Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 26
 Chapter 26 - Evaluation of
Portfolio Performance
Questions to be answered:
• What major requirements do clients expect
from their portfolio managers?
• What can a portfolio manager do to attain
superior performance?
• What is the peer group comparison method
of evaluating an investor’s performance?
 Chapter 26 - Evaluation of
Portfolio Performance
• What is the Treynor portfolio performance
measure?
• What is the Sharpe portfolio performance
measure?
• What is the critical difference between the
Treynor and Sharpe portfolio performance
measures?
 Chapter 26 - Evaluation of
Portfolio Performance
• What is the Jensen portfolio performance
measure, and how does it relate to the Treynor
measure?
• What is the information ratio and how is it
related to the other performance measures?
• When evaluating a sample of portfolios, how
do you determine how well diversified they
are?
 Chapter 26 - Evaluation of
Portfolio Performance
• What is the bias found regarding the
composite performance measures?
• What is the Fama portfolio performance
measure and what information does it provide
beyond other measures?
• What is attribution analysis and how can it be
used to distinguish between a portfolio
manager’s market timing and security
selection skills?
 Chapter 26 - Evaluation of
Portfolio Performance
• What is the Roll “benchmark error” problem,
and what are the two factors that are affected
when computing portfolio performance
measures?
• What is the impact of global investing on the
benchmark error problem?
• What are customized benchmarks?
• What are the important characteristics that
any benchmark should possess?
 Chapter 26 - Evaluation of
Portfolio Performance
• How do bond portfolio performance measures
differ from equity portfolio performance
measures?
• In the Wagner and Tito bond portfolio
performance measure, what is the measure of
risk used?
• What are the components of the Dietz, Fogler,
and Hardy bond portfolio performance
measure?
 Chapter 26 - Evaluation of
Portfolio Performance
• What are the sources of return in the Fong,
Pearson, and Vasicek bond portfolio
performance measure?
• What are the time-weighted and dollar-
weighted returns and which should be
reported under AIMR’s Performance
Presentation Standards?
 What is Required of
a Portfolio Manager?
1.The ability to derive above-average returns for a
given risk class
Superior risk-adjusted returns can be derived from
either
– superior timing or
– superior security selection
2. The ability to diversify the portfolio completely to
eliminate unsystematic risk. relative to the
portfolio’s benchmark
 Composite Portfolio
Performance Measures
• Portfolio evaluation before 1960
– rate of return within risk classes
• Peer group comparisons
– no explicit adjustment for risk
– difficult to form comparable peer group
• Treynor portfolio performance measure
– market risk
– individual security risk
– introduced characteristic line
 Treynor Portfolio
Performance Measure
• Treynor recognized two components of risk
– Risk from general market fluctuations
– Risk from unique fluctuations in the securities in the
portfolio
• His measure of risk-adjusted performance
focuses on the portfolio’s undiversifiable risk:
market or systematic risk
 Treynor Portfolio
Performance Measure
T=
( R i − RFR )
βi
• The numerator is the risk premium
• The denominator is a measure of risk
• The expression is the risk premium return per unit of
risk
• Risk averse investors prefer to maximize this value
• This assumes a completely diversified portfolio
leaving systematic risk as the relevant risk
 Treynor Portfolio
Performance Measure
• Comparing a portfolio’s T value to a similar measure for
the market portfolio indicates whether the portfolio would
plot above the SML
• Calculate the T value for the aggregate market as follows:

Tm =
( R m − RFR )
βm
 Treynor Portfolio
Performance Measure

• Comparison to see whether actual return of

portfolio G was above or below expectations
can be made using:

E( R G ) = RFR + β i ( R m − RFR )
 Sharpe Portfolio
Performance Measure

• Risk premium earned per unit of risk

R i − RFR
Si =
σi
 Treynor versus Sharpe Measure
• Sharpe uses standard deviation of returns as the
measure of risk
• Treynor measure uses beta (systematic risk)
• Sharpe therefore evaluates the portfolio manager
on the basis of both rate of return performance
and diversification
• The methods agree on rankings of completely
diversified portfolios
• Produce relative not absolute rankings of
performance
 Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

