Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown

Chapter 25
 Chapter 25 - Evaluation of
Portfolio Performance
Questions to be answered:
• What major requirements do clients expect from
their portfolio managers?
• What can a portfolio manager do to attain
superior performance?
• What is the peer group comparison method of
evaluating an investor’s performance?
 Chapter 25 - Evaluation of
Portfolio Performance
• What is the Treynor portfolio performance
measure?
• What is the Sharpe portfolio performance measure
and how can it be adapted to include multifactor
models of risk and expected return?
• What is information ratio and how it related to
the other performance measures?
 Chapter 25 - Evaluation of
Portfolio Performance
• When evaluating a sample of portfolios, how do
you determine how well diversified they are?
 Chapter 25 - Evaluation of
Portfolio Performance
• What is the Fama portfolio performance measure
and what information does it provide beyond
other measures?
• What is attribution analysis and how can it be
used to distinguish between a portfolio
manager’s market timing and security selection
skills?
 Chapter 25 - Evaluation of
Portfolio Performance
• What is the benchmark error problem, and what
are the two factors that are affected when
computing portfolio performance measures?
• What are customized benchmarks and What are
the important characteristics that any benchmark
should possess?
 Chapter 26 - Evaluation of
Portfolio Performance
• How do bond portfolio performance measures
differ from equity portfolio performance
measures?
 Chapter 25 - Evaluation of
Portfolio Performance
• What are the time-weighted and dollar-weighted
returns and which should be reported under
CFA’s Performance Presentation Standards?
• How can investment performance be measured
by analyzing the security holdings of a portfolio?
 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 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
 Treynor Portfolio
Performance Measure
• Treynor portfolio performance measure
– market risk
– individual security risk
– introduced characteristic line
• Treynor recognized two components of risk
– Risk from general market fluctuations
– Risk from unique fluctuations in the securities in the portfolio
• His measure of risk-adjusted performance focuses on
the portfolio’s undiversifiable risk: market or systematic
risk
 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
• Calculate the T value for the aggregate market as follows:

Tm 
R m  RFR 
m
 Demonstration of Comparative
Treynor Measure

• Comparison to see whether actual return of

portfolio G was above or below expectations
can be made using:

ER G   RFR   i R m  RFR 

 Sharpe Portfolio
Performance Measure

• Risk premium earned per unit of 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 of returns as the
measure of risk
• Treynor measure uses beta (systematic risk)
• Sharpe therefore evaluates the portfolio manager
on the basis of both rate of return performance
and diversification
• The methods agree on rankings of completely
diversified portfolios
• Produce relative not absolute rankings of
performance
 Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

ER j   RFR   j ER m   RFR 

 Jensen Portfolio
Performance Measure
• Also based on 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
 Applying the Jensen Measure
• 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
 Jensen Measure and Multifactor
Models
• Advantages:
– It is easier to interpret
– Because it is estimated from a regression equation, it is possible to
make statements about the statistical significance of the manger’s
skill level
– It is flexible enough to allow for alternative models of risk and
expected return than the CAPAM. Risk-adjusted performance can
be computed relative to any of the multifactor models:

R jt  RFRt   j  [b j1F1t  b j 2 F2t  b jk Fkt ]  e jt

 The Information Ratio
Performance Measure
• Appraisal ratio
• measures average return in excess of
benchmark portfolio divided by the standard
deviation of this excess return

R j  Rb ER j j
IR j   
 ER  ER U
 Application of Portfolio
Performance Measures

EPit  Div it  Cap.Dist .it  BPit

Rit 
BPit
 Potential Bias of One-
Parameter Measures
• positive relationship between the composite
performance measures and the risk involved
• alpha can be biased downward for those
portfolios designed to limit downside risk
 Measuring Performance with
Multiple Risk Factors
• Form of the estimation equation

R jt  RFRt   j  [b j1 ( RMt  RFRt )  b j 2 SMBt  b j 3 HMLt ]  e jt

 Relationship between
Performance Measures
• Although the measures provide a generally
consistent assessment of portfolio
performance when taken as a whole, they
remain distinct at an individual level.
• Therefore it is best to consider these
composites collectively
• The user must understand what each means
 Components of Investment
Performance
• Fama suggested overall performance, which
is its return in excess of the risk-free rate
Overall Performance=Excess return=Portfolio
Risk + Selectivity
 Components of Investment
Performance
• The selectivity measure is used to assess the
manager’s investment prowess
• 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 
Rx  RFR    x
  Rm  

