Key Ideas in Modern Portfolio Theory (MPT) and the Capital Asset

Pricing Model (CAPM)

For the exam, be prepared to solve for the expected return and variance of a two-asset portfolio:
 The variance of a two-asset portfolio is the sum of three terms:
× + × +2× × ×
where is a fraction of portfolio held in A
 The standard deviation (a.k.a., volatility) of a two-asset portfolio is the square root of the
variance and is always denoted with sigma (σ):

= + +2

 Covariance (A, B) = Standard deviation (A) * Standard deviation (B) * Correlation(A,B)

= ⇔ =

o Be ready to apply covariance in the special cases where correlation is -1.0, zero, or
1.0; for example, when correlation is zero, the third term under the square root above
drops out.
You want to understand the sequence that produces the capital market line (CML), but for
the exam, you probably do not need to worry about deep theoretical details. At least be aware
that there is a set of minimum variance portfolios that plot on the total risk-versus-return
space; a subset of these are efficient and include the Market Portfolio (i.e., the risky portfolio
with the highest Sharpe ratio). When the risk-free asset is introduced, we can perceive the CML
as a straight line running from the risk-free rate to the Market Portfolio:
 The minimum variance portfolios are the curve of portfolios represented by the
minimum variance conditional on a given return.
o The global minimum variance portfolio (global MVP) is the portfolio of risky assets
with the minimum variance.
 After we introduce (add) the risk-free asset to the minimum variance portfolio set, the
(straight-line) CML becomes the efficient frontier.
o The efficient frontier includes the dominating portfolios on the upper segment,
starting with the global MVP.
o The market portfolio has the highest Sharpe ratio among the efficient portfolios on
the efficient frontier.
You must be comfortable with the components of the capital asset pricing model (CAPM).
Historically, the exam has been primarily concerned only with a superficial application of the
formula (for example, given beta, the expected market return and a risk-free rate, compute the
expected return of a security), and less concerned with CAPM theory, which is deeper than you
might expect.

3
Continuing with only the key points …
 The security market line (SML) expresses the capital asset pricing model (CAPM). The
most likely exam question in this section is an application of the CAPM.
 CAPM formula
o CAPM: E[R(i)] = Rf + Beta (i,M)*[R(M) - Rf]
= + , ( − )

o Beta (i,M) = Covariance (i, M) / variance(M)

= Correlation(i,M) * StdDev(i) / StdDev(M)

, = = ,

 CAPM in English
o Expected return = Price of time + Price of risk × Quantity of risk

where risk-free rate is the price of time

MRP (market risk premium) is price of risk
beta is quantity of risk
o Expected excess return = Price of risk × quantity of risk

 The CAPM is often used to generate a discount rate to compute the present value:
o For example, you may be asked to use CAPM to compute expected return (R), then
discount a cash flow; e.g., PV = FV/(1+R)^n
o But keep in mind, if we only use the CAPM to generate a discount rate (i.e.,
presumably with an equity or levered beta), then it is a cost of equity, not a weighted
average cost of capital.
 For purposes of the exam only, instead of a deep dive into the underlying theory, we
advise you to focus on:
o Two-asset variance
o Covariance and correlation
o Beta, as both standardized covariance; and as correlation multiplied by cross-
volatility
o At least a superficial understanding of CML & SML; but including the Sharpe ratio
(e.g., slope of the CML) as it applies elsewhere
o Application of CAPM: the best thing you can do here is practice computing the
expected return, per the CAPM, based on input assumptions.

4
Chapter 5. Modern Portfolio Theory (MPT) and the Capital
Asset Pricing Model (CAPM)

 Explain modern portfolio theory and interpret the Markowitz efficient frontier.

 Understand the derivation and components of the CAPM.

 Describe the assumptions underlying the CAPM.

 Interpret and compare the capital market line and the security market line.

 Apply the CAPM in calculating the expected return on an asset.

 Interpret beta and calculate the beta of a single asset or portfolio.

 Calculate, compare, and interpret the following performance measures: the Sharpe
performance index, the Treynor performance index, the Jensen performance index,
the tracking error, information ratio, and Sortino ratio.

Explain modern portfolio theory and interpret the Markowitz efficient

frontier.
Harry Markowitz founded modern portfolio theory (MPT), which requires certain assumptions:
 Capital markets are perfect. What are perfect markets? Perfect markets have these
features:
 No friction: No transaction costs; no taxes
 Perfect competition exists among all participants
 Perfect information: All participants have access to all available information, and
the information is accessed free
 Mean-variance framework: Returns are normally distributed.

