PORTFOLIO PERFORMANCE

MEASUREMENT

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 What is Required of
a Portfolio Manager?
1.The ability to derive above-average returns for a given
risk class
Superior risk-adjusted returns can be derived from
either
 superior timing or
 superior security selection
2. The ability to diversify the portfolio completely to
eliminate unsystematic risk. relative to the portfolio’s
benchmark
 Early Performance Measure Techniques

 Portfolio evaluation before 1960

 Once upon a time, investors evaluated a portfolio’s
performance based purely on the basis of the rate of
return.
 Research in the 1960’s showed investors how to
quantify and measure risk.
 Grouped portfolios into similar risk classes and
compared rates of return within risk classes.

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 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.

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Treynor Portfolio Performance Measure

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 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.
R p,t   p   p R M, t    p ,t
 The beta is the slope that measures the volatility of the
portfolio’s returns relative to the market.
 Alpha represents unique returns for the portfolio.
 As the portfolio becomes diversified, unique risk
diminishes.

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 Treynor Measure
A risk-adjusted measure of return that divides a portfolio's
excess return by its beta.

The Treynor Measure is given by

R p  rf
Tp =
p
The Treynor Measure is defined using the average rate of return
for portfolio p and the risk-free asset.

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 Treynor Measure

R p  rf
Tp =
p

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.

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 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.

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T-Lines

Q has higher
alpha, but P has
steeper T-line.
P is the better
portfolio.
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Sharpe Portfolio Performance Measure

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 Sharpe Measure
 Similar to the Treynor measure, but uses the total risk of the
portfolio, not just the systematic risk.
 The Sharpe Ratio is given by

R p  rf
Sp =
p

 The larger the measure the better, as the portfolio earned a

higher excess return per unit of total risk.

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 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.

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 SML vs. CML
 Treynor’s measure uses Beta and hence examines portfolio
return performance in relation to the SML.
 Sharpe’s 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.

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 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).

R p  rf = Tp  p R p  rf  Sp p

 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).

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Jensen Portfolio Performance Measure

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 Jensen’s Alpha
 Alpha is a risk-adjusted measure of superior performance

R p,t  rf, t   p   p R M, t  r f ,t    p ,t

 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, Jensen’s method does not consider the
ability of the manager to diversify, as it is only accounts for
systematic risk.
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 Multifactor Jensen’s Measure
Measure can be extended to a multi-factor setting, for example:

R p,t  rf, t   p   1 p R M, t  rf ,t    2 p SML   3 p HML   p,t

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Information Ratio

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 Information Ratio 1
 Using a historical regression, the IR takes on the form

IR p   p  
where the numerator is Jensen’s alpha and the denominator is the
standard error of the regression. Recalling that
R p,t  rf, t   p   p R M, t  r f ,t    p ,t

Note that the risk here is nonsystematic risk, that could, in theory,
be eliminated by diversification.

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 Information Ratio 2

R p  Rb
IR p =
 ER
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.
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 Portfolio Tracking Error
Excess Return relative
ERt  R p ,t  Rb ,t
to benchmark portfolio b

T
1
Average Excess Return ER 
T
 ER
t 1
t

 
2
Variance in Excess Difference 1 T
 2
ER  
T  1 t 1
ERt  ER

Tracking Error
 ER   ER
2

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 Information Ratio
 Excess return represents manager’s ability to use information
and talent to generate excess returns.
 Fluctuations in excess returns represent random noise that is
interpreted as unsystematic risk.

R p  Rb
IR p =
 ER
Information to noise ratio.
 Annualized IR
IR p = T IR p
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M2 Measure

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 M2 Measure
Developed by Leah and her grandfather Franco Modigliani.

M2 = rp*- rm

rp* is return of the adjusted portfolio that matches the volatility of the
market index rm. 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.
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 M2 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, M2 is
negative, and the managed portfolio underperformed the market.

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M2 of Portfolio P

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 Factors That Affect Use of Performance
Measures
 Market portfolio difficult to approximate
 Benchmark error
 can affect slope of SML

 can affect calculation of Beta

 greater concern with global investing

 problem is one of measurement

 Sharpe measure not as dependent on market portfolio

 Benchmark Portfolios

 Performance evaluation standard

 Usually a passive index or portfolio
 May need benchmark for entire portfolio and
separate benchmarks for segments to evaluate
individual managers
 Characteristics of Benchmarks
 Unambiguous
 Investable
 Measurable
 Appropriate
 Reflective of current investment opinions
 Specified in advance
 Building a Benchmark
 Specialize as appropriate
 Provide value weightings
 Provide constraints to portfolio manager
Style Analysis

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 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.

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 Sharpe’s Style Portfolios for the Magellan Fund

Monthly returns on Magellan

Fund over five year period.
Regression coefficient only
positive for 3.
They explain 97.5% of
Magellan’s returns.
2.5 percent attributed to
security selection within asset
classes.

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Fidelity Magellan Fund Returns vs Benchmarks

Fund vs Style and Fund vs SML

Impact of positive 19.19%

alpha on abnormal
returns.

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Market Timing

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 Perfect Market Timing
 A manager with perfect market timing, that shifts assets
efficiently across stocks, bonds and cash would have a return
equal to

R pt  RFRt  max Rst  RFRt , Rbt  RFRt ,0

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 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
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 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

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Performance of Bills, Equities and Timers
Beginning with $1 dollar in 1926, and ending in 2005....

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 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.

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 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 ßeta

 High Market Return – high weight on the market - high ßeta

Henriksson (1984) showed little evidence of market timing.

Evidence of market efficiency.

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 Characteristic Lines: Market Timing

No Market Timing

Beta Increases with Return Two Values of Beta

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 Testing Market Timing
 The following regression equation, controls for the movements
in bond and stock markets, and captures the superior market
timing of managers

R pt  RFRt      b Rbt  RFRt    s Rst  RFR 

  max Rst  RFRt , Rbt  RFRt ,0  t

 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.

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Performance Attribution Analysis

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 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

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 Overall performance = Portfolio Risk
Premium+ Selectivity

R p    
 R f = R x ( p )  R f  R p - R x ( p ) 
Overall
Portfolio Risk Selectivity
Performance Premium

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.

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 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 portfolio’s overall performance.
Total value added performance is the sum of selection
and allocation effects.

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 Formula for Attribution
Set up a ‘Benchmark’ or ‘Bogey’ portfolio
n n
rB  w
i 1
Bi rBi & r p  w
i 1
pi r pi
n n
r p  rB  w
i 1
pi r pi   wBi rBi 
i 1
n

 (w
i 1
pi r pi  wBi rBi )

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

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 Allocation Effect
 Asset Allocation Effect

  i wPi  wBi   rBi 

 Captures the manager’s decision to over or

underweight a particular market segment i.
 Overweighting a segment i when the benchmark yield
is high is rewarded.

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 Selection Effect
 Security Selection Effect

  i wPi   rPi  rBi 

 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.

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