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CONTENT
Chapter 7: 2

PORTFOLIO PERFORMANCE MEASUREMENT  1. Time-Weighted and Money-Weighted Returns

 2. Composite Portfolio Performance Measures

Lecturer: D r. L I N H D . N G U Y E N
FA C U LT Y O F F I N A N CE
BANKING UNIVERSITY OF HCMC

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1. TIME-WEIGHTED AND MONEY-WEIGHTED RETURNS TIME-WEIGHTED AND MONEY-WEIGHTED RETURNS

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 A. Time-Weighted Returns  If markets are efficient, investors must be able to

 B. Money-Weighted Returns
 C. Time-Weighted vs. Money-Weighted Returns
measure asset management performance
 Two common ways to measure average portfolio
return:
 Time-weighted returns (geometric mean return)
 Money-Weighted Returns/Dollar-weighted returns (IRR)

 Returns must be adjusted for risk

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A. TIME-WEIGHTED RETURNS B. DOLLAR-WEIGHTED RETURNS

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 The time-weighted returns is the geometric mean  Dollar-weighted returns is internal rate of return
return (IRR)
 Each period’s return has equal weight:  Returns are weighted by the amount invested in each
period:
1+ = 1+ × 1+ ×. . .× 1 +
C1 C2 Cn
= 1+ × 1+ ×. . .× 1 + −1
PV  1
 2
 ...
1  r  1  r  1  r n

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TIME-WEIGHTED VS. MONEY-WEIGHTED RETURNS

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 Example: Total cash outlays are shown below, let’s compute

time-weighted and money-weighted return.

$2 $4 + $108

-$50 -$53

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2. COMPOSITE PORTFOLIO PERFORMANCE MEASURES A. SHARPE PORTFOLIO PERFORMANCE MEASURES

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 A. Sharpe Portfolio Performance Measures  This performance measure seeks to measure the total
 B. Treynor Portfolio Performance Measures risk of the portfolio by using the standard deviation of
returns
 C. Jensen Portfolio Performance Measures
R  RFR
 D. The Information Ratio Performance Measures Si  i
i
 Where:
: average rate of return for Portfolio during a specified time period
: average rate of return on a risk−free investment during the same time
period
: standard deviation of the rate of return for Portfolio during the time
period
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SHARPE PORTFOLIO PERFORMANCE MEASURES SHARPE PORTFOLIO PERFORMANCE MEASURES

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 Demonstration of comparative Sharpe measures Portfolio Average Annual Rate of Return Standard Deviation of Return
D 0.13 0.18
 Suppose that during the most recent 10-year period, the
E 0.17 0.22
average annual total rate of return (including dividends) on F 0.16 0.23
an aggregate market portfolio, such as the S&P 500, was
 Let’s calculate the Sharpe measures for each of these funds.
14% and the average nominal rate of return on government
T-bills was 8%.
 The standard deviation of the annual rate of return for the
market portfolio over the past 10 years was 20%.
 In addition, total rate of return and standard deviation of the
annual rate of return for the portfolio D, E and F are as
follows:

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SHARPE PORTFOLIO PERFORMANCE MEASURES B. TREYNOR PORTFOLIO PERFORMANCE MEASURE

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Rate of Return
CML  Treynor (1965)
0.20
 Postulated two components of risk:
0.18
SE  Risk produced by general market fluctuations
0.16 SF
 Risk resulting from unique fluctuations in the portfolio securities
0.14
SM  Introduced the characteristic line
0.12
SD
0.10
0.08  Building on capital market theory, he introduced a risk-free
0.06 asset that could be combined with different portfolios to
0.04 form a portfolio possibility line
0.02 Standard Deviation of Return  He showed that rational investors would always prefer the
0.0 0.1 0.2 0.3 0.4 portfolio line with the largest slope
Exhibit: Plot of Performance on CML (S Measure)
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TREYNOR PORTFOLIO PERFORMANCE MEASURE TREYNOR PORTFOLIO PERFORMANCE MEASURE

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 The slope of this portfolio possibility line (designated T) is:  Comparing a portfolio’s T value to a similar measure for
the market portfolio indicates whether the portfolio
Ri  RFR
Ti  would plot above the security market line (SML)
i
 Where:  Calculate the T value for the aggregate market as
 βi = slope of the fund’s characteristic line during that time period follows:
−
=

 Where:
 βM = 1.0 (the market’s beta)
 TM = slope of the SML

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TREYNOR PORTFOLIO PERFORMANCE MEASURE TREYNOR PORTFOLIO PERFORMANCE MEASURE

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 Demonstration of comparative Treynor measures  Compute T values for the market portfolio and for each of the
 Assume again that RM = 0.14 and RFR = 0.08 individual portfolio managers as follows:
 You are deciding between three different portfolio managers, based
on their past performance:

