Evaluation of Portfolio

Performance
CHAPTER 9
What is Required of a Portfolio Manager?
➢There are two desirable attributes of a portfolio manager’s
performance:
1. The ability to derive above-average returns for a given risk class
2. The ability to diversify the portfolio completely to eliminate all
unsystematic risk, relative to the portfolio’s benchmark
➢Superior risk-adjusted returns can be derived through either
superior timing or superior security selection
 What is Required of a Portfolio Manager?
➢Portfolio manager shall be superior in predicting the peaks or troughs in the
market
✓Adjust the portfolio’s composition in anticipation of these trends
✓Holding a completely diversified portfolio of high-beta stocks through rising markets and
✓Favouring low-beta stocks and money market instruments during declining markets

➢The level of diversification can be judged based on the correlation

between the portfolio returns and the returns for a market
(benchmark) portfolio.
✓ A completely diversified portfolio is perfectly correlated with the fully
diversified benchmark portfolio.
Early Performance Measures
Techniques
Portfolio evaluation before 1960
◦ rate of return within risk
classes
Peer group comparisons
◦ no explicit adjustment for risk
◦ difficult to form comparable
peer group
 Composite Portfolio Performance Measures
➢Combine risk and return performance into a single value
➢The four major composite portfolio performance measures are:
1. Treynor Portfolio Performance Measure

2. Sharpe Portfolio Performance Measure

3. Jensen Portfolio Performance Measure

4. The information ratio performance Measure

Treynor Portfolio
Performance Measure
➢Treynor recognized two components of risk
▪ Risk from general market fluctuations
▪ Risk from unique fluctuations in the securities in the portfolio
➢Measures risk-adjusted performance focusing on the portfolio’s systematic risk
➢Treynor introduced the characteristic line, which defines the relationship
between the returns to a managed portfolio and the market portfolio
✓Deviations from the characteristic line indicate unique return components for
the portfolio
✓Since Treynor was not concerned about the unique return, he gave no further
consideration to the diversification measure
 Treynor ‘s Composite
Performance Measure

T=
(R i − RFR )
i
▪The numerator is the risk premium
▪The denominator is a measure of risk
▪The expression is the risk premium return per unit of risk
▪Risk averse investors prefer to maximize this value
▪This assumes a completely diversified portfolio leaving
systematic risk as the relevant risk
 Treynor ‘s Composite
Performance Measure

➢Comparing a portfolio’s T value to a similar measure for the market

portfolio indicates whether the portfolio would plot above the SML
✓A portfolio with a higher T value than the market portfolio plots
above the SML, indicating superior risk-adjusted performance.
✓We calculate the T value for the aggregate market as follows:

Tm =
(R m − RFR )
m
 Sharpe Portfolio
Performance Measure
➢The measure followed Sharpe’s earlier work dealing specifically with the
capital market line (CML)
➢This performance measure is similar to the Treynor measure
➢However, it applies the total risk of the portfolio measured by the standard
deviation of returns.
➢This measure indicates the risk premium return earned per unit of total risk
 Sharpe Portfolio
Performance Measure
Risk premium earned per unit of total risk

R i − RFR
Si =
i
Demonstration of Comparative Sharpe
Measure
Average Annual Rate of Standard Deviation of
Portfolio
Return Return
D 0.13 0.18
E 0.17 0.22
F 0.16 0.23

0.14 − 0.08 0.13 − 0.08

SM = = 0.300 SD = = 0.278
0.20 0.18

0.17 − 0.08 0.16 − 0.08

SE = = 0.409 SF = = 0.348
0.22 0.23
•The D portfolio had the lowest risk premium return per unit of total risk, failing
even to perform as well as the aggregate market portfolio. In contrast, Portfolio E
and F performed better than the aggregate market: Portfolio E did better than
Portfolio F.
 Treynor versus Sharpe Measure

➢Sharpe uses standard deviation and Treynor measure uses beta

(systematic risk) as the measure of risk
✓Sharpe therefore evaluates the portfolio manager on the basis of both rate of
return performance and diversification
➢T and S give identical performance rankings because total risk and systematic risk are the same.
➢However, a poorly diversified portfolio could have a high ranking based on the Treynor ratio but a much
lower ranking with the Sharpe measure.

➢Any difference in rankings produced by T and S comes directly from a difference in portfolio
diversification levels.

➢The methods agree on rankings of completely diversified portfolios

 Jensen Portfolio
Performance Measure

➢Jensen measure (Jensen, 1968) was originally based on the capital asset
pricing model (CAPM)
➢Expected return on any security or portfolio is:

E (R j ) = RFR +  j E (R m ) − RFR 
Where:
✓E(Rj) = the expected return on security
✓RFR = the one-period risk-free interest rate
✓j= the systematic risk for security or portfolio j
✓E(Rm) = the expected return on the market portfolio of risky assets
 Jensen Portfolio
Performance Measure
➢The realized rate of return on a security or portfolio during a given time
period should be a linear function of:
✓Risk-free rate of return during the period
✓A risk premium that depends on the systematic risk
✓plus a random error term (ejt).

