You are on page 1of 80

# Albert Lee Chun Portfolio Management

Portfolio Management
3-228-07
Albert Lee Chun
Lecture 11
Evaluation of Portfolio
Performance
2 Dec 2008
Albert Lee Chun Portfolio Management
Introduction
As portfolio managers, how can we evaluate the
performance of our portfolio?
We know that there are 2 major requirements of
a portfolio managers performance:
1. The ability to derive above-average returns
conditioned on risk taken, either through
superior market timing or superior security
selection.
2. The ability to diversify the portfolio and
eliminate non-systematic risk, relative to a
benchmark portfolio.
wealth
Albert Lee Chun Portfolio Management
Today
Performance Measurement
Risk Adjusted Performance Measures
Measures of Sharpe, Treynor and Jensen
Measures of Skill and Timing
Attribution de performance
Concept de mesures ajustes pour le risque
Mesures de Sharpe, Treynor et Jensen
Mesure des habilits de timing
wealth
Albert Lee Chun Portfolio Management
Averaging Returns
Arithmetic Mean:

=
=
n
t
t
n
r
r
1
Geometric Mean:
1 ) 1 (
/ 1
1

(

+ =
[
=
n
n
t
t
r r
Example:
(.10 + .0566) / 2 = 7.83%
[ (1.1) (1.0566) ]
1/2
- 1
= 7.808%
Example:
17-3
wealth
Albert Lee Chun Portfolio Management
Geometric Average
The arithmetic average provides unbiased estimates of the
expected return of the stock. Use this to forecast returns in the
next period.

The fixed rate of return over the sample period that would yield
the terminal value is know as the geometric average.

The geometric average is less than the arithmetic average and this
difference increases with the volatility of returns.

The geometric average is also called the time-weighted average (as
opposed to the dollar weighted average), because it puts equal
weights on each return.
17-4
wealth
Albert Lee Chun Portfolio Management
Dollar- and Time-Weighted Returns
Dollar-weighted returns
Internal rate of return.
Returns are weighted by the amount invested in each
stock.

Time-weighted returns
Not weighted by investment amount.
Equal weighting
Geometric average
17-5
wealth
Albert Lee Chun Portfolio Management
Example: Multiperiod Returns
Period Action
0 Purchase 1 share of Eggberts Egg Co. at \$50
1 Purchase 1 share of Eggberts Egg Co. at \$53
Eggbert pays a dividend of \$2 per share
2 Eggbert pays a dividend of \$2 per share
Sell both shares for \$108

17-6
wealth
Albert Lee Chun Portfolio Management
Period Cash Flow
0 -50 share purchase
1 +2 dividend -53 share purchase
2 +4 dividend + 108 shares sold
% 117 . 7
) 1 (
112
) 1 (
51
50
2 1
=
+
+
+

=
r
r r
Internal Rate of Return:
Dollar-Weighted Return
Dollar Weighted: The stocks performance in the second year,
when we own 2 shares, has a greater influence on the overall return.
wealth
Albert Lee Chun Portfolio Management
Time-Weighted Return
% 66 . 5
53
2 53 54
% 10
50
2 50 53
2
1
=
+
=
=
+
=
r
r
[ (1.1) (1.0566) ]
1/2
- 1
= 7.808%
17-8
Time Weighted: Each return has equal weight in the geometric
average.
Geometric Mean:
wealth
Albert Lee Chun Portfolio Management
Performance Measurement
wealth
Albert Lee Chun Portfolio Management
Early Performance Measure Techniques
Portfolio evaluation before 1960
Once upon a time, investors evaluated a portfolios
performance based purely on the basis of the rate of
return.
Research in the 1960s showed investors how to
quantify and measure risk.
Grouped portfolios into similar risk classes and
compared rates of return within risk classes.
wealth
Albert Lee Chun Portfolio Management
Peer Group Comparisons

This is the most common manner of evaluating
portfolio managers.
Collects returns of a representative universe of
investors over a period of time and displays them
in a box plot format.
Example: US Equity with Cash relative to peer
universe of US domestic equity managers.
Issue: There is no explicit adjustment for risk. Risk
is only considered implicitly.

wealth
Albert Lee Chun Portfolio Management
wealth
Albert Lee Chun Portfolio Management
Treynor Portfolio Performance
Measure
wealth
Albert Lee Chun Portfolio Management
Treynor (1965)
Treynor (1965) developed the first composite measure of
portfolio performance that included risk.
He introduced the portfolio characteristic line, which
defines a relation between the rate of return on a specific
portfolio and the rate of return on the market portfolio.

