Chapter 22: Evaluation of Investment Performance

4 broad issues in evaluating the portfolio performance:

1. Performance Measurement Issues-
2. Well known measures of performance
3. Performance attribution and style analysis
4. Portfolio presentation standards
Performance Measurement Issues
● Note that ratings only reflect past performance and not future performance.
○ 3 questions to answer in measuring portfolio performance
1. Was the return on a portfolio, less all expenses, adequate, all things considered?
2. How much risk did the investor, or portfolio manager, take in creating and
managing a particular portfolio?
a. Given the risks that all investors face, it is inappropriate to consider only
the returns from various investment alternatives.
b. To evaluate portfolio performance properly, we must determine whether
the returns are large enough given the risk involved.
3. What return should have been earned on the portfolio, given the risk taken and
alternative returns available to be earned from other investments over the same
period?
a. Proper benchmark comparison
b. Dow Jones Industrial average (stock market index) - most famous but not
used in benchmarking
c. The Dow’s 30 blue-chip stocks are not as good an indicator of the
breadth of today’s stock market as are some other indexes.
d. The measurement process must involve relevant and obtainable
alternatives; that is, the benchmark portfolio must be a legitimate
alternative that accurately reflects the objectives of the portfolio being
evaluated. (e.g. S&P)
e. Rather than only one, multiple benchmarks are more appropriate to use
when evaluating portfolio returns. Customized benchmarks, can be
constructed to more accurately evaluate a manager’s style.
● Return Calculations
○ Performance measurement begins with portfolio valuations and transactions translated
into rate of return.
○ A proper measure of this return is the total return (TR), which captures both the income
component and the capital gains (or losses) component of return.

○
■ Rp = rate of return
■ Ve = ending value of the portfolio
■ Vb=beginning value of the portfolio
○ Assumes that no funds were added and withdrawn during the measurement period
● Dollar weighted returns
○ Equivalent to the IRR, which measures the actual return earned on a beginning portfolio
value and on any net contributions made during the period.
 ○ Dollar-weighted Rate of Return (DWR) Equates all cash flows, including ending market
value, with the beginning market value of the portfolio
○ Measures investor’s return
○ DWR is a misleading measure of the manager’s ability because the manager does not
have control over the timing of the cash inflows and outflows
● Time-weighted returns
○ Time-weighted Rate of Return (TWR) Measures the actual rate of return earned by the
portfolio manager
○ In order to evaluate a manager’s performance properly, we should use the time-weighted
rate of return

○
Risk Considerations
● The two prevalent measures of risk used in investment analysis are total risk and
nondiversifiable, or systematic, risk.
○ Total risk is measured by calculating the standard deviation, and systematic risk—that
part of total risk that cannot be diversified away—is assessed by considering the beta for
the portfolio.
● Measures of risk:
○ Standard deviation - measure of total risk
○ Beta - market beta=1; relative measure of systematic risk
○ Coefficient of Determination - The square of the correlation coefficient, measuring the
percentage of the variance in the dependent variable that is explained by the
independent variable (R^2)
■ If the fund is totally diversified, the R2 will approach 1.0
■ Lower- less the portfolio returns are attributable to market returns
Performance Benchmarks and Performance Universes
● Two primary standards for benchmarking
● Characteristics of a good universe or benchmark
○ Unambiguous
○ Specified in advance
○ Appropriate
○ Investable
○ Measurable
● Performance universes
○ Constructed by aggregating market valuations and income accruals for a large number of
portfolios that are managed individually
○ Issues
■ they usually are broadly defined, and therefore may not accurately reflect the
portfolio of a particular manager.
■ they represent someone else’s portfolios, so they are not investable.
■ they are not specified in advance.
 ■ , manager universes are subject to survivorship bias, whereby the poor
performing managers may drop out
● Performance Benchmarks
○ Unmanaged, passive portfolios that reflect a manager’s investment style
○ unambiguous, measurable, and investable.
○ t if the portfolio performs above or below the benchmark, such performance can be
attributed to the manager’s skill.
○ Issue: broad market indices may be too broad to reflect a particular portfolio’s style,
except those containing S&P500 and DJIA
Risk-adjusted Measures of Performance
● Sharpe Ratio
○ o A measure of portfolio performance calculated as the ratio of excess portfolio return to
the standard deviation
○ Reward to Variability Ratio (RVAR)

○ Note the following about the Sharpe ratio: 1. It measures the excess return per unit of
total risk (standard deviation). 2. The higher the calculated value, the better the portfolio
performance. 3. Portfolios can be ranked using the Sharpe ratio
○ Since this is an ordinal (relative) measure of portfolio performance, different portfolios
can easily be ranked on this variable. In addition, a Sharpe ratio for the appropriate
market index can also be calculated and used for comparison purposes
○ Sharpe ratio measures the slope of the line from RFtothe portfolio being evaluated. The
steeper the line, the higher the slope and the better the performance
○ Treynor’s reward to volatility - similar, beta denominator
● Jensen’s Alpha
○ The difference between an independently determined expected rate of return on a stock
and the required rate of return on that stock.
○ One-period eq

○
○ Eq below relates the realized return on portfolio p during any period t to the sum of the
risk-free rate and the portfolio’s risk premium plus an error term.