The theory says that a rational investor (who is risk-averse and seeks maximum utility) will
allocate her portfolio's securities based on their means (i.e., expected return) and variances of
their expected rate of return distributions. As such, this rational investor only cares about the
first two moments such that, for example, skew or kurtosis is irrelevant.
The theory assumes normally distributed returns in order to simplify the investor's utility function,
which can be defined by only two parameters: mean (performance) and variance (risk). Of
course, ceteris paribus, a rational investor will seek higher returns and lower variance.

5
According to Markowitz's theory, the allocation of a security (in the portfolio) should be a
function of its contribution to the portfolio's overall return distribution. The security's contribution
to the portfolio return variance, in turn, is based on the covariance between the security's return
and the portfolio's return. Due to diversification benefits, the risk of the portfolio is less than the
average of the risks of each asset taken individually.

There is no cost involved in the reduction of risk exposures through diversification.

Consequently, there is no compensation for taking asset-specific risk. Portfolio diversification
ensures maximum return at given level of risk (aka, optimization). For each level of risk, there is
an optimal return. The plot of the expected return against risk level results in a portfolio
possibilities curve (PPC) which the dominating (upper) segment is the efficient frontier:

From the above figure (which is abstract/stylistic rather than quantitatively accurate):
 Compared to the lower segment (imagine a vertical line going down), Portfolio P offers a
better return for the same level of risk; it is said to be "more efficient."
 Portfolio K is suboptimal: other portfolios can offer higher return at the same level of risk
 On the efficient frontier, higher return can only be achieved through higher risk
 Portfolio L lies below the efficient frontier: the investor can achieve higher return for the
same level of risk
 Portfolio M is called the market portfolio: it includes all risky assets in the economy
weighted by their relative market values. Portfolio M assumes equilibrium.

The typical proxy for the market portfolio is an index such as the S&P 500 or Russell 2000 (but
these are U.S. portfolios).

6
Understand the derivation and components of the CAPM.
The standard single-factor capital asset pricing model (CAPM) is among the simplest model
that allows us to determine a relationship between (systematic) risk and expected asset return
when markets are in equilibrium. CAPM holds that under a set of unrealistic assumptions
(including frictionless and efficient markets), the expected return is a linear function of exposure,
measured by beta, β, to the common factor called the market risk premium.

 Expected return, E[R(i)] = Risk-free rate + (Price_of_risk × Quantity_of_risk); or

 Expected excess return, E[R(i)] - Risk-free rate = (Price_of_risk × Quantity_of_risk)

where "Price of risk" is the excess market return or market return premium, and "quantity of
risk" refers to beta. Algebraically, CAPM gives the expected return as follows:

Deriving the CAPM

If there is no lending and borrowing, the curve of possible portfolios is shown below:
 While ABC represents the portfolios with minimum variance, BC represents the efficient
frontier (i.e., the portfolios with maximum return for the same amount of risk)
 Efficiency for each investor will differ due to differences in each asset's risk-return
expectations
When lending and borrowing (at the risk-free rate) are added to the mix (when they are
"allowed"), the portfolio of risky assets no longer depends on the investors' risk preferences.
 Such a portfolio (see the red triangle in the next figure) lies on the tangency point
between the original efficient frontier and the ray that passes through the riskless return
(on the vertical axis).
 The investors combine their portfolios with lending or borrowing to satisfy their risk
preferences.
 If the investors have homogeneous expectations and can lend and borrow at the same
risk-free rate, then all the investors will perceive the same diagram; i.e., all the investors
will have an identical portfolio of risky assets.
 In equilibrium, all the investors will hold the market portfolio. The market portfolio is a
portfolio of all the risky assets in proportion to their market value.

7
In such a scenario, all
investors will have only two
portfolios: the market
portfolio (M) and a riskless
security. All investors will
have portfolios along the
straight line (also called as
capital market line (CML)),
and all efficient portfolios will
lie along the capital market
line. The capital market line
does not include all the
securities or portfolios, the
inefficient portfolios of risky
and riskless assets lie below
the capital market line.