The beta is the slope that measures the volatility of the
portfolios returns relative to the market.
Alpha represents unique returns for the portfolio.
As the portfolio becomes diversified, unique risk
diminishes.

( )
t p p p , t M, t p,
R R c | o + + =
Albert Lee Chun Portfolio Management
A risk-adjusted measure of return that divides a portfolio's
excess return by its beta.

The Treynor Measure is given by

Treynor Measure
p
f p
p
r R
= T
|

## The Treynor Measure is defined using the average rate of return

for portfolio p and the risk-free asset.

wealth
Albert Lee Chun Portfolio Management
Treynor Measure
p
f p
p
r R
= T
|

## A larger Tp is better for all investors, regardless of their risk

preferences.

Because it adjusts returns based on systematic risk, it is the
relevant performance measure when evaluating diversified
portfolios held in separately or in combination with other
portfolios.
wealth
Albert Lee Chun Portfolio Management
Treynor Measure
Beta measures systematic risk, yet if the portfolio is not fully
diversified then this measure is not a complete
characterization of the portfolio risk.
Hence, it implicitly assumes a completely diversified portfolio.
Portfolios with identical systematic risk, but different total
risk, will have the same Treynor ratio!
Higher idiosyncratic risk should not matter in a diversified
portfolio and hence is not reflected in the Treynor measure.
A portfolio negative Beta will have a negative Treynor
measure.
Also known as the Treynor Ratio.
wealth
Albert Lee Chun Portfolio Management
T-Lines
17-18
Q has higher
alpha, but P has
steeper T-line.
P is the better
portfolio.
wealth
Albert Lee Chun Portfolio Management
Sharpe Portfolio Performance Measure
wealth
Albert Lee Chun Portfolio Management
Similar to the Treynor measure, but uses the total risk of the
portfolio, not just the systematic risk.
The Sharpe Ratio is given by

The larger the measure the better, as the portfolio earned a
higher excess return per unit of total risk.

Sharpe Measure
p
f p
p
r R
= S
o

wealth
Albert Lee Chun Portfolio Management
Sharpe Measure
It adjusts returns for total portfolio risk, as opposed to only
systematic risk as in the Treynor Measure.
Thus, an implicit assumption of the Sharpe ratio is that the
portfolio is not fully diversified, nor will it be combined with
other diversified portfolios.
It is relevant for performance evaluation when comparing
mutually exclusive portfolios.
Sharpe originally called it the "reward-to-variability" ratio, before
others started calling it the Sharpe Ratio.

wealth
Albert Lee Chun Portfolio Management
SML vs. CML
Treynors measure uses Beta and hence examines portfolio
return performance in relation to the SML.
Sharpes measure uses total risk and hence examines portfolio
return performance in relation to the CML.
For a totally diversified portfolio, both measures give equal
rankings.
If it is not a diversified portfolio, the Sharpe measure could
give lower rankings than the Treynor measure.
Thus, the Sharpe measure evaluates the portfolio manager in
terms of both return performance and diversification.
wealth
Albert Lee Chun Portfolio Management
Price of Risk
Both the Treynor and Sharp measures, indicate the risk
premium per unit of risk, either systematic risk (Treynor) or
total risk (Sharpe).

They measure the price of risk in units of excess returns per
each unit of risk (measured either by beta or the standard
deviation of the portfolio).

T = r R
p p f p
|
p p f p
S r R o =
Albert Lee Chun Portfolio Management
Jensen Portfolio Performance Measure
wealth
Albert Lee Chun Portfolio Management
Alpha is a risk-adjusted measure of superior performance

This measure adjusts for the systematic risk of the portfolio.
Positive alpha signals superior risk-adjusted returns, and that
the manager is good at selecting stocks or predicting market
turning points.
Unlike the Sharpe Ratio, Jensens method does not consider the
ability of the manager to diversify, as it is only accounts for
systematic risk.