E ( R j ) = RFR + β j [ E( R m ) − RFR ]
 Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

E ( R j ) = RFR + β j [ E( R m ) − RFR ]
Where: E(Rj) = the expected return on security
RFR = the one-period risk-free interest rate
βj= the systematic risk for security or portfolio j
E(Rm) = the expected return on the market portfolio of
risky assets
 The Information Ratio
Performance Measure
• Appraisal ratio
• measures average return in excess of
benchmark portfolio divided by the
standard deviation of this excess return

R j − Rb ER j αj
IR j = = =
σ ER σ ER σU
 Application of Portfolio
Performance Measures

EPit + Divit + Cap.Dist.it − BPit

Rit =
BPit
Potential Bias of One-Parameter
Measures
• positive relationship between the composite
performance measures and the risk involved
• alpha can be biased downward for those
portfolios designed to limit downside risk
 Components of Investment
Performance
• Fama suggested overall performance, which
is its return in excess of the risk-free rate
Portfolio Risk + Selectivity
• Further, if there is a difference between the
risk level specified by the investor and the
actual risk level adopted by the portfolio
manager, this can be further refined
Investor’s Risk + Manager’s Risk + Selectivity
 Components of Investment
Performance
• The selectivity measure is used to assess the
manager’s investment prowess
• The relationship between expected return
and risk for the portfolio is:

( ) ( ) (
 E m Rˆ − RFR  Cov R̂ j , R̂ m
E Rˆ = RFR + 
)

 σ ( Rm )  σ ( Rm )
 Components of Investment
Performance
• The market line then becomes a benchmark
for the manager’s performance
 Rm − RFR 
R x = RFR +  β x
 σ ( Rm ) 

Selectivity = Ra − R x ( β a )
 Components of Investment
Performance
• The selectivity component can be broken
into two parts
– gross selectivity is made up of net selectivity
plus diversification

