PERFORMANCE MEASUREMENT

Performance evaluation typically starts with an examination of the overall portfolio’s total
return and risk during a specific period. The evaluation process cannot be conducted in a
vacuum. Rather investment performance must be compared to a predetermined set of goals in
order to judge the effectiveness of the portfolio’s manager. This requires the evaluator to
compare the actual investment results with predetermined established benchmarks. These
benchmarks, or performance requirements, are generally stated in terms of achieving returns
relative to an index or selected universe as stipulated in the investment policy statement.
Traditionally, individuals responsible for monitoring investment performance are faced with
difficulties in measuring accurately the returns achieved by funds and in evaluating the
performance of the fund’s manager. These difficulties are even more bothersome when the
performance results of one fund manager are compared to those of other managers,
composites, and/or indexes. Often the performance measures of the fund managers and the
comparison group are based on divergent calculation methodologies. This prevents
meaningful comparisons. The investment community has long recognized this short-coming.
As a result, investment professionals have adopted the dollar-weighted rate of return as a
uniform measure of investment performance. Unfortunately, this measure has significant
weaknesses. The actual performance results are distorted when the fund experiences inflows
(contributions) and/or outflows (withdrawals) at any time during the measurement period. In
these instances, investment performance is systematically overstated or understated,
depending on the nature of the flows, (i.e., inflows or outflows).

Dollar Weighted Returns

The simplest form of performance measurement is the dollar weighted return (DWR), which
measures the amount of money gained or lost from the beginning of a review period to the
end of a review period, as a percentage of the original dollars invested. It is the rate of return
required to equate the present value of future cash flows with the initial value of the portfolio.
This is a return that incorporates the effect of deposits and withdrawals during the investment
period. It is more appropriate when computing returns generated by the client or sponsor than
when computing returns generated by the fund manager.
DWR= (MV1-MV0)/MV0

Where MV1 = Ending market value.

MV0 = Beginning market value
Example
Let’s assume that on December 31, we invested $1,000,000 in CAM’s small-cap value
product and that the value of that investment increased during the month, finishing at
$1,100,000 on January 31. Let’s assume that we did not make any contributions or
distributions during that period. We calculate the following return for the month of January:
DWR = (1,100,000-1,000,000)/1,000,000
= 0.10 (10%)
Time Weighted Return
Investment managers often experience cash inflows and outflows throughout the
measurement period. Hence, the time-weighted rate of return (TWRR) is the standard method
employed to evaluate the performance of money managers. This performance measure, also
referred to as the unit rate of return, considers explicitly the impact that the timing of
contributions and withdrawals has on investment performance. Thus it allows for a fair
evaluation of the fund manager’s performance free from the distortions associated with the
use of the dollar-weighted rate-of-return method. The only caveat is that it is necessary to
value the portfolio every time there is a cash flow into or out of the portfolio, and this is not
always possible. Single-manager portfolios can be valued relatively easily (depending on the
underlying assets), but multiple-manager portfolios can be a bit of a challenge. For a pension
plan, it would be nearly impossible to value every manager across every asset class each time
monies are added, subtracted, or reallocated. Liquidity also plays a part, as some portfolio
holdings might not trade on a daily basis and, as a result, may not have daily pricing
available. Lastly, there is a cost factor involved in valuing a portfolio (or series of portfolios)
each time a cash flow takes place. As a result, most pension plans calculate performance only
at regular intervals (most often on a monthly basis). TWR seeks to eliminate the distorting
effects of cash flows so that the manager’s investment skills are correctly determined. The
first step is to split the period into a number of shorter periods, each starting when there is a
cash flow. Returns for these sub –periods are combined to give the TWR for the holding
period. These are returns culled of deposits and withdrawals during the holding period i.e.
they are computed in such a way that deposits and withdrawals do not influence the outcome.
Each dollar is evaluated taking into account the time period it was actively employed.
Appropriate when evaluating the effectiveness of the fund manager. The measure of
calculation is as follows
 TWR= [(MV1/MV0)*(MV2/ (MV1 +C1)]-1
where:
TWR = the time weighted rate of return
MV0 = market value of fund at the end of period 0
MV1 = market value of fund at the end of period 1
MV2 = market value of fund at the end of period 2
C1 = net contribution in period 1
Example

Date Market Value Market Value (Prior to contribution)

1/1 1,000,000 1,000,000
7/1 1,030,000 980 000
12/31 1,082,530
Specifically, the Fund receives contributions of $50,000 during the investment period.
Determine the rate of return

TWR= [(980 000/1,000,000)*(1,082,530/1,030,000)]-1 =0.03 (3%)

Self Assessment Question 1

Suppose on April 30, Eskom Ltd owned 71,000 shares of Pick and Pay Pvt Ltd. At this time
the price of Pick and Pay was $8. On May 15, Eskom makes an additional deposit of
$250,000 when the price of Eskom was $8.50. On May 30, the terminal value of the portfolio
was $745,000. Assume that the portfolio is managed by Invested Fund Managers; determine
the Dollar Weighted and Time Weighted Returns