Jensens Alpha
( )
t p t f p p
r
, , t M, t f, t p,
R r R c | o + + =
wealth
Albert Lee Chun Portfolio Management
Multifactor Jensens Measure
Measure can be extended to a multi-factor setting, for example:

( )
t p
p p
t f
p
p
HML SML r
,
3 2
, t M,
1
t f, t p,
R r R c | | | o + + + + =
Albert Lee Chun Portfolio Management
Information Ratio
wealth
Albert Lee Chun Portfolio Management
Information Ratio 1
Using a historical regression, the IR takes on the form

where the numerator is Jensens alpha and the denominator is
the standard error of the regression. Recalling that
c
o o
p p
IR =
( )
t p t f p p
r
, , t M, t f, t p,
R r R c | o + + =
Note that the risk here is nonsystematic risk, that could, in theory,
be eliminated by diversification.
Albert Lee Chun Portfolio Management
Information Ratio 2
ER
b
p
p
R R
= IR
o

## Measures excess returns relative to a benchmark portfolio.

Sharpe Ratio is the special case where the benchmark equals
the risk-free asset.
Risk is measured as the standard deviation of the excess return
(Recall that this is the Tracking Error)
For an actively managed portfolio, we may want to maximize
the excess return per unit of nonsystematic risk we are bearing.

wealth
Albert Lee Chun Portfolio Management
Portfolio Tracking Error
Excess Return relative
to benchmark portfolio b

Average Excess Return

Variance in Excess Difference

Tracking Error

t b t p t
R R ER
, ,
=

=
=
T
t
t
ER
T
ER
1
1
( )
2
1
2
1
1

=
T
t
t ER
ER ER
T
o
2
ER ER
o o =
wealth
Albert Lee Chun Portfolio Management
Information Ratio
Excess return represents managers ability to use information
and talent to generate excess returns.
Fluctuations in excess returns represent random noise that is
interpreted as unsystematic risk.

Information to noise ratio.
Annualized IR
p p
IR T = IR
ER
b
p
p
R R
= IR
o

## Albert Lee Chun Portfolio Management

Information Ratios
wealth
Albert Lee Chun Portfolio Management
M
2
Measure
wealth
Albert Lee Chun Portfolio Management
M
2
Measure

Developed by Leah and her grandfather Franco Modigliani.

M
2
= r
p*
- r
m

r
p*
is return of the adjusted portfolio that matches the volatility of
the market index r
m
. It is mixed with a position in T-bills.
If the risk of the portfolio is lower than that of the market, one has
to increase the volatility by using leverage.
Because the market index and the adjusted portfolio have the same
standard deviation, we may compare their performances by
comparing returns.

wealth
Albert Lee Chun Portfolio Management
M
2
Measure: Example
Managed Portfolio: return = 35% st dev = 42%
Market Portfolio: return = 28% st dev = 30%
T-bill return = 6%
Hypothetical Portfolio:
30/42 = .714 in P (1-.714) or .286 in T-bills
Return = (.714) (.35) + (.286) (.06) = 26.7%
Since the return of the portfolio is less than the market, M
2
is
negative, and the managed portfolio underperformed the market.

17-35
wealth
Albert Lee Chun Portfolio Management
M
2
of Portfolio P
17-36
17-36
wealth
Albert Lee Chun Portfolio Management
Excess Returns for Portfolios P and Q and
the Benchmark M
wealth
Albert Lee Chun Portfolio Management
Performance Statistics
17-38
wealth
Albert Lee Chun Portfolio Management
Which Portfolio is Best?
It depends.
If P or Q represent the entire portfolio, Q
would be preferable based on having higher
sharp ratio and a better M
2
.
If P or Q represents a sub-portfolio, the Q
would be preferable because it has a higher
Treynor ratio.
For an actively managed portfolio, P may be
preferred because its information ratio is
larger (that is it maximizes return relative to
nonsystematic risk, or the tracking error).
wealth
Albert Lee Chun Portfolio Management
Style Analysis
wealth
Albert Lee Chun Portfolio Management
Style Analysis
Introduced by William Sharpe
1992 study of mutual fund performance
91.5% of variation in return could be
explained by the funds allocations to bills,
bonds and stocks
Later studies show that 97% of the variation
in return could be explained by the funds
allocation to set of different asset classes.
17-41
wealth
Albert Lee Chun Portfolio Management
Sharpes Style Portfolios for the Magellan Fund
17-42
Monthly returns on Magellan
Fund over five year period.
Regression coefficient only
positive for 3.
They explain 97.5% of
Magellans returns.
2.5 percent attributed to
security selection within asset
classes.