Selectivity Diversification
Ra − R x ( β a ) = Net Selectivity + [ R x ( σ ( Ra ) ) − R x ( β a ) ]
 Components of Investment
Performance
• Assuming the investor has a target level of
risk for the portfolio equal to βT, the portion
of overall performance due to risk can be
assessed as follows:
Risk = Manager' s Risk + Investor's Risk
[ Rx ( β a ) − RFR] = [ R x ( β a ) − R x ( β T ) ] + [ R x ( β T ) − RFR]
 Relationship Among
Performance Measures
•Treynor
•Sharpe
•Jensen
•Information Ratio
•Fama net selectivity measures
Highly correlated, but not perfectly so
Performance Attribution Analysis
[( ) (
• Allocation effect = Σ i Wai − W pi × R pi − R p )]
• Selection effect = Σ [ (W ) × ( R − R ) ]
i ai ai pi
Measuring Market Timing Skills
• Tactical asset allocation (TAA)
• Attribution analysis is inappropriate
– indexes make selection effect not relevant
– multiple changes to asset class weightings
during an investment period
• Regression-based measurement
 Measuring Market Timing Skills
R pt = RFRt + max[ Rst − RFRt , Rbt − RFRt ,0]
(R pt − RFRt ) = α + β b ( Rbt − RFRt ) + β s ( Rst − RFR )
+ γ { max[ Rst − RFRt , Rbt − RFRt ,0]} + U t
 Factors That Affect Use of
Performance Measures
• Market portfolio difficult to approximate
• Benchmark error
– can effect slope of SML
– can effect calculation of Beta
– greater concern with global investing
– problem is one of measurement
• Sharpe measure not as dependent on market
portfolio
 Benchmark Portfolios
• Performance evaluation standard
• Usually a passive index or portfolio
• May need benchmark for entire portfolio
and separate benchmarks for segments to
evaluate individual managers
 Characteristics of Benchmarks
• Unambiguous
• Investable
• Measurable
• Appropriate
• Reflective of current investment opinions
• Specified in advance
 Building a Benchmark
• Specialize as appropriate
• Provide value weightings
• Provide constraints to portfolio manager
 Evaluation of
Bond Portfolio Performance
• How did performance compare among
portfolio managers relative to the overall
bond market or specific benchmarks?
• What factors explain or contribute to
superior or inferior bond-portfolio
performance?
 A Bond Market Line
• Need a measure of risk such as beta
coefficient for equities
• Difficult to achieve due to bond maturity
and coupon effect on volatility of prices
• Composite risk measure is the bond’s
duration
• Duration replaces beta as risk measure in a
bond market line
Bond Market Line Evaluation
• Policy effect
– Difference in expected return due to portfolio
duration target
• Interest rate anticipation effect
– Differentiated returns from changing duration
of the portfolio
• Analysis effect
– Acquiring temporarily mispriced bonds
• Trading effect
– Short-run changes
 Decomposing Portfolio Returns
Into maturity, sector, and quality effects
• Total return during a period is the income effect
and a price change effect
• The yield-to-maturity (income) effect is the
return an investor would receive if nothing had
happened to the yield curve during the period
• Interest rate effect measures changes in the term
structure of interest rates during the period
Decomposing Portfolio Returns
• The sector/quality effect measures expected
impact on returns because of changing yield
spreads between bonds in different sectors
and ratings
• The residual effect is what is left after
accounting for the first three factors
• A large positive residual would indicate
superior selection capabilities
• Time-series plot demonstrates strengths and
weaknesses of portfolio manager
 Analyzing Sources of Return
• Total return (R) made up of the effect of the
interest rate environment (I) and the contribution
of the management process (C)
R=I+C
• I is the expected rate of return (E) on a portfolio of
default-free securities and the unexpected return
(U) on the Treasury Index
I=E+U
 Analyzing Sources of Return
• C is composed of
M = return from maturity management
S = return from spread/quality management
B = return attributable to the selection of
specific securities
R= I + C
= (E + U) + (M + S + B)
 Consistency of Performance
• A study by Kritzman revealed no relationship
between performance in the two periods
examined in the study
• A further test also revealed no relationship
between past and future performance even
among the best and worst performers
• Based on these results, Kritzman concluded that
it would be necessary to examine something
besides past performance to determine superior
bond portfolio managers
 Computing Portfolio Returns
• To evaluate portfolio performance, we have
to measure it
• From Chapter 1 we learned how to calculate
a holding period yield, which equals the
change in portfolio value plus income
divided by beginning portfolio value:

HPY =
( Ending Value) −1
Beginning Value
 Computing Portfolio Returns
• Dollar-weighted rate of return (DWRR)
– Internal rate of return on the portfolio’s cash flows
• Time-weighted rate of return (TWRR)
– Geometric average return
• TWRR is better
– Considers actual period by period portfolio returns
– No size bias - inflows and outflows could affect
results
 Performance Presentation Standards
• AIMR PPS have the following goals:
– achieve greater uniformity and comparability among
performance presentation
– improve the service offered to investment
management clients
– enhance the professionalism of the industry
– bolster the notion of self-regulation
 Performance Presentation Standards
• Total return must be used
• Time-weighted rates of return must be used
• Portfolios valued quarterly and periodic returns
geometrically linked
• Composite return performance (if presented) must
contain all actual fee-paying accounts
• Performance calculated after trading expenses
• Taxes must be recognized when incurred
• Annual returns for all years must be presented
• Disclosure requirements
 The Internet
Investments Online
www.nelnet.com
www.styleadvisor.com
www.valueline.com
www.morningstar.com
www.valueline.com
www.aimr.org
End of Chapter 26
–Evaluation of Portfolio
Performance