Average Annual
Investment Manager Beta
Rate of Return

W 0.12 0.90

X 0.16 1.05

Y 0.18 1.20

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TREYNOR PORTFOLIO PERFORMANCE MEASURES TREYNOR VS SHARPE MEASURE

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Rate of Return
SML
Ri  RFR Ri  RFR
0.20
TY
Ti  Si 
0.18 i i
0.16 TX

0.14  For a completely diversified portfolio, T and S give identical

TM performance rankings because systematic risk (β) and total risk
0.12
0.10 TW (σ) are the same
0.08  However, a poorly diversified portfolio could have a high
0.06 ranking based on the Treynor ratio, which ignores unsystematic
0.04 risk, but a much lower ranking with the Sharpe measure, which
0.02 Beta does not.
0.0 0.5 1.00 1.50 2.00  Any difference in rankings produced by T and S comes directly
Exhibit: Plot of Performance on SML (T Measure) from a difference in portfolio diversification levels
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C. JENSEN PORTFOLIO PERFORMANCE MEASURE JENSEN PORTFOLIO PERFORMANCE MEASURE

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 The Jensen measure (Jensen, 1968) was originally based on the
capital asset pricing model (CAPM), which calculates the
expected one-period return on any security or portfolio by the
following expression:
R jt  RFRt   j   j  Rmt  RFRt   e jt
 αj indicates whether the portfolio manager is superior or inferior in her
investment ability
 A superior manager has a significant positive α (alpha) value,
while an inferior manager’s returns consistently fall short of
expectations based on the CAPM, leading to a significant
negative α
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 Applying the Jensen Measure
 The Jensen alpha measure of performance requires using a different
RFR for each time interval during the sample period
 It does not directly consider the portfolio manager’s ability to
diversify because it calculates risk premiums in terms of systematic
risk
 The Jensen performance measure is flexible enough to allow for
alternative models of risk and expected return than the CAPM
 Risk-adjusted performance (α) can be computed relative to any
multifactor model:
R jt  RFRt   j  b j1 F1t  b j 2 F2t    b jk Fkt   e jt
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D. INFORMATION RATIO PERFORMANCE MEASURE

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 The information ratio (IR) measures a portfolio’s

average return in excess of that for a benchmark
portfolio divided by the standard deviation of this excess
return:
R j  Rb ER j
IR j  
 ER  ER

 Where:
Rb  average return for the benchmark portfolio during the period
 ER  standard deviation of the excess return during the period

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SUMMARIZING
THE RISK-ADJUSTED PERFORMANCE MEASURES
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 Each of the risk-adjusted performance statistics just

described is widely used in practice and has strengths
and weaknesses
Performance Risk-Adjustment Advantages Disadvantages
Measure Measure
Treynor Portfolio beta • Simple and intuitive • Permits only relative
ratio (T ) relative to market “benefit–cost” comparison of assessments of
index proxy the risk–return trade-off. performance for
• Linked conceptually to the
different portfolios.
SML and capital market
theory. • Difficult to interpret and
• Relatively simple to calculate assess statistical
and widely used in practice significance
• Ignores unsystematic
risk in a portfolio
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Performance Risk-Adjustment Advantages Disadvantages Performance Risk-Adjustment Advantages Disadvantages

Measure Measure Measure Measure
Sharpe (1) Standard • Simple and intuitive “benefit– • Permits only relative Information Standard • Direct comparison of • Permits only relative
ratio (S) deviation of cost” comparison of the risk– assessments of ratio (IR) deviation portfolio performance assessments of
total portfolio return trade-off performance for different of portfolio compared to benchmark in performance for different
return; or • Linked conceptually to the portfolios return in investment style class portfolios in a style class
(2) Standard CML and capital market • Difficult to interpret and excess of return • Simple and intuitive • Difficult to interpret and
deviation of theory assess statistical
to style-class measure of the “benefit– assess statistical
portfolio return • Simplest to calculate and significance
benchmark cost” trade-off significance
in excess of widely used in practice • Ignores diversification
risk-free rate potential of portfolio index (i.e., involved with active • Implicitly assumes that
tracking management portfolio and benchmark
Jensen’s (1) Portfolio • Most rigorous risk-adjustment • More difficult computation error) • Flexible design permitting have similar levels
alpha (α ) beta relative to process separating systematic requiring formal regression multiple benchmark of systematic risk
market index and unsystematic risk analysis
comparisons
proxy; or components • Diversification of portfolio
(2) Portfolio • Can be adapted to either assessed in separate
betas relative to CAPM or multifactor models measure from performance
multiple risk of the risk–return trade-off • Alpha level and
factors • Intuitive interpretation of significance can
measure that permits vary greatly depending on
statistical significance specification of return-
assessment generating model

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