Selectivit y  Ra  Rx  a 
 Evaluating Diversification
• The selectivity component can be broken
into two parts
– gross selectivity is made up of net selectivity
plus diversification

Selectivit y Diversific ation

Ra  R x  a   Net Selectivit y  R x  Ra   R x  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 prowess
 Holding Based Performance
Measurement
• 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  wj
jt ( R jt  RBjt )

 CS t
Average CS  t
T
Performance Attribution Analysis


• Allocation effect   i Wai  W pi  R pi  R p  
• Selection effect   W   R
i ai ai 
 R pi 
 Performance Attribution
Extensions
• Attribution methodology can be used to
distinguish security selection skills from
any of several other decisions that investor
might make
 Measuring Market Timing Skills

• Tactical asset allocation (TAA)

• Attribution analysis is inappropriate
– indexes make selection effect not relevant
– multiple changes to asset class weightings
during an investment period
• Regression-based measurement
 Measuring Market Timing Skills
R pt  RFRt  max Rst  RFRt , Rbt  RFRt ,0
R pt  RFRt      b Rbt  RFRt    s Rst  RFR 
  max Rst  RFRt , Rbt  RFRt ,0 U t
 Factors That Affect Use of
Performance Measures
• 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
• 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
 Demonstration of the Global
Benchmark Problem
• 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 definition of the
benchmark portfolio are employed.
 Implications of the Benchmark
Problems
• Benchmark problems do not negate the
value of the CAPM as a normative model of
equilibrium pricing
• There is a need to find a better proxy for the
market portfolio or to adjust measured
performance for benchmark errors
• Multiple markets index (MMI) is major step
toward a truly comprehensive world market
portfolio.
 Required Characteristics of
Benchmarks
• Unambiguous
• Investable
• Measurable
• Appropriate
• Reflective of current investment opinions
• Specified in advance
 Selecting a Benchmark
Must be selected at two levels:
• A global level that contains the broadest
mix of risky asset available from around
the world
• A fairly specific level consistent with the
management style of an individual money
manager (i.e., a customized benchmark).
 Evaluation of
Bond Portfolio Performance
• 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.
– Fama and French addressed the flaw
R jt - RFR t = α j +  b j1  R mt - RFR t  + b j2SMBt + b j3HML t  +  b j4TERM t + b j4 DEFt  + e jt
Bond Performance Attribution
• How did the performance levels of portfolio
managers compare to the overall bond
market?
• What factors lead to superior or inferior
bond-portfolio performance?
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 bond’s duration
– Duration replaces beta as risk measure in a
bond market line
Bond Performance Attribution
• This technique divides the portfolio return that
differs from the return on the Lehman Brothers
Index into four components:
– Policy effect
• Difference in expected return due to
portfolio duration target
– Rate anticipation effect
• Differentiated returns from changing
duration of the portfolio
– Analysis effect
• Acquiring temporarily mispriced bonds
– Trading effect
• Short-run changes
 Reporting Investment
Performance
• Time-Weighted and Dollar-Weight Returns
– A better way to evaluate performance regardless of the
size or timing of the investment involved.
– The dollar-weighted and time-weighted returns are the
same when there are no interim investment
contributions within the evaluation period.
Ending Value of Investment
HPY = -1
Beginning Value of Investemnt

Ending Value of Investment - 1 - DW  Contribution 

Adjusted HPY = 1
Beginning Value of Investemnt +  DW  Contribution 
 Reporting Investment
Performance
• Performance Presentation Standards (PPS)
– The goals of the AIMR-PPS are:
• achieve greater uniformity and comparability
among performance presentation
• improve the service offered to investment
management clients
• enhance the professionalism of the industry
• bolster the notion of self-regulation
 Reporting Investment
Performance
• Performance Presentation Standards
– Fundamental principles
• Total return must be used
• Time-weighted rates of return must be used
• Portfolios must be valued at least monthly and periodic returns must
be geometrically linked
• Composite return performance (if presented) must contain all actual
fee-paying accounts
• Performance must be calculated after deduction of trading expenses
• Taxes must be recognized when incurred
• Annual returns for all years must be presented
• Disclosure requirements must be met
 The Internet
Investments Online
http://www.nelsons.com
http://www.styleadvisor.com
http://www.morningstar.com
http://www.cfainstitute.org
End of Chapter 25
–Evaluation of Portfolio
Performance