wealth
Albert Lee Chun Portfolio Management
Fidelity Magellan Fund Returns vs Benchmarks
17-43
Fund vs Style and Fund vs SML
Impact of positive
alpha on abnormal
returns.
19.19%
wealth
Albert Lee Chun Portfolio Management
Average Tracking Error for 636 Mutual Funds
17-44
Bell shaped
wealth
Albert Lee Chun Portfolio Management
Market Timing
wealth
Albert Lee Chun Portfolio Management
Perfect Market Timing
A manager with perfect market timing, that shifts assets
efficiently across stocks, bonds and cash would have a return
equal to
| | 0 , , max
t bt t st t pt
RFR R RFR R RFR R + =
Albert Lee Chun Portfolio Management
Returns from 1990 - 1999
Year Lg Stocks T-Bills
1990 -3.20 7.86
1991 30.66 5.65
1992 7.71 3.54
1993 9.87 2.97
1994 1.29 3.91
1995 37.71 5.58
1996 23.07 5.58
1998 28.58 5.11
1999 21.04 4.80
17-47
wealth
Albert Lee Chun Portfolio Management
With Perfect Forecasting Ability
Switch to T-Bills in 90 and 94
Mean = 18.94%,
Standard Deviation = 12.04%
Invested in large stocks for the entire
period:
Mean = 17.41%
Standard Deviation = 14.11
17-48
wealth
Albert Lee Chun Portfolio Management
Performance of Bills, Equities
and Timers
Beginning with \$1 dollar in 1926, and ending in 2005....
wealth
Albert Lee Chun Portfolio Management
Value of Imperfect Forecasting
Suppose you are forecasting rain in Seattle. If you predict rain,
you would be correct most of the time.
Does this make you a good forecaster? Certainly not.
We need to examine the proportion of correct forecasts for
rain (P1) and the proportion of correct forecasts for sun (P2).
The correct measure of timing ability is
P = P1 + P2 1
An forecaster who always guesses correctly will show P1 = P2 =
P =1, whereas on who always predicts rain will have P1 = 1, P2
= P = 0.
wealth
Albert Lee Chun Portfolio Management
Identifying Market Timing
If an investor holds only the market and the risk free security, and
the weights remained constant, the portfolio characteristic line
would be a straight line.

Adjusting portfolio weights for up and down movements in
market returns, we would have:

Low Market Return - low weight on the market - low eta
High Market Return high weight on the market - high eta
17-51
Henriksson (1984) showed little evidence of market timing.
Evidence of market efficiency.
wealth
Albert Lee Chun Portfolio Management
Characteristic Lines: Market Timing
17-52
No Market Timing
Beta Increases with Return
Two Values of Beta
wealth
Albert Lee Chun Portfolio Management
Testing Market Timing
The following regression equation, controls for the movements
in bond and stock markets, and captures the superior market
timing of managers

Gamma was found to be equal to .3 and statistically significant,
suggesting that TAA managers were able to time the markets.
However, the study also found a negative alpha of -.5.

( ) ( ) ( )
| | { }
t t bt t st
st s t bt b t pt
RFR R RFR R
RFR R RFR R RFR R
c
| | o
+ +
+ + =
0 , , max
Albert Lee Chun Portfolio Management
Performance Attribution Analysis
wealth
Albert Lee Chun Portfolio Management
Selectivity
The basic premise of the Fama method is that
overall performance of a portfolio can be
decomposed into a portfolio risk premium
component and a selectivity component.
Selectivity is the portion of excess returns that
exceeds that which can be attained by an
unmanaged benchmark portfolio.

Overall performance = Portfolio Risk Premium
+ Selectivity

wealth
Albert Lee Chun Portfolio Management
Overall performance = Portfolio
Risk Premium+ Selectivity
| | | | | | ) ( R - R R ) ( R = R
x p f x f p p p
R | | +
Overall
Performance
Portfolio Risk
Premium
Selectivity
Selectivity measures the distance between the
return on portfolio p and the return on a
benchmark portfolio with beta equal to the beta
of portfolio p.
wealth
Albert Lee Chun Portfolio Management
Attribution Analysis
Portfolio managers add value to their investors
by
1) selecting superior securities
2) demonstrating superior market timing skills
by allocating funds to different asset classes or
market segments.