Let's not confuse the capital

market line (CML) with the
security market line (SML):
 The CML is a straight line that includes only efficient portfolios: All portfolios on the
CML are efficient because they mix only two assets (the market portfolio and the risk-
free asset). Standard deviation is the measure of risk in CML.
 However, the SML includes any asset or portfolio, including inefficient portfolios.
The SML says the expected return is a linear function only of the systematic risk in the
portfolio, so the beta coefficient determines the risk factor of SML.

8
Formulation for CAPM:

In the CAPM, all portfolios are expected to lie on the SML. If a portfolio lies above or below the
SML, there is an arbitrage opportunity (to gain a riskless profit). Only two points are needed to
identify the straight line:
 Everybody wants to hold the market portfolio (under the assumptions). T market portfolio
is an anchor. By definition, the market portfolio has a beta of 1.0.
 The intercept is the second anchor. The intercept occurs where beta (the systematic risk
measure) is zero. The asset with zero systematic risk is a riskless asset. Thus, the
intercept can be considered as the rate of return on the riskless asset.
The above two points can be used to identify the straight line which gives the expected return
on the portfolio as:
= + ( − )
A well-diversified portfolio does not have nonsystematic risk (idiosyncratic risk). The only risk in
a well-diversified portfolio is the systematic risk, which is measured by beta.

This equation represents the security market line that describes the expected return for all
assets and portfolios of assets in the economy, whether it is efficient or not.

 The first term in the above equation is the riskless return or the return on a riskless
asset. The first term is the intercept term, where the systematic risk (beta) is zero.
 The second term is the excess risk times the amount of risk (beta) in a portfolio. This is
the amount of return the investor receives for taking systematic risk that cannot be
diversified.
 Beta (aka, the quantity of risk) is equal to covariance [security return, market return] ÷
(variance of market return). In this way, we can view beta as a standardized, unitless
translation of the covariance. Importantly, we can divide σ(M) and observe that beta is
also equal to correlation multiplied by cross-volatility:

= =

 Substituting for beta, an equivalent expression for CAPM can be given by:

− −
= + = +

Here measures how the risk on a security affects the risk of the market portfolio.

9
 Key additional and/or summary points:
 The CAPM is represented by the SML (not the CML) because the SML portrays
expected return as a linear function of systematic risk (aka, beta is the X-axis)
 In CAPM, beta, β(i, M) is the asset's (or portfolio's) exposure to the market's excess
return, which is the single common factor. It matters to say that beta is with respect to
the market factor: the denominator is the market's return variance, σ^2(M), which is
relevant because β(i,M) <> β(M,i), unlike correlation where ρ(i,M) = ρ(M,i).
 Alpha, α, is not so far included simply because its expected value is zero! In ex-ante
CAPM, alpha is zero and excluded, but in ex-post CAPM, alpha is the vertical distance
from the SML.
 Is the model valid? This is a deeply researched question, but we can momentarily skirt
the issue by acknowledging that the CAPM requires several assertions that are, to
varying degrees, clearly unrealistic.

Describe the assumptions underlying the CAPM.

Perfect
No transaction Assets infinitely
No personal tax competition
costs divisible
(price takers)

Unlimited
Investors care
Short selling lending and Homgeneity:
only about µ and
allows borrowing (at Rf single period
σ
rate)

Homgeneity: All assets are

same µ, σ, and ρ marketable

No transaction costs

CAPM assumes no transaction costs (in buying or selling). Historically, this assumption was
unrealistic but increasing it is a valid approximation, at least for liquid securities.

Assets are infinitely divisible

CAPM that assets can be divided indefinitely: investors can hold as little as they want.

Absence of personal income tax

This assumption (no personal income tax) implies investors are indifferent to whether capital is
returned via dividends or capital gains.

10
Perfect competition (individuals are "price-takers")

Perfect competition implies that investors are "price takers" who cannot affect the asset's price
when buying or selling.

Mean-variance framework

Investors only care about the first two moments of the return distribution, i.e., mean (return) and
standard deviation (risk). Investors do not care about skew or kurtosis.

Unlimited short sales allowed

There is no limit on the amount of short selling the shares.

Unlimited lending and borrowing at the riskless rate

There is no limit on lending and borrowing of funds at the rate of return for riskless security.

Homogeneity of expectations: single period

Investors have homogeneous expectations with respect to the price of a security over a single
period. All Investors define the single period in the same manner.

Homogeneity of expectations: identical expectations

The model assumes that all investors have identical expectations related to return, variance,
and correlation between the returns of the assets.

