Investment Management

Lecture 19

Risk & performance measurement

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◼ Performance Measurement – Introduction

◼ Sharpe Ratio and Capital Market Line

◼ Treynor’s ratio and Security Market Line

◼ Sharpe vs Treynor

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Performance Measurement – Introduction
◼ When we seek to measure performance of
financial investments we measure these against
the risk of the investment
 We know that financial investments tend to compensate
the investors for risk taking
 This is due to the fact that most investors tend to be
risk averse (Positive risk aversion coefficient) and must
be paid compensation for carrying risk

◼ The compensation comes in the form of excess

return, that risky investments have an average
return that is greater than the return on risk free
investments
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Measurement of Performance
and Sharpe Ratio
◼ The easiest way to boost the expected return of a portfolio
is to increase the risk of the portfolio
 NOT in itself constitute performance enhancement

◼ There exists a collection of performance measures that

adjusts the performance of a given portfolio for the risk it
takes

◼ The first is the Sharpe measure which is the ratio of the

excess return to the standard deviation of the portfolio:
E (r ) − rf
Sharpe.Ratio =


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Sharpe Ratio
◼ The Sharpe ratio for a portfolio needs to be
measured against the Sharpe ratio of the market
index, which forms a benchmark:
E (rM ) − rf
Market.Sharpe.Ratio =
M
◼ If the Sharpe Ratio for a particular stock is greater
than the Market Sharpe, the performance is
relatively “Better”

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Asset Allocation:1 risky & 1 risk free asset

E(rp) = rf + p (E(r) – rf) / 

The above figure shows the investment opportunity set in the µp – p plane
(expected return and standard deviation place): E (r ) − rf
It demonstrates that the investment opportunity set is linear, with slope 

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Treynor's ratio
◼ The second is Treynor's measure which measures
the expected excess return on the portfolio
relative to the beta risk of the portfolio
E (ri ) − rf
Treynor' s.Ratio =
i
◼ The measure should also be measured against the
market index (which has unit beta)

◼ Treynor ratio for the market = E(rM ) – rF

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Treynor's ratio
◼ The Treynor's ratio is really a test of whether the
asset is on the security market line (SML)
◼ The CAPM model predicts that assets should be
priced according to the formula:

E (ri ) = rf +  i (E (rM ) − rf )

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E (ri ) = rf +  i (E (rM ) − rf )

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Sharpe vs Treynor
◼ To see the connection between the Sharpe & Treynor ratio
 To compare two portfolios with different risk
characteristics it is important that the risk premium is
linear in the risk measure

 We know that this is true for the Sharpe ratio if we use

standard deviation of total risk as the risk measure

 It is also linear for the Treynor ratio if we use beta risk

(i.e. the market risk, or systematic risk, component of
total risk) as the relevant risk measure, and if the
investor already holds a large diversified portfolio with
the same risk characteristics of the market portfolio

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Sharpe vs Treynor
◼ What is important here is that we have taken into account
total risk, but when we look at small portfolios on top of a
large diversified portfolio, total risk is roughly equal to
market or systematic risk

◼ Whether we should use Sharpe or Treynor depends,

therefore, on the current situation we're in.

◼ If we look at a portfolio as a stand-alone investment we

should use Sharpe (or some other measure that is based
on total risk).

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Sharpe vs Treynor
◼ If we look at a portfolio as an additional investment on
top of an already diversified holding
 we need to consider the marginal contribution to
variance from the new investment
→ may be better evaluated using Treynor rather than
using Sharpe

◼ It is clear that no measure is general enough to

encompass all intermediate cases, and a great deal of
judgment may be necessary to carry out an adequate
evaluation of portfolio performance in these cases

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Treynor’s ratio
◼ The graph shows the security market line in the  - plane

◼ Slope of SML = E(rM ) – rF

◼ If the asset has a Treynor ratio that is greater than the

market, then it is located above the security market line,
and vice versa

◼ Assets with Treynor greater than the market are considered

good buys, but they may carry idiosyncratic risk for which
the investor is not compensated
(Actual term is different from Expected term)

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◼ More portfolio performance measures
◼ Jensen Alpha – A version of Treynor measure

◼ M measure – A version of Sharpe

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◼ Information Ratio

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More portfolio performance measures
◼ A version of the Treynor measure is Jensen's alpha:

◼ It the (actual) average return on the portfolio over and

above that predicted by the CAPM.

◼ A version of the Sharpe ratio is the M2 measure which is

generated by an imaginary mixing of the portfolio in
question with the risk free asset
 The imagined mixing process enables us to scale up
or down the standard deviation of our portfolio

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Sharpe ratio → M2 measure
◼ Let x the weight of our original portfolio
◼ and 1 – x be the imaginary weight in the risk free asset
◼ Suppose the original portfolio has standard deviation 
◼ Then the standard deviation of the mixed portfolio = x
(Covariance and variance of rf with others are Zero)

◼ Purpose: Compare with the Market to find the value x

 Set the standard deviation of the mixed portfolio equal
to that of the market index:
→ Standard deviation market = M = x →

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Sharpe ratio → M2 measure
◼ We have M = x, which implies that the mixed
portfolio has now the same risk as the market portfolio,
 we can then compare the return of the mixed
portfolio with the market portfolio, the difference is
the M2 measure
M = xE (r ) + (1 − x)rf − E (rM )
2

M M
M =2
E (r ) + (1 − )rf − E (rM )
 
 An advantage of this performance measure is that it is
in terms of returns
→easy to evaluate the over or under performance
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More portfolio performance measures
Information Ratio
◼ It is given by the ratio of the portfolio's (Jensen) alpha
measure to the standard deviation of the idiosyncratic risk

(Extra return per unit of Idiosyncratic Risk)

◼ Find the standard deviation of the idiosyncratic risk:
→ Use single index model to compute the beta of the
portfolio, and we have the variance of the idiosyncratic risk:
difference between total risk and market (systematic) risk:

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