Attribution analysis attempts to distinguish is
the source of the portfolios overall
performance.
Total value added performance is the sum of
selection and allocation effects.

wealth
Albert Lee Chun Portfolio Management
) (
&
1
1 1
1 1
Bi Bi
n
i
pi pi
n
i
Bi Bi
n
i
pi pi B p
n
i
pi pi p
n
i
Bi Bi B
r w r w
r w r w r r
r w r r w r

= =
= =

=
= =
= =
Where B is the bogey portfolio and p is the managed portfolio.
Formula for Attribution
17-58
Set up a Benchmark or Bogey portfolio
wealth
Albert Lee Chun Portfolio Management
Allocation Effect
Asset Allocation Effect

Captures the managers decision to over or
underweight a particular market segment i.
Overweighting a segment i when the
benchmark yield is high is rewarded.

( ) ( ) | |
Bi Bi Pi i
r w w E =
wealth
Albert Lee Chun Portfolio Management
Selection Effect
Security Selection Effect

Captures the stock picking ability of the manager,
and rewards the ability to form specific market
segment portfolios. Rewards the manger for
placing larger weights on those segments where
his portfolio outperforms the benchmark
portfolio in that particular segment.

( ) ( ) | |
Bi Pi Pi i
r r w E =
Albert Lee Chun Portfolio Management
Performance of the Managed
Portfolio
17-61
wealth
Albert Lee Chun Portfolio Management
Performance Attribution
17-62
wealth
Albert Lee Chun Portfolio Management
Sector Selection within the Equity Market

17-63
wealth
Albert Lee Chun Portfolio Management
Portfolio Attribution: Summary

17-64
wealth
Albert Lee Chun Portfolio Management
Global Benchmark Problem
(Optional)
wealth
Albert Lee Chun Portfolio Management
Benchmark Error
Market portfolio is difficult to approximate
Benchmark error
can effect slope of SML
can effect calculation of Beta
greater concern with global investing
problem is one of measurement
Note: Sharpe measure not as dependent on
market portfolio as the Treynor measure and
others relying on Beta.

wealth
Albert Lee Chun Portfolio Management
Differences in Betas
Two major differences in the various beta
statistics:
For any particular stock, the beta estimates
change a great deal over time.
There are substantial differences in betas
estimated for the same stock over the same time
period when two different definitions of the
benchmark portfolio are employed.

wealth
Albert Lee Chun Portfolio Management
wealth
Albert Lee Chun Portfolio Management
Global Benchmark Problem - SML
wealth
Albert Lee Chun Portfolio Management
Global Benchmark Problem - SML
wealth
Albert Lee Chun Portfolio Management
Global Benchmark Problem - SML
wealth
Albert Lee Chun Portfolio Management
Bond Portfolio Performance
Measures
(Optional)
wealth
Albert Lee Chun Portfolio Management
Bond Portfolio Measures
Returns-Based Bond Performance Measurement
Early attempts to analyze fixed-income performance
involved peer group comparisons
Peer group comparisons are potentially flawed because
they do not account for investment risk directly.
How did the performance levels of portfolio managers
compare to the overall bond market?
What factors lead to superior or inferior bond-portfolio
performance?

Albert Lee Chun Portfolio Management
Fama-French Measure
Fama and French extended their 3-factor equity pricing
model with 2 additional factors to account for the return
characteristics of bonds

TERM captures the term premium in the slope of the yield
curve.
DEF captures the default premium in the credit spread
between corporate bonds and treasuries.
These two bond factors are the dominate drivers of bond
portfolio returns.

( )
jt t j j1 mt t j2 t j3 t j4 t j4 t jt
R - RFR = + b R - RFR + b SMB + b HML + b TERM + b DEF + e ( (

Albert Lee Chun Portfolio Management
Seven Bond Portfolios
wealth
Albert Lee Chun Portfolio Management
Bond Performance Attribution
A Bond Market Line
Need a measure of risk such as beta coefficient for
equities
Difficult to achieve due to bond maturity and
coupon effect on volatility of prices
Composite risk measure is the bonds duration
Duration replaces beta as risk measure in a bond
market line

wealth
Albert Lee Chun Portfolio Management
Bond Market Line
wealth
Albert Lee Chun Portfolio Management
wealth
Albert Lee Chun Portfolio Management
Thats all for today!
wealth