All assets are marketable

Model assumes that all the assets (tangible or intangible, including human capital) can be
bought and sold in the market.

Interpret and compare the capital market line and the security market
line.
The capital market line (CML) is the set of optimal portfolios: a linear combination of (i) the
market portfolio and (ii) the risk-free asset.
 The market portfolio has the highest Sharpe ratio (expected excess return divided by
standard deviation), and it is invested proportionally in all risky assets
 CAPM says each investor, when seeking a risky portfolio, wants to hold the same
market portfolio
 Each investor can also invest in the risk-free asset: either the investor can add leverage
by borrowing or can reduce risk by allocating some fraction to the risk-free asset
 All investors can construct an optimum portfolio based on the two-mutual fund theorem,
i.e., by combining the market portfolio with a riskless asset.

11
  Therefore, all investors will hold some portfolio along the capital market line (CML),
which defines an efficient frontier (i.e., there do not exist more efficient portfolios
"vertically above" the CML).
 CML is a special case of SML (CAPM) where the portfolio is efficient and perfectly
correlated to the market portfolio, i.e., ρ(i,M) = 1.0.
 The CML equation gives the return on the efficient portfolio, which is equal to the risk-
free rate plus the Sharpe ratio of the market portfolio multiplied by the standard deviation
of the return of the efficient portfolio (risk of the efficient portfolio).

−
= +

Summary: security market line (SML) and capital market line (CML)
 The CML is a plot of efficient (optimal) portfolios under the restrictive set of assumptions
implied by the general equilibrium relationship. Portfolios on the CML are optimal, and
the CML includes the Market Portfolio (the Market Portfolio is represented by the red
triangle in the graph below and the set of optimal risky assets)
o The CML graphs total risk (standard deviation) on its x-axis, and the slope of the
CML is the market's Sharpe ratio (i.e., the Sharpe ratio of the Market Portfolio)
 The SML plots the expected return as a function of a portfolio's (or asset's) systemic risk
o The SML graphs systemic risk (beta) on its x-axis and the slope of the SML is the
market risk premium; i.e., the expected excess return on the market portfolio

As Noel Amenc helpfully writes (in

Chapter 4): "The capital market line
represents all the linear combinations
of the efficient portfolio of risky assets
with a risk-free investment. It
characterizes the efficient frontier in
the case where one of the assets is
risk-free. The introduction of a risk-free
asset, therefore, simplifies the result
since the efficient frontier is now a
straight line. In addition, the risk of the
portfolios is reduced for a given return
since the straight line dominates the
efficient frontier of risky assets at
every point. Investors, therefore,
benefit from having such an asset in
their portfolio."1

1 Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John

Wiley & Sons, 2003)

12
Also, please note that the CAPM implicitly assumes efficient markets. Specifically, the CAPM
assumes the strong form of the efficient market hypothesis.

CAPM's assumption of a perfect market requires (assumes) the

STRONG FORM of the Efficient Market Hypothesis (EMH)

Apply the CAPM in calculating the expected return on an asset.

The following question is from Elton Chapter 132

Assume that the following assets are correctly priced according to the security market line.
Derive the security market line.

What is the expected return on an asset with a Beta of 2.0?

= 6%, = 0.5, = 12%, = 1.5

Answer:

12% = + 1.5
6% = + 0.5
6% =

⇒ = 3% and the implied CAPM model is given by = %+ × %.

So that = 2.0, = 3% + 6%(2) = 15%

2 Edwin J. Elton, Martin J. Gruber, Stephen J. Brown and William N. Goetzmann, Modern Portfolio Theory and

Investment Analysis, 9th Edition (Hoboken, NJ: John Wiley & Sons, 2014)

13
An illustrated example illustrated from the associated learning spreadsheet

This example assumes only two assets (A and B) in the market portfolio, with these
assumptions:

While there is an almost infinite number of

minimum-variance portfolio combinations (of
these two assets), there is one minimum
variance portfolio (see green dot) and one
portfolio with the highest Sharpe ratio (see red
triangle), which is the "most efficient" portfolio.

Under these assumptions, the "most efficient" portfolio holds 56.82% in Asset A and the
remainder in Asset B. Its Sharpe ratio is 0.564519, which is the maximum achievable.