○
 ○

○
○ This indicates that the risk premium on portfolio p is equal to the product of its beta and
the market risk premium plus an error term

○
○ CAPM asserts that equilibrium conditions should result in zero intercept term.
○ Alpha measures the contribution of the portfolio manager since it represents the average
increment rate of return per period beyond the return attributable to the level of risk
assumed.
1. If alpha is significantly positive, this is evidence of superior performance
(illustrated in Figure 22-2 with portfolio X, which has a positive intercept).
2. If alpha is significantly negative, this is evidence of inferior performance
(illustrated in Figure 22-2 with portfolio Z, which has a negative intercept).
3. If alpha is insignificantly different from zero, this is evidence that the portfolio
manager matched the market on a risk-adjusted basis (as in the case of portfolio
Y).
○ Rearranged version:

○
○ αp is the difference between the actual excess return on portfolio p during some period
and the risk premium on that portfolio that should have been earned, given its level of
systematic risk and the use of the CAPM.
○ Measures constant return earned above or below the return on unmanaged portfolio of
same risk
○ Superior and inferior portfolio performance can result from at least two sources. First, the
portfolio manager may be able to select undervalued securities consistently enough to
affect portfolio performance. Second, the manager may be able to time market turns,
varying the portfolio’s composition in accordance with the rise and fall of the market.
○ Not suitable for ranking
● M2
○ return adjusted for volatility that allows returns between portfolios to be compared.
○ Equates volatility of portfolio using treasury bills and the portfolio being evaluated

○
Style Analysis and Performance Attribution
● Style Analysis - A classification reflecting a portfolio manager’s “style” characteristics
● Performance Attribution - A part of portfolio evaluation that seeks to determine why success or
failure occurred
● Style Analysis
 ○ Style box analyzes the stocks in the portfolio based on their size and value/growth
characteristics.
○ Two approaches in style analysis:
■ Holdings-based style analysis uses the stocks in a portfolio to describe a fund’s
allocation among asset classes or equity styles.
■ Returns-based style analysis compares a portfolio’s return to the returns
generated by a set of market indexes, each of which tracks a specific investment
style such as large-cap growth or small-cap value.
○ Sharpe analysis produces a “style benchmark”, or customized benchmark which reflects
an individualized weighting of a set of indices that document the manager’s style.
● Performance Attribution
○ to decompose the total performance of a portfolio into specific components that can be
associated with specific decisions made by the portfolio manager.
○ It often begins with the policy statement that guides the management of the portfolio.
○ After this analysis, performance attribution might analyze sector (industry) selection and
security selection.
○ Identify a benchmark of performance (bogey) to use in comparing the portfolio’s results.
○ Bogey - measures passive results (excluding asset allocation and security selection
decisions
○ performance different from a properly constructed benchmark comes from one of two
sources, or both:
1. Market timing
2. Security selection
Summary
● Evaluation of portfolio performance, the bottom line of the investing process, is an important
aspect of interest to all investors and money managers.
● The framework for evaluating portfolio performance consists of measuring both the realized return
and the risk of the portfolio being evaluated, determining an appropriate benchmark portfolio to
use to compare a portfolio’s performance, and recognizing any constraints that the portfolio
manager may face.
● The time-weighted, as opposed to the dollar-weighted, return captures the rate of return actually
earned by the portfolio manager. Total returns are used in the calculations.
● The two prevalent measures of risk are total risk (standard deviation) and systematic risk (beta).
● The coefficient of determination, or R2 , is used to denote the degree of diversification.
● Risk-adjusted (composite) measures of portfolio performance combine return and risk together in
one calculation.
● The Sharpe and Treynor measures can be used to rank portfolio performance and indicate the
relative positions of the portfolios being evaluated. Jensen’s measure is an absolute measure of
performance. M2 is a variant of the Sharpe measure.
● Both the Sharpe and Treynor measures relate the excess return on a portfolio to a measure of its
risk. Sharpe’s RVAR uses standard deviation, whereas Treynor’s RVOL uses beta. Portfolio
rankings from the two measures can differ if portfolios are not well diversified.
● Jensen’s differential return measures the difference between what the portfolio was expected to
earn, given its systematic risk, and what it actually did earn. By regressing the portfolio’s excess
return against that of the market index, alpha can be used to capture the superior or inferior
performance of the portfolio manager.
● Based on capital market theory, alphas are expected to be zero. Significantly positive or negative
alphas are used to indicate corresponding performance.
● M2 is a newer measure of performance that gives rankings identical to the Sharpe measure but
states results in percentage terms.
● A good universe or benchmark for evaluating portfolio performance should be unambiguous,
specified in advance, appropriate, investable, and measurable.
● Style analysis seeks to identify the characteristics of a portfolio.
● Sharpe developed returns-based style analysis using an asset class factor model (think of it as
similar to a regression model) ⁄ Performance attribution is concerned with why a portfolio manager
did better or worse than an expected benchmark. It involves decomposing performance to
determine why the particular results occurred.
● CFA Institute (the successor to AIMR) created GIPSs as a way to obtain global acceptance of a
standard for fair presentation of performance results by investment management firms.