Learning Outcomes
BFC5935 Portfolio Management and
Theory
Lecture 10 – Portfolio Management II
Lecturer: Dr. Manapon Limkriangkrai, CFA
The Investment Funds Industry
• Investors typically have portfolio focus
• Fund manager acts as an intermediary between the
investor and the investment markets, and charges a fee
for their service
• Perception of better skills and management experience
• Fund manager can achieve Economies of scale
• Choice of fund(s) depends on investors'
Risk tolerance / Preferences
Holding periods
3 Source: www.unisuper.com.au
The Relevance of Past Performance
Key Questions:
 Is past performance relevant?
 How can fund performance be measured?
 What has been the evidence on fund managers
performance?
Past information is typically regarded as an important input in
investment decisions.
 Sweeney Research found that 54% of investors regard
long-term performance as the most important factor.
 (ASIC) revealed that past performance is included in 70%
of commercial advertisements.
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 Relevance of past performance information for decision-
making
 Range of risk-adjusted performance measures for
investment portfolios
 Performance assessment of managed funds
 Evidence concerning the performance of managed
funds
 Impact of different portfolio management strategies
may impact on portfolio performance
 Morningstar Ratings
 Performance Attribution Analysis
The Investment Funds Industry
[INV Options] 4
Performance Measures
The managed funds industry places an emphasis on
performance measures.
Examples include:
 the star ratings of Morningstar
 the publication of league tables
 statistics and rankings of funds based on past
performance that are regularly carried by the Australian
Financial Review and Personal Investment.
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Performance Measures Performance Measures
Benchmark Portfolios The Sharpe Index

Performance evaluation standard  It is based on the CML:

Usually a passive index Ri  RFR

Si 
i
May need benchmark for entire portfolio and separate
benchmarks for segments to evaluate individual managers  The benchmark value is the Sharpe index for the
market
 It does not rely on an asset pricing model
 It captures jointly aspects of return and risk

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Performance Measures Performance Measures

The Treynor Index Jensen's Alpha
 It is based on the ex-post SML:  Jensen’s (1968) alpha relies on the SML:

R i  RFR R jt  RFRt  a j   j [ Rmt  RFRt ]  e jt

Ti 
i
 If a fund is performing to expectations (relative to
 Superior performance indicated where the Treynor the CAPM) then a would be zero.
index exceeds the market risk premium (MRP).
 Superior performance is indicated positive a while
 Problems include correct value of MRP, the need to under-performance negative a.
estimate beta, and the appropriateness of CAPM.
 It relies on CAPM being the correct model.
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Performance Measures Performance Measures

Carhart’s Alpha Information Ratio
 A variant on Jensen’s alpha involves invoking the
assumption of an alternative asset pricing model. R j  Rb ER j
IR j  
 ER  ER

 An efficiency measure
 Carhart’s four-factor model has four return
generating factors.

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Performance Measures Performance Measures
M2 M2
M 2
 *
rP  rM  Portfolio P had a return of 10% and a standard deviation of
* 18%. The market had a return of 11% and a standard
where rP  (1  w )rf  w rP deviation of 20%. Risk-free rate is 5%.
w  M / P
 Adjusts portfolio’s risk to that of the market’s by using w  .20 / .18  1.1111
lending or borrowing at the risk-free rate
rP*  ( 0.1111)(.05 )  (1.1111)(.10 )  .1056
 M2 > 0 indicates that the portfolio outperformed the MP2  .1056  .11  .0044
market; M2 < 0 indicates underperformance
 Portfolio P underperformed the market by 0.44% on a risk-
 Gives identical rankings as the Sharpe measure adjusted basis.

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Performance Measures Performance Measures

First, both Funds A and B are judged to be superior
performers.
 Their values of Jensen’s alpha are positive.
 Both the Sharpe and Treynor indices exceed
those of the market index.
 However, Fund A is considered to be the most
efficient given the values of the information ratio.

Second, Fund C is judged to have poor performance.

 Negative Jensen’s alpha, Sharpe and Treynor
indices for Fund C are less than those of the
market index.
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Performance Measures Performance Measures

Third, there is inconsistency in rankings across the
measures.
 Fund A is ranked highest under both Jensen’s alpha,
the Treynor index and the information ratio.
 Fund B is ranked highest under the Sharpe index.
 The inconsistency in rankings is due to differences in
the unit risk measure.
 The Sharpe index uses standard deviation whereas
the Treynor index uses beta risk.
Empirical Evidence
 Early studies found that managed funds, on average,
under-performed the benchmarks.
 Sharpe (1966): average Sharpe index was less than the
Dow Jones Market Index.
 Jensen (1968): average Jensen's alpha was -1.1%.
 Recent evidence is mixed.
 Findings depend on sample period used, benchmark
index and fees.

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Performance Attribution Analysis Performance Attribution Analysis
Attribution analysis attempts to distinguish between the Attribution analysis typically starts from the broadest asset
manager’s contribution due to: allocation choices and progressively focus on ever-finer
details of portfolio choice
 Allocation Effect The attribution method explains the difference in returns
 Selection Effect between a managed portfolio, P, and a selected benchmark
portfolio called the bogey
The ability to be in the right asset class at the right time
The manager’s performance may be compared with a or choosing the relatively better-performing stocks within
predetermined benchmark portfolio and decomposed into an a particular industry.
allocation effect and a selection effect.