14
This market portfolio anchors the security market line (SML) (as the red dot).

Now that we have an SML (in this case, a line between the Y-intercept at the risk-free rate of
6.0% running straight to the "highly efficient" market portfolio with an expected return of 12.6%
and, by definition, a beta of 1.0), we can retrieve the expected return for various asset mixes
(between A and B):

For example, consider the long/short portfolio that consists of short 50% of Asset A plus long
150% of Asset B.

 Its expected return, of course, is

given by (-50%)*10.0% +
(150%)*16.0% = +19.0%.
 However, we can also confirm that its
expected return is a function of its
beta. Because its beta is 1.972, its
expected return is 6.0% +
1.972*(12.59% - 6.0%) = 19.0%; note
that 12.59% or ~12.6% is the
expected return of the most efficient
portfolio shown on the

15
Interpret beta and calculate the beta of a single asset or portfolio3
The beta is simply a measure of the sensitivity of a stock to market movements. To estimate the
beta for a firm for the period from t = 1 to t = n:

∑ [( − )( − )
= =
∑ ( − )

The beta on a portfolio βP is a weighted average of the individual beta on each stock in the
portfolio, where the weights are the fraction of the portfolio invested in each stock.

N
βP = X i βi
i=1

However, on the exam, as a practical matter:

 It is most likely that you will be given beta as an input, e.g., in order to compute a
discount rate or expected return.
 Alternatively, you could be given correlation and volatilities and be expected to extract
beta from these quantities. That is, you should be able to apply:
, × ×
, = = = ,

Calculate, compare, and interpret the following performance

measures: the Sharpe performance index, the Treynor performance
index, the Jensen performance index, the tracking error, information
ratio, and Sortino ratio.
The Treynor measure is the portfolio's excess return divided by its beta:

( )−
=

The Sharpe measure is the portfolio's excess return divided by its volatility (standard deviation):

( )−
=
( )

3 All information under this learning objective was retrieved from Edwin J. Elton, Martin J. Gruber, Stephen J. Brown

and William N. Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th Edition (Hoboken, NJ: John Wiley
& Sons, 2014)

16
Jensen's alpha is the portion of the excess return (alpha) that is not explained by systematic
risk (beta multiplied by the market's excess return):

( )− = + ( ( )− ) such that Jensen's alpha is given by:

= ( )−[ + ( ( )− )] = ( )− − ( ( )− )

Please note Jensen's alpha is the same alpha (aka, residual return) reviewed in the FRM's
Investment Risk topic (T9), but generic alpha is a residual return in a multi-factor model with
common factors, while Jensen alpha is the special case where the CAPM is assumed such that
there exists only a single factor (i.e., excess market return). In fact, both the Treynor measure
and Jensen's alpha presuppose the single-factor capital asset pricing model (CAPM).

For an example of each, let's assume the following:

 Risk-free rate, = 3.0%. The Market ‘s return, = 8.0% with volatility, σ(M) = 20.0%
 The portfolio's expected return, [ ] = 9.0% with portfolio volatility, σ(P) = 30.0%
 The portfolio’s correlation with market, ρ (p, M) = 0.50. Therefore, portfolio's beta with
respect to the market, , = 0.50*30%/20% = 0.750
Under the previous assumptions, we can calculate the following measures:

 Treynor measure = (9.0% - 3.0%)/0.750 = 0.080

 Sharpe measure = (9.0% - 3.0%)/0.30 = 0.200
 Jensen’s alpha = (9.0% - 3.0%) – [(8.0% - 3.0%)*0.750] = 2.25%
o CAPM says this portfolio's excess return should be the product of quantity (i.e., β)
and price of risk (risk premium): 0.750*(8.0% - 3.0%) = 3.75%.
o But the portfolio’s excess return is 6.0%, so its alpha = 6.0% - 3.75% = 2.25%

Comparison of Treynor, Sharpe, and Jensen's alpha4

Treynor Measure
 Treynor captures the relationship between the excess return on the portfolio (i.e., the
return above the risk-free rate) and the beta, β(p,M), of the portfolio. Therefore, Treynor
gives us the "excess return per unit of beta."
 This ratio is directly drawn from CAPM. Calculating this indicator requires a reference
index to be chosen to estimate the beta of the portfolio. The results can then depend
heavily on that choice, a fact that has been criticized by Roll.
 The Treynor measure (ratio) is good for evaluating the performance of a well-diversified
portfolio (as it only accounts for systematic risk) or a portfolio that constitutes only
part of an investor's assets.

