timing Ability

Recent Methodology
Fama, E. and K.R French (1993). Common risk factors in the returns on
stocks and bonds, Journal of Financial Economics, Vol. 33, pp. 3-56.
Carhart, M.M. (1997). On persistence in mutual fund performance,
Journal of Finance, Vol. 52, pp. 57-82.
Henriksson, R.D. (1984). Market Timing and Mutual Fund Performance:
An Empirical Investigation, Journal of Business, Vol. 57, pp. 73-96.