UNIT 7.

EVALUATING OF INVESTMENT
PORTFOLIO PERFORMANCE
Introduction
This unit describes in detail the four major composite equity portfolio performance
measures that combine risk and return performance into a single value. We also compare
the measures and discuss how they differ and why they rank portfolios differently.

Aim
How portfolio performance is measured and reviewed in investment.

7.1 Treynor Portfolio Performance Measure

This section describes in detail the four major composite equity portfolio performance measures
that combine risk and return performance into a single value. We also compare the measures
and discuss how they differ and why they rank portfolios differently.
Treynor Portfolio Performance Measure
Treynor was interested in a measure of performance that would apply to all investors, regardless
of their risk preferences. Building on capital market theory, he introduced a risk-free asset that
could be combined with different
portfolios to form a portfolio possibility line. He showed that rational, risk-averse investors
would always prefer the portfolio line with the largest slope because this would place them
on the highest indifference curve. The slope of this portfolio possibility line (designated T) is
equal to;
𝑅̅𝑖 − 𝑅𝐹𝑅
̅̅̅̅
̅𝑖 =
𝑇
𝛽𝑖

where:
𝑅̅𝑖 = the average rate of return for Portfolio/Market i during a specified time period
̅̅̅̅= the average rate of return on a risk-free investment during the same time period such as
𝑅𝐹𝑅
T-Bills
𝛽𝑖 = the slope of the fund’s characteristic line during that time period (Market Beta)

The Numerator of the above formula is the risk premium while the denominator is the measure
of risk. This formula indicates the Market risk premium return per unit of risk taken.
All risk-averse investors would prefer to maximize this value. The risk variable beta measures
systematic risk and tells us nothing about the diversification of the portfolio. It implicitly assumes
a completely diversified portfolio.

Example: Suppose that during the most recent 10-year period, the average annual total rate
of return (including dividends) on an aggregate market portfolio, such as the S&P 500, was 14
percent ( 𝑅̅𝑖 = 0.14) and the average nominal rate of return on government T-bills( Our risk free
rate) was 8 percent (RFR = 0:08). As a manager of a Pension Fund that has been divided
among three money managers during the past 10 years. You must decide whether to renew
their investment contracts based on the following results.

Investment Manager Average annual rate of Beta

return
X .12 .90
Y .16 1.05
Z .18 1.20

This can be determined by computing the T for each of the portfolio to determine which one
performed well as follows:

We first compute for the whole Market which we assumed had a Beta of 1.00:
0.14−0,08
̅̅̅̅
𝑇𝑀 = 1.00 =0.06

Then we follow up with the portfolio’s money managers:

0.12−0,08
̅̅̅
𝑇 𝑋 = =0.044
0.90
0.16−0,08
̅̅̅
𝑇𝑌 = 1.05 =0.076
 0.12−0,08
̅𝑇̅̅̅
𝑤 = =0.083
1.20

These results indicate that Investment Manager W not only ranked the lowest of the three
managers but did not perform as well as the aggregate market on a risk-adjusted basis. In
contrast, both X and Y beat the market portfolio, and Manager Y performed somewhat better
than Manager X.

7.2 Sharpe Portfolio Performance Measure

The Sharpe measure of portfolio performance (designated S) is stated as follows:
𝑅̅𝑖 − 𝑅𝐹𝑅
̅̅̅̅
𝑆̅𝑖 =
𝜎𝑖
where in addition to the earlier notation:
𝜎𝑖 = the standard deviation of the rate of return for Portfolio i during the time period.
This performance measure clearly is similar to the Treynor measure; however, it seeks to
measure the total risk of the portfolio by using the standard deviation of returns rather than
considering only the systematic risk summarized by beta. Because the numerator is the
portfolio’s risk premium, this measure indicates the risk premium return earned per unit of total
risk.
Example: assume that 𝑅̅𝑀 = 0:14 and 𝑅𝐹𝑅
̅̅̅̅ = 0:08. Suppose you are told that the standard

deviation of the annual rate of return for the market portfolio over the past 10 years was 20
percent (𝜎𝑀 = 0.20). You want to examine the risk-adjusted performance of the following
portfolios:

Investment Manager Average annual rate of Beta

return
D 0.13 .18
E 0.17 .22
F 0.16 .23

This can be determined by computing the T for each of the portfolio to determine which one
performed well as follows:
We first compute for the whole Market:
0.14−0,08
̅̅̅̅
𝑆𝑀 = 0.20 =0.300