4 The comparisons on this page were retrieved from Noel Amenc and Veronique Le Sourd, Portfolio Theory and

Performance Analysis (West Sussex, England: John Wiley & Sons, 2003)

17
Sharpe Measure5
 It has the same numerator as the Treynor measure but uses the total risk of the
portfolio in the denominator.
 It is drawn from the portfolio theory, and It does not refer to a market index and is not
therefore subject to Roll's criticism.
 One of the most common variations on this measure involves replacing the risk-free
asset with a benchmark portfolio. The measure is then called the information ratio.
 The Sharpe ratio is good for portfolios that are not well-diversified (as it accounts for total
risk) and/or a portfolio that represents an individual's total investment.
Jensen's alpha
 Based on CAPM and defined as the differential between the return on the portfolio in
excess of the risk-free rate and the return explained by the market model.
 The Jensen measure is subject to the same criticism as the Treynor measure: the result
depends on the choice of the reference index.
 The Jensen's alpha can be used to rank portfolios within peer groups when the peers
have comparable risk levels, i.e., similar betas.

Summary Table 4.1: Characteristics of the Sharpe, Treynor, and Jenson indicators6

Metric Formula Risk Useful for:

( )−
Sharpe = Total,  Relative performance of a portfolio that is
( ) not well-diversified (because it accounts
measure σ
(ratio) for total risk)
 Portfolio is individual's total wealth
( )−
Treynor = Systematic,  Relative performance of a well-diversified
measure β portfolio (because it only accounts for
(ratio) systematic risk)
 Portfolio is only part of an investor's wealth

Jensen's ( )− Systematic,  To rank portfolios within a peer group

alpha β where the peers have comparable risk
= + ( ( ) levels; e.g., peers have same beta β
− )

5 The comparisons on this page were retrieved from Noel Amenc and Veronique Le Sourd, Portfolio Theory and
Performance Analysis (West Sussex, England: John Wiley & Sons, 2003)
6 Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John

Wiley & Sons, 2003)

18
Key relationship #1: Portfolio Treynor versus Market's excess return

Under the restrictive (unrealistic) assumption of a single-factor model, the Treynor ratio of a
well-diversified portfolio should equal the market's excess return:

( )−
= = ( )−

The Treynor depends on the security market line (SML). The left-hand term (above) is the
portfolio's Treynor ratio, while the right-hand term is the market portfolio's Treynor ratio (its beta
is 1.0). Comparing the two Treynor ratio checks whether portfolio risk is sufficiently rewarded.7

Key relationship #2: Sharpe ratio of portfolio versus Market

This relationship (based on the CML) indicates that, at equilibrium, the Sharpe ratio of the
portfolio to be evaluated and the Sharpe ratio of the market portfolio are equal.7

− −
= ( )
= ( )

The Sharpe ratio represents the slope of the market line. For a well-diversified portfolio, the
Sharpe ratio is close to that of the market portfolio. Sharpe ratio provides a measure to compare
the return of the managed portfolio with the market portfolio. It measures whether the expected
return on the managed portfolio is sufficient for additional risk taken by the manager.

Key relationship #3: Exact linear relationship between Treynor and Jensen's alpha

If we divide the formula for Jensen's alpha by beta, we get the Treynor on the left-hand side,
expressed as an exact function of alpha/beta and the market's excess return:

( )−
= +[ ( )− ]

7Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John
Wiley & Sons, 2003)

19
Relationship between Treynor, Sharpe, and Jensen's Alpha indicators:

Treynor and Jensen

 As we saw above, = +[ ( )− ]

Sharpe and Jensen

σ σ σ
 By definition = . In a well-diversified portfolio ≈ since =1
σ2 σ

 Replacing this value of in the Jensen's equation and dividing by σ we get

( )− ( ( )− )
≈ +
σ σ σ
( − )
 This is the Sharpe indicator on the left side, so: ≈σ + σ
Treynor and Sharpe (according to Amenc)8
σ
 Using an approximation of beta for a well-diversified portfolio: ≈σ

− −
 Then Treynor indicator can be written as: ≈ ≈ σ
σ

−
 Using this, Sharpe indicator can be written as: = =
σ σ

These relationships can be summarized as follows:

Treynor and Jensen Sharpe and Jensen Treynor and Sharpe

( ( )− )
= +[ ( )− ] ≈ + =
σ σ σ

Tracking Error (TE)

Tracking error (TE) is the standard deviation of the difference in return between the portfolio and
its benchmark.8 The lower the TE, the nearer the portfolio's risk to the benchmark's risk.