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Performance Attribution Analysis Performance Attribution Analysis

Allocation Effect i [(Wai Wpi )][(Rpi  Rp )] Allocation effect
Over (+) or under (-) weight in a particular market segment
when:
Selection Effect   i [(Wai 0][( Rai  R pi )]
Wai, Wpi, = the investment proportions given to the ith market segment in
the manager’s actual portfolio and the benchmark portfolio, respectively.
Wai  W pi   0  R pi  R p   0
Rai, Rpi, = the investment return to the ith market segment in the manager’s
actual portfolio and the benchmark portfolio, respectively. Selection effect

Rp = the total return to the benchmark portfolio.


Wai  Rai  R pi 
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Performance Attribution Analysis Performance Attribution Analysis

Manager's Allocation Effect
Benchmark Portfolio
Manager Benchmark Excess Wt Benchmark Overall X-Returns
Asset class Stocks Bonds Cash
Weight Weight (M - B) Returns Benchmark (BR - OR)
Weights 0.55 0.30 0.15 ASX 0.6 0.55 0.05 13.57% 12.40% 1.17%
Return 13.57% 11.58% 9.76% Bonds 0.32 0.30 0.02 11.58% 12.40% -0.82%
Overall return 7.46% 3.47% 1.46% 12.40% Cash 0.08 0.15 -0.07 9.76% 12.40% -2.64%

Manager’s Portfolio Manager's Allocation Effect

Asset class Shares Bonds Cash
Manager Benchmark Excess Wt X-Returns (Excess Wt)* Attributed
Weights 0.60 0.32 0.08 Weight Weight (M - B) (BR - OR) (X-Returns) (M-B)*(BR-OR)
Return 14.43% 10. 81% 5.60% ASX 0.6 0.55 0.05 1.17% (0.05)(1.17%) 0.0585%
Overall return 8.66% 3.46% 0.45% 12.56% Bonds 0.32 0.30 0.02 -0.82% (0.02)(-0.82%) -0.0164%
Cash 0.08 0.15 -0.07 -2.64% (-0.07)(-2.64%) 0.1848%
Manager portfolio is better than benchmark portfolio:
12.56% - 12.40% = 0.16% 0.2269%
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 Performance Attribution Analysis Performance Attribution Analysis
Conclusions
Security Selection Effect
 The manager has earned a positive return and therefore
has some skill at market timing and sector allocation.
Manager Manager Benchmark Excess Return Attributed However, the manager earns negative returns and
demonstrates poor skills at security selection.
Weight (MW) Returns Returns (MR – BR) (MW *Ex. R)

ASX 0.6 14.43% 13.57% 0.86% 0.516%  Different managers may have different strengths, so the
Bonds 0.32 10.81% 11.58% -0.77% -0.246%
fund should employ a manager who earns positive
returns at security selection to be included on the team
Cash 0.08 5.60% 9.76% -4.16% -0.333% and have the current manager just perform market
timing decisions.
-0.063%

Total Value Added = Allocation Effect + Selection Effect

0.227% - 0.063% = 0.164%
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Performance Attribution Analysis Performance Measurement

• Such analysis can be used to identify even further specific
roles managers are suited for Morningstar was the first to introduce star ratings for managed
funds in Australia.
• Consider the following summaries of the manager’s
performance
• Qualitative research – Recommendation from ‘Highly
Manager's Allocation Effect
Manager's Selection Effect Recommended’ to ‘Avoid’.
ASX 0.0585% ASX 0.516%
Bonds -0.0164% Bonds -0.246% • Quantitative research – Ratings based on a fund’s Morningstar
Cash 0.1848% Cash -0.333% Risk-Adjusted Return (MRAR) measure.

• have the manager perform just Allocation decisions.

• the manager has Stock Selection skill

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Performance Measurement Performance Measurement

Step 1: Establishing the category to which the fund belongs. Step 2: Star rating is assigned based on the fund’s risk-adjusted
Specific categories reflect their similar risk exposure. performance.

Morningstar ratings are based on expected utility theory.

• Investors are more concerned about poor performance.

• Investors are willing to give up certain portion of their

expected return for greater certainty.

Funds are rated up to three periods: 3, 5 & 10 years

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Performance Measurement Performance Measurement
Source: www.morningstar.com.a

Source: www.morningstar.com.au 31 Source: www.morningstar.com.au 32

Performance Measurement Case Study

Star Rating Limitations Hedge Fund: LTCM

• Backward looking measure  Founded in 1994 with the initial capital of ~ $1billion; the
capital increased to over $4billion by 1997.
• Strictly quantitative measure  Partners include two Nobel Prize winners (Prof. Myron
Scholes and Prof. Robert Merton), several PhDs from
• Does not take into account of fundamentals M.I.T., and others.
 Employ complex mathematical models to conduct fixed
• Rating stays with the fund not the manager income arbitrage.
• Not all funds with the same star rating are interchangeable  Over the period 1995-1997, LTCM had Avg. return over 33%
p.a. [Eicherngreen, 1999]
[LTCM]
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Case Study – LTCM Performance Copyright statement for items

Source: https://en.wikipedia.org/wiki/Long-Term_Capital_Management#/media/File:LTCM.png

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