𝑅𝑗𝑡 = 𝑅𝐹𝑅𝑡 + 𝛽𝑗 𝑅𝑚𝑡 − 𝑅𝐹𝑅𝑡 + 𝑒𝑗𝑡

➢An intercept for the regression is not expected if all assets and portfolios were in
equilibrium
 Jensen Portfolio
Performance Measure
➢Alternatively, superior portfolio managers earn higher risk premiums over time
than those implied by this model.
✓Such managers have mostly positive random error terms because the actual returns
for their portfolios consistently exceed their expected returns.
✓ To detect this superior performance, you must allow for an intercept (a nonzero
constant).
✓Consistent positive differences cause a positive intercept, whereas consistent
negative differences (inferior performance) cause a negative intercept.
✓With an intercept included, the earlier equation becomes:
𝑅𝑗𝑡 = 𝛼𝑗 + 𝑅𝐹𝑅𝑡 + 𝛽𝑗 𝑅𝑚𝑡 − 𝑅𝐹𝑅𝑡 + 𝑒𝑗𝑡
Jensen Portfolio Performance Measure

 P = rP −  rf +  P (rM − rf ) 

p = Alpha for the portfolio

rp = Average return on the portfolio
ßp = Weighted average Beta
rf = Average risk free rate
rm = Average return on market index portfolio
Applying the Jensen Measure
➢the α coefficient represents how much of the managed portfolio’s return is
attributable to the manager’s ability to derive above-average returns adjusted
for risk.
➢Superior risk-adjusted returns indicate that the manager is good at either
predicting market turns or selecting undervalued issues for the portfolio, or both.

➢Jensen 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 term of systematic risk
Which Measure is Appropriate?
It depends on investment assumptions
1) If the portfolio represents the entire investment for an
individual, Sharpe Index compared to the Sharpe Index for the
market
2) If many alternatives are possible, use the Jensen  or the
Treynor measure
➢The Treynor measure is more complete because it adjusts for risk
The Information Ratio
Performance Measure
➢Measures average return in excess of benchmark portfolio divided by the standard
deviation of this excess return
➢Information Ratio divides the alpha of the portfolio by the non-systematic risk
➢Non-systematic risk could, in theory, be eliminated by diversification
R j − Rb ER j j
IR j = = =
 ER  ER U
Rb = the average return for the benchmark portfolio during the period
σER = the standard deviation of the excess return during the period
 The Information Ratio
Performance Measure
➢To interpret IR,
✓the mean return differential in the numerator represents the investor’s ability to
use her talent and information
✓to generate a portfolio return that differs from that of the benchmark against
which her performance is being measured
➢The mean return differential can be considered the investor’s average alpha if the
benchmark is actively managed portfolio
 The Information Ratio
Performance Measure
➢The denominator of the IR statistic measures the amount of residual
(unsystematic) risk that the investor incurred in pursuit of those incremental returns.
➢The coefficient σER is called the tracking error of the investor’s portfolio, and
➢it is a “cost” of active management in that fluctuations in the periodic ERj values
represent random noise
➢Thus, the IR can be viewed as a benefit-to-cost ratio
✓that assesses the quality of the investor’s information deflated by unsystematic risk
generated by the investment process
Components of Investment
Performance
➢Fama (1972) suggested overall performance, return in excess of the risk-
free rate, can be decomposed into measures of risk-taking and security
selection skill
▪ Overall Performance= Excess return = Portfolio Risk + Selectivity

➢The relationship between expected return and risk for the portfolio is:

() ()
 Em Rˆ − RFR  Cov R̂ j , R̂ m
E Rˆ = RFR + 
( )

  (Rm )   (Rm )
Evaluating Selectivity
The market line then becomes a benchmark for the
manager’s performance

 Rm − RFR 
R x = RFR +   x
  ( Rm ) 

Selectivity = Ra − R x ( a )
Evaluating Diversification
The selectivity component can be broken into two
parts
◦ gross selectivity is made up of net selectivity plus
diversification

Selectivity Diversification
Ra − Rx ( a ) = Net Selectivity + Rx ( (Ra )) − Rx ( a )
Holding Based Performance
Measurement
➢There are two distinct advantages to assessing performance based on
investment returns
✓Return are usually easy for the investor to observe on a frequent basis
✓Represent the bottom line that the investor actually takes away from the portfolio
manager’s investing ability

➢Returns-based measures of performance are indirect indications of the

decision-making ability of a manager
➢Holdings-based approach can provide additional insight about the quality of
the portfolio manager
Grinblatt -Titman (GT) Performance
Measure
Among the first to assess the quality of the services provided by money managers by looking at
adjustments they made to the contents of their portfolios

GTt =  (w
j
jt − w jt −1 )R jt

 GT t
Average GT = t
T
 Characteristic Selectivity (CS)
Performance Measure
CS performance measure compares the returns of each stock
held in an actively managed portfolio to the return of a benchmark
portfolio that has the same aggregate investment characteristics
as the security in question
CSt = w
j
jt ( R jt − RBjt )

 CS t
Average CS = t
T
Performance Attribution
➢Decomposing overall performance into components
➢Components are related to specific elements of
performance
➢Example components
▪ Broad Allocation
▪ Industry
▪ Security Choice
▪ Up and Down Markets
Attributing Performance to Components
➢Set up a ‘Benchmark’ or ‘Bogey’ portfolio
▪ Use indexes for each component
▪ Use target weight structure
➢Calculate the return on the ‘Bogey’ and on the managed
portfolio
➢Explain the difference in return based on component
weights or selection
➢Summarize the performance differences into appropriate
categories
Formulan for Attribution
n
rB =  wBi rBi & rp =  w pi rpi
i =1 i =1
n n
rp − rB =  w pi rpi −  wBi rBi =
i =1 i =1
n

 (w
i =1
pi pi r − wBi rBi )

Where B is the bogey portfolio and p is the managed portfolio

Performance of the Managed Portfolio
Performance Attribution…
Sector Selection within the Equity Market
Portfolio Attribution: Summary
Chapter End