Then we follow up with the portfolio’s money managers:

0.13−0,08
̅̅̅
𝑆 𝐷 = =0.278
0.18
0.17−0,08
̅̅̅
𝑆𝐸 = 0.22 =0.409
0.12−0,08
̅̅̅
𝑆𝐹 = 0.23 =0.348

Portfolio D had the lowest risk premium return per unit of total risk, failing to perform as well as
the market portfolio. In contrast, Portfolios E and F performed better than the aggregate market:
Portfolio E did better than Portfolio F.

7.3 Jensen Portfolio Performance Measure

Like the T and S measures just discussed, the Jensen is based on the capital asset pricing model
(CAPM), which calculates the expected one-period return on any security or portfolio by the
following expression:
𝐸(𝑅𝑗 ) = 𝑅𝐹𝑅 + 𝛽𝑗 [𝐸(𝑅𝑀 ) − 𝑅𝐹𝑅]
where:
𝐸(𝑅𝑗 ) = the expected return on security or Portfolio j
RFR = the one-period risk-free interest rate
𝛽𝑗 = the systematic risk (beta) for security or Portfolio j
[𝐸(𝑅𝑀 ) = the expected return on the market portfolio of risky assets
The expected return and the risk-free return vary for different periods. Consequently, we are
concerned with the time series of expected rates of return for Security or Portfolio j. Moreover,
you can express Equation 25.3 in terms of realized rates of return as follows:

This equation states that the realized rate of return on a security or portfolio during a given time
period should be a linear function of the risk-free rate of return during the period, plus a risk
premium that depends on the systematic risk of the security or portfolio during the period plus
a random error term( 𝑒𝑗𝑡 ).
Subtracting the risk-free return from both sides, we have:

so that the risk premium earned on the jth portfolio is equal to βj times a market risk premium
plus a random error term. An intercept for the regression is not expected if all assets and
portfolios were in equilibrium. Alternatively, superior portfolio managers who forecast market
turns or consistently select undervalued securities earn higher risk premiums over time than
those implied by this model. Such managers have mostly positive random error terms because
the actual returns for their portfolios consistently exceed their expected returns. To detect this
superior performance, you must allow for an intercept (a nonzero constant) that measures any
positive or negative difference from the model. Consistent positive differences cause a positive
intercept, whereas consistent negative differences (inferior performance) cause a negative
intercept. With an intercept included, the earlier equation becomes:

the αj value indicates whether the portfolio manager is superior or inferior in her investment
ability. A superior manager has a significant positive α (or “alpha”) value, while an inferior
manager’s returns consistently fall short of expectations based on the CAPM model producing a
significant negative value for α.
The performance of a portfolio manager with no forecasting ability but not clearly inferior equals
that of a naive buy-and-hold policy. Because returns on such a portfolio typically match the
returns you expect, the residual returns generally are randomly positive and negative. This gives
a constant term that differs insignificantly from zero, indicating that the portfolio manager
basically matched the market on a risk-adjusted basis.
Therefore, the α coefficient represents how much of the managed portfolio’s return is
attributable to the manager’s ability to derive above-average returns adjusted for risk. Superior
risk-adjusted returns indicate that the manager is good at either predicting market turns or
selecting undervalued issues for the portfolio, or both.
Also, like the Treynor measure, the Jensen measure does not directly consider the portfolio
manager’s ability to diversify because it calculates risk premiums in terms of systematic risk.
When evaluating the performance of a group of well-diversified portfolios such as mutual funds,
this is likely to be a reasonable assumption, since such portfolios can be correlated with the
market at rates above 0.90.
Finally, the Jensen performance measure is flexible enough to allow for alternative models of
risk and expected return than the CAPM. Specifically, risk-adjusted performance (i.e., α) can be
computed relative to any of the multifactor models:

Where: Fkt represents the Period t return to the kth common risk factor.

Summary
In summary, this unit has discussed poertfolio valuation using; Treynor, Sharpe, and
Jensen’s Alpha Ratios.

Activity
1. Explain the role of portfolio management in an efficient market?
2. How is portfolio performance measured?
3. Explain the Markowitz Model?
4. Explain the theory of covariance and correlation coefficient?