= ( − )

Tracking error is especially used to analyze benchmark funds: funds that assume a construction
similar to a benchmark but deviate from the benchmark composition by "under-weighting" or
"over-weighting" selected assets, with the aim of obtaining a higher return.

8 Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John

Wiley & Sons, 2003)

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Information ratio (IR)

The information ratio (IR, aka, the appraisal ratio) is given by:

( )− ( )
=
( − )

The information ratio (IR) is used to evaluate a benchmark fund's manager by answering the
question, "Was the manager sufficiently rewarded for the risk incurred by deviating from the
benchmark?"

There are two valid definitions of information ratio

At least in the FRM, there are two acceptable definitions of information ratio:
 IR = alpha / σ(alpha)
 IR = active_return / σ(active_return) = active_return / tracking_error
These are both acceptable because they are ratio-consistent: the denominator is the standard
deviation of the numerator. The first definition uses alpha, α, which is also called the residual
return, and this definition is implied by the assigned reading:
 "The information ratio, which is sometimes called the appraisal ratio, is defined by the
residual return of the portfolio compared with its residual risk. The residual return of a
portfolio corresponds to the share of the return that is not explained by the
benchmark."—Amenc9
However, the second definition (which uses active return, i.e., the difference between the
portfolio and the benchmark without accounting for beta) is generally easier to compute.

As evidence, consider GARP's 2012 Practice Exam Part 1, Question #3 [Notes by David Harper
within square brackets]: "The information ratio may be calculated by either a comparison of the
residual return to residual risk, or the excess return [i.e., active return] to tracking error [tends to
refer to active risk; such that notice the ratio consistency]." Forum thread here:
https://www.bionicturtle.com/forum/threads/information-ratio-definition.5554/.

Sortino Ratio

The Sortino ratio is based on the same principle as Sharpe's ratio. However, the risk-free rate is
replaced by the minimum acceptable return (MAR), the return below which the investor does not
wish to drop, and the standard deviation of the returns is replaced with the standard deviation of
the returns that are below the MAR; aka, downside deviation.9 It is given as:

( )−
Sortino Ratio =
1
∑ , ( − )

9 Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (West Sussex, England: John

Wiley & Sons, 2003)

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All three of these measures (tracking error, information ratio, and Sortino) are more natural as
ex-post (after the performance) rather than ex-ante (before the performance) metrics, but the
Sortino in particular, due to the denominator, makes almost no sense ex-ante and therefore is
truly an ex-post metric.

Summary of Tracking error, information ratio, and Sortino Ratio

Metric Formula Notes:

= ( − )  Risk differentials between portfolio and
Tracking
error (TE) benchmark

( )− ( )
Information =  Two versions are acceptable:
( − ) active return ÷ active risk, or
ratio (IR)
residual return ÷ residual risk
( )−
Sortino =  MAR is minimum acceptable return
ratio 1
∑ , ( − )  Denominator is downside deviation,
which divides by the total sample (T)

Most of these measures in this reading are (some measure of) return per unit of risk.

Indicator Return Risk

Sharpe Excess Return Volatility (Total)
Treynor Excess Return Beta (Systematic)

Information Ratio Residual Return (alpha) or Residual Risk, or Active Risk

Active Return (TE)
Sortino Excess over M.A.R. Downside deviation

In short, both Treynor and Sharpe measure ratios of excess return-to-risk but use a different
definition of risk. They differ in their denominator: Treynor uses beta (systemic risk) while
Sharpe uses volatility (total risk).

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An illustrated example (from our learning spreadsheet)
On the next page, we illustrate a complete example. The input assumptions are colored in
yellow. Specifically,
 The market's excess return is 7.0%, and the portfolio's excess returns is 9.0%
 The covariance between the market and portfolio returns given the correlation, and
volatilities, ( ), ( ) is calculated as 0.1260
 The portfolio's beta, , given the correlation, and volatilities, ( ), ( ) is 1.40.
 The portfolio's expected return per the CAPM [ + ( ( ) − )] is 10.80%; so we
can see already that the portfolio’s expected excess return (given a riskfree rate of 1.0%)
is 9.80% and, because the portfolio’s excess return is 9.0%, the portfolio’s (Jensen’s)
alpha = 9.80% - 9.00% = -0.80%.
 An ex-ante tracking error is computed by applying the covariance property: σ^2(p – B) =
σ^2(p) + σ^2(B) – 2*σ(p,B). As previously mentioned, this ex-ante tracking error is
unusual; in practice, an ex-post tracking error is more likely (but we are not simulating
with data here!).