Risk Adjusted Measures of Performance Measurement

Measuring the pure return of a portfolio may not be adequate since it does not reflect the risk
assumed in earning that return. Risk adjusted evaluation seeks to determine the efficiency of
fund managers in terms of risk –return balancing. These indicate the extent to which the
funds of a client were exposed to risk by fund managers. Some of commonly used measures
are discussed below
Sharpe Ratio
The sharpe ratio showed that the frontier is where the most efficient portfolios are, for a given
collection of securities. The sharpe model goes further. It actually helps you find the best
possible proportion of these securities to use, in a portfolio that contain cash. A number
measuring the reward to-risk efficiency of an investment, used to create risk efficient
portfolios. The Sharpe Index compares the excess return of a portfolio to its risk. Excess
return is defined as the portfolio return in excess of the riskless rate of return. Recall that the
numerator of the Sharpe Index (i.e., Rj – Rf ) measures the so-called excess return of the
portfolio, while the denominator measures the fund’s overall risk or variability. In essence,
the numerator provides the evaluator with a measure of the additional return or “premium”
earned by taking on risk, while the denominator reports the level of risk taken during the
measurement period. It measures ability to diversify. The higher the Sharpe Index, the greater
return premium per unit of risk. Thus, this excess return to variability measure captures the
trade-off between additional return and its associated risk .The definition of the Sharpe Ratio
is:
S(x) = (Rx – Rf)/Std.Dev(x)
where,
x is some investment
Rx is the average annual rate of return of x
Rf is the best available rate of return of a “risk-free” security
(i.e., cash)
Std. Dev(x) is the standard deviation of Rx
The Sharpe model is a direct measure of reward to risk. If sharp ratio ˃ Rm-Rf/σm then the
portfolio performed well

Treynor Ratio

The Treynor Ratio (TR), is similar to the Sharpe Index except that it compares the fund’s
excess return to the fund’s market risk as measured by its beta. The Treynor Ratio is used to
compare the fund’s excess return to the fund’s market risk as defined by its beta. The
Treynor Ratio measures the trade-off between the additional return earned (i.e., above the
risk-free rate) and the portfolio’s exposure to market risk. A higher ratio, therefore, would
suggest the greater the reward. Thus the numerator in the equation is the same as the Sharpe
Index. However, instead of using total variability, the Treynor measure divides excess return
by the portfolio’s beta.
The formula is as follows:
TR=[R(x)-Rf]/ βx
If the Treynor measure is ˃ Rm-Rf /βm then the portfolio performed well
Jensen Measure
Jensen Measure is return on the portfolio over and above that predicted by CAPM, given the
portfolio’s beta and average market return. It can also be referred to as the portfolio’s Alpha.
The Jensen Measure is given by:
α = R(x) – [ Rf +β ( Rm- Rf)]
Positive alpha values are preferred.
Appraisal Ratio
This measure is the ratio of the portfolio’s alpha to the non-market or unique risk of the
portfolio. The portfolio’s alpha measures the average return over that predicted by the market
return, given the portfolio’s beta. The unsystematic risk is that risk which, in principle, can be
eliminated via diversification. It measures abnormal return per unit of risk which can be
diversified away. Hence the appraisal ratio indicates abnormal return per unit of diversifiable
risk. The Appraisal Ratio formula is
AP =α/σ (еp)
where
α = portfolio alpha
σ( ep) = diversifiable risk or specific risk
The measures do not provide consistent assessment of performance since the risk measures
that are used differ substantially. However, using them to complement the weaknesses of the
other can assist in correctly assessing portfolio performance.
EXAMPLE
Market Portfolio Portfolio Y
Average return 28% 33%
Beta 1 1.2
Standard Deviation 32% 40%
Non systematic risk 0 20%
The T-Bill rate is currently at 5%
Calculate the four risk measures

Sharpe ratio =( Ry-Rf) /standard deviation (Rm-Rf)/ σm

=(33-5)/ (40) = (28-5)/(32)
=0.7 = 0.71
Treynor’s ratio=( Ry-Rf) /β =(Rm-Rf)/βm
=(33-5)/ 1.2 =(28-5)/1
= 23.3 = 23

Jensen measure = Ry-[Rf+βy(Rm-Rf)] 0

= 33-[5+1.2(28-5)]
= 0.40

Appraisal ratio= α/ σ(ep)

=0.40/20
=0.02

PERFOMANCE ATTRIBUTION

Superior investment performance depends on the ability to be in the right securities at the
right time (selection and timing). Performance attributions try to decompose overall
performance into discrete components that may be identified with a particular level of
portfolio selection process. The difference between the managed portfolio’s performance and
the benchmark may be expressed as the sum of the contributions to performance of a series of
decisions made at various levels of the portfolio construction process. The attribution method
explains the difference in returns between the managed portfolio and the benchmark portfolio
known as the bogey. The bogey portfolio is set to have fixed weight in each asset class and its
rate of return is given by

Rb=Σ Wbi * Rbi

Where Wbi is the weight of the bogey portfolio in the asset class i and Rbi is return on the
benchmark portfolio of that asset class over the investment horizon. The portfolio manager
will allocate different weights to assets classes (Wpi) according to market expectations and
they choose a portfolio of securities within each class based on their security analysis. The
return from these securities is denoted by Rpi. Return on the managed portfolio is calculated
using the formulae below

Rp=Σ Wpi*Rpi
Contribution from asset allocation is given by Σ Rbi (Wpi-Wbi),while contribution from
security selection is obtained using Σ Wpi (Rpi-Rbi).The sum total of asset allocation and
security selection gives total contribution from asset class i
Example
Actual weight Benchmark weight Market return
Equity 0.7 0.6 5.81
Bonds 0.07 0.3 1.45
Cash 0.23 0.1 0.48

Contribution from asset allocation = ΣRbi (Wpi-Wpb)

=5.81(0.7-0.6) + 1.45(0.07-0.3) + 0.48(0.23-0.1)
=
=

Actual return Index return Portfolio weight

Equity 7.28 5.81 0.70
Fixed Income 1.89 1.45 0.07
Cash 0.10 0.48 0.23
Contribution of security selection = ΣWpi (Rpi-Rbi)
= 0.70(7.28-5.81) + 0.07(1.89-1.45)
=
=