Investment Analysis and Portfolio

Management (ACFN 711)

Chapter 6 – Performance Evaluation

 Topics to be covered

• Performance Measurement
Risk Adjusted Performance Measures
Measures of Sharpe, Treynor and Jensen
Measures of Skill and Timing

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 Introduction
• As portfolio managers, how can we evaluate the performance
of our portfolio?
• We know that there are 2 major requirements of a portfolio
manager’s performance:
1. The ability to derive above-average returns conditioned on
risk taken, either through superior market timing or superior
security selection.
2. The ability to diversify the portfolio and eliminate non-
systematic risk, relative to a benchmark portfolio.
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Early Performance Measure Techniques
• Portfolio evaluation before 1960
– Once upon a time, investors evaluated a portfolio’s
performance based purely on the basis of the rate of
return.
– Research in the 1960’s showed investors how to quantify
and measure risk.
– Grouped portfolios into similar risk classes and
compared rates of return within risk classes.
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 Peer Group Comparisons
• This is the most common manner of evaluating portfolio
managers.

• Collects returns of a representative universe of investors

over a period of time and displays them in a box plot
format.

• Example: “US Equity with Cash” relative to peer universe

of US domestic equity managers.

• Issue: There is no explicit adjustment for risk. Risk is only

considered implicitly.
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Treynor Portfolio Performance
Measure

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 Treynor (1965)
• Treynor (1965) developed the first composite measure of
portfolio performance that included risk.
• He introduced the portfolio characteristic line, which defines a
relation between the rate of return on a specific portfolio and
the rate of return on the market portfolio.

R p,t   p   p  R M,t    p ,t
• The beta is the slope that measures the volatility of the
portfolio’s returns relative to the market.
• Alpha represents unique returns for the portfolio.
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 Treynor Measure
A risk-adjusted measure of return that divides a portfolio's
excess return by its beta.

The Treynor Measure is given by

R p  rf
Tp =
p
The Treynor Measure is defined using the average rate of return
for portfolio p and the risk-free asset.

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 Treynor Measure
R p  rf
Tp =
p
• A larger Tp is better for all investors, regardless of their risk
preferences.
• Because it adjusts returns based on systematic risk, it is the
relevant performance measure when evaluating diversified
portfolios held in separately or in combination with other
portfolios.

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 Treynor Measure
• Beta measures systematic risk

• Hence, it implicitly assumes a completely diversified portfolio.

• Portfolios with identical systematic risk, but different total risk,

will have the same Treynor ratio!

• Higher idiosyncratic risk should not matter in a diversified

portfolio and hence is not reflected in the Treynor measure.

• A portfolio negative Beta will have a negative Treynor measure.

• Also known as the Treynor Ratio.

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Sharpe Portfolio Performance Measure

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 Sharpe Measure
 Similar to the Treynor measure, but uses the total risk of
the portfolio, not just the systematic risk.

 The Sharpe Ratio is given by

R p  rf
Sp =
p
 The larger the measure the better, as the portfolio earned
a higher excess return per unit of total risk.
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 Sharpe Measure
• It adjusts returns for total portfolio risk, as opposed to only
systematic risk as in the Treynor Measure.

• Thus, an implicit assumption of the Sharpe ratio is that the

portfolio is not fully diversified, nor will it be combined with
other diversified portfolios.

• It is relevant for performance evaluation when comparing

mutually exclusive portfolios.

• Sharpe originally called it the "reward-to-variability" ratio, before

others started calling it the Sharpe Ratio.
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 Treynor’s Vs. Sharpe’s measure
• Treynor’s measure uses Beta, market risk

• Sharpe’s measure uses total risk

• For a totally diversified portfolio, both measures give equal

rankings.

• If it is not a diversified portfolio, the Sharpe measure could give

lower rankings than the Treynor measure.

• Thus, the Sharpe measure evaluates the portfolio manager in

terms of both return performance and diversification.

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 Price of Risk
• Both the Treynor and Sharp measures, indicate the risk
premium per unit of risk, either systematic risk (Treynor) or
total risk (Sharpe).

R p  rf = Tp  p R p  rf  Sp p
• They measure the price of risk in units of excess returns per
each unit of risk (measured either by beta or the standard
deviation of the portfolio).

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Jensen Portfolio Performance Measure

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 Jensen’s Alpha
 Alpha is a risk-adjusted measure of superior performance

R p,t  rf, t   p   p R M, t  r f ,t    p,t

 This measure adjusts for the systematic risk of the portfolio.

 Positive alpha signals superior risk-adjusted returns, the manager

is good at selecting stocks or predicting market turning points.

 Unlike the Sharpe Ratio, Jensen’s method does not consider the
ability of the manager to diversify, as it is only accounts for
systematic risk.
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 Multifactor Jensen’s Measure
Measure can be extended to a multi-factor setting, for example:

R p,t  rf, t   p   1 p R M, t  rf ,t    2 p SML   3 p HML   p,t

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Information Ratio

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 Information Ratio 1
• Using a historical regression, the IR takes on the form

IR p   p  

where the numerator is Jensen’s alpha and the denominator is

the standard error of the regression. Recalling that

R p,t  rf, t   p   p R M, t  r f ,t    p,t

Note that the risk here is nonsystematic risk, that could, in theory,
be eliminated by diversification.

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 Information Ratio 2
R p  Rb
IR p =
 ER
Measures excess returns relative to a benchmark portfolio.
Sharpe Ratio is the special case where the benchmark equals the
risk-free asset.
Risk is measured as the standard deviation of the excess return
(Recall that this is the Tracking Error)
For an actively managed portfolio, we may want to maximize the
excess return per unit of nonsystematic risk we are bearing.

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 Portfolio Tracking Error
Excess Return relative ERt  R p ,t  Rb,t
to benchmark portfolio b
T
1
Average Excess Return ER 
T
 ER
t 1
t

Variance in Excess Difference

 
T 2
1
 ER
2
 
T  1 t 1
ERt  ER

Tracking Error
 ER   2
ER
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 Information Ratio
• Excess return represents manager’s ability to use information
and talent to generate excess returns.
• Fluctuations in excess returns represent random noise that is
interpreted as unsystematic risk.

R p  Rb
IR p =
 ER
Information to noise ratio.
• Annualized IR
IR p = T IR p
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End