 The residual risk (aka, nonsystematic risk), σ(e), is simply assumed to be 3.0%.

* * * see exhibit on next page * * *

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 Treynor's measure is 0.0667 [portfolio's excess return / , ]
 Sharpe ratio is 0.150 [portfolio’s excess return / ( )]
 Jensen's alpha is -0.80% (portfolio's excess return less beta times market excess return)
 The information ratio (IR) can be defined in two ways, but both are ratio-consistent.
 Information ratio, active is 0.045 [Active return/active risk = ( )− / )]
 Information ratio, residual is -0.267 (alpha / residual_risk)

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Simulation-based Information ratio

On the next page, we illustrate an example of computing both versions of the information ratio
(IR) based on a simulation where again, the input assumptions are colored in yellow. Please
note that you can retrieve a copy of this worksheet (in the workbook) in the Study Planner, and
the sheet is fully dynamic (including the formula labels that are dynamically linked!). In this way,
the version on the following page is merely a single simulation, and we can expect each re-
calculation to produce a different set of outcomes.

In the following version, in addition to an assumption of 1.0% for the risk-free rate, the
assumptions are:
 The benchmark’s expected return is 4.0% and the portfolio’s expected return is 8.0%.
Therefore, the expected active return is +4.0% = 8.0% - 4.0%; however, due to sampling
variation, actual results will vary.
 The benchmark's volatility is 10.0%, and the portfolio's volatility is 20.0%. The correlation
between the portfolio and the benchmark is 0.70. In short, ( ) = 20.0%, ( ) =
10.0%, and = 0.70. Note this allows us to infer an expected tracking error of
14.83% per the variance of the difference between two variables.
Based on this particular simulation of 36 monthly periods (note: months four through 33 are
hidden, but can be displayed in the spreadsheet) where the returns are correlated per the rho,
ρ(B,P), assumption, we can observe:
 The realized statistics are generally near to their expected values, but we have an
almost-small sample such that sampling variation generated differences; e.g., realized
correlation is 0.717, which is fairly close to the assumed 0.70!.
 The realized active return is +3.32% (compared to an expected active return of +4.0%),
and the realized active risk (aka, tracking error) is 15.73% (compared to an expected
TE of 14.83%). Therefore, the unscaled monthly active information ratio is equal to 0.211
= 3.32%/15.73%.
 The realized residual return (aka, alpha) is +0.21%, which is the regression intercept;
note the realized slope of 1.704 happened to be significantly greater than the expected
slope of 1.40. The realized residual risk is 14.69%, which is given by the standard error
of the regression (SER); this is slightly higher than the standard deviation of the
residuals (i.e., 14.48%) only because the SER assumes 34 degrees of freedom (= 36-2)
while the standard deviation assumes 35 degrees of freedom (=36-1). Therefore, the
unscaled monthly residual information ratio is equal to 0.014 = 0.21%/14.69%. In this
particular sample, the higher beta (slope) exposure effectively reduced the alpha, while
the risk denominators were similar, such that the alpha-based residual information ratio
is significantly lower than the active information ratio (which does not differentiate
between outperformance due to alpha versus beta).
* * * see exhibit on next page * * *

25
26
Simulation-based Sortino ratio

On the following page, we simulate a one-month period (with 20 trading days) in order to
calculate and illustrate the Sortino ratio; this employs a worksheet from our learning
spreadsheet. Please note:
 The portfolio and benchmark assumptions are used to simulate benchmark and portfolio
returns, including the correlation between the portfolio and benchmark. While the
benchmark is used to compute the information ratio, it has no role in the Sortino
calculation.
 In this particular simulation, the average portfolio return is +7.33%, with a realized
sample standard deviation of 7.27%. This implies an ex-post Sharpe ratio of 0.870
compared to the expected (ex-ante) Sharpe ratio of 0.700. The return was lower than
expected, but the volatility was also lower.
 Given an assumed minimum acceptable return (MAR) of 3.0%, in this particular
simulation, the portfolio return was below the MAR on only six (6) days out of the 20
simulated days. Consequently, the downside deviation is only 2.58%. This contributes to
a high Sortino value of 1.675.

* * * see exhibit on next page * * *

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