MEB

Financial Strategy

Session 5 – portfolio performance evaluation

Introduction
• Complicated subject
• Theoretically correct measures are difficult to
construct
• Different statistics or measures are appropriate for
different types of investment decisions or portfolios
• Many industry and academic measures are
different
• The nature of active management leads to
measurement problems
Dollar- and Time-Weighted Returns
Dollar-weighted returns
• Internal rate of return considering the cash flow
from or to investment
• Returns are weighted by the amount invested in
each stock
Time-weighted returns
• Not weighted by investment amount
• Equal weighting
Text Example of Multiperiod Returns
Period Action
0 Purchase 1 share at $50
1 Purchase 1 share at $53
Stock pays a dividend of $2 per share
2 Stock pays a dividend of $2 per share
Stock is sold at $108 per share
Dollar-Weighted Return
Period Cash Flow
0 -50 share purchase
1 +2 dividend -53 share purchase
2 +4 dividend + 108 shares sold

Internal Rate of Return:

 51 112
 50  
(1  r ) (1  r ) 2
1

r  7.117%
Time-Weighted Return

53  50  2
r1   10%
50
54  53  2
r2   5.66%
53

Simple Average Return:

(10% + 5.66%) / 2 = 7.83%
Averaging Returns
Arithmetic Mean: Text Example Average:
n
rt
r (.10 + .0566) / 2 = 7.81%
t 1 n

Geometric Mean: Text Example Average:

1/ n
n

r   (1  rt )  1 [ (1.1) (1.0566) ]1/2 - 1
 t 1  = 7.83%
Comparison of Geometric and Arithmetic
Means
• Past Performance - generally the geometric mean is preferable to
arithmetic
• Predicting Future Returns- generally the arithmetic average is
preferable to geometric
• Geometric has downward bias
Abnormal Performance
What is abnormal?
Abnormal performance is measured:
• Benchmark portfolio
• Market adjusted
• Market model / index model adjusted
• Reward to risk measures such as the Sharpe Measure:
E (rp-rf) / p
Factors That Lead to Abnormal Performance

• Market timing
• Superior selection
• Sectors or industries
• Individual companies
Composite Portfolio Performance Measure
11

• Treynor Portfolio Performance

Measure
• Sharpe Portfolio Performance Measure
• Jensen (alpha) Portfolio Performance
Measure

11
Risk Adjusted Performance: Sharpe
1) Sharpe Index
r p - rf

σp
rp = Average return on the portfolio

rf = Average risk free rate

= Standard deviation of portfolio
σ p return
 Sharpe Portfolio Performance Measures

• Sharpe likewise conceived of a composite measure to evaluate the

performance of mutual funds.
• The measure followed closely his earlier work on the capital asset
pricing model (CAPM), dealing specifically with the capital market line
(CML).
• The Sharpe measure of portfolio performance (designated S) is stated
as follows:
 Sharpe Portfolio Performance Measures

• The Sharpe ratio or Sharpe index or Sharpe measure or reward-to-

variability ratio is a measure of the excess return (or Risk Premium)
per unit of risk in an investment asset or a trading strategy.
Sharpe Portfolio Performance Measures
 Sharpe Portfolio Performance Measures

• This composite measure of portfolio performance clearly is similar to

the Treynor measure;
• It seeks to measure the total risk of the portfolio by including the
standard deviation of returns rather than considering only the
systematic risk summarized by beta.
• Because the numerator is the portfolio’s risk premium, this measure
indicates the risk premium return earned per unit of total risk.
 Sharpe Portfolio Performance Measures

• In terms of capital market theory, this portfolio performance measure

uses total risk to compare portfolios to the CML, whereas the Treynor
measure examines portfolio performance in relation to the SML.
• Finally, notice that in practice the standard deviation can be
calculated using either total portfolio returns or portfolio returns in
excess of the risk-free rate.
 Demonstration of Sharpe Measures

• The following examples use the Sharpe measure of performance.

• Assume that Avg.Rm = 0.14 and Avg.Rf= 0.08.
• Suppose the standard deviation of the annual rate of return for the
market portfolio over the past 10 years was 20 percent (σM = 0.20).
Now you want to examine the performance of the following
portfolios:
 Demonstration of Sharpe Measures

PORTFOLIO AVERAGE ANNUAL RATE OF RETURN STANDARD DEVIATION OF RETURN

D 0.13 0.18
E 0.17 0.22
F 0.16 0.23
 Demonstration of Sharpe Measures

• The Sharpe measure of these portfolio is as follows:

 Demonstration of Sharpe Measures

• 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,
• Portfolios E and F performed better than the aggregate market:
Portfolio E did better than Portfolio F.
Risk Adjusted Performance:
Treynor
2) Treynor Measure rp - r f

ßp
rp = Average return on the portfolio

rf = Average risk free rate

ßp = Weighted average ß for portfolio

Treynor’s Composite Performance Measure
23

• Treynor was interested in a measure of performance that

would apply to all investors—regardless of their risk
preferences.
• Building on developments in capital market theory, he
introduced a risk-free asset that could be combined with
different portfolios to form a straight portfolio possibility
line.

23
 TREYNOR COMPOSITE MEASURE
24

• Treynor developed the first composite measure of portfolio

performance that included risk.
• He postulated two components of risk:
(1) risk produced by general market fluctuations and
(2) risk\resulting from unique fluctuations in the portfolio
securities.
• To identify risk due to market fluctuations, he introduced the
characteristic line, which defines the relationship between
the rates\of return for a portfolio over time and the rates of
return for an appropriate market portfolio

24
 TREYNOR COMPOSITE MEASURE
25

• He noted that the characteristic line’s slope measures the

relative\volatility of the portfolio’s returns in relation to
returns for the aggregate market.
• This slope is the portfolio’s beta coefficient. A higher slope
(beta) characterizes a portfolio that is more sensitive to
market returns and that has greater market risk.

25
 Treynor Portfolio Performance Measures

• The Treynor ratio is a measurement of the returns earned in excess of

that which could have been earned on a riskless investment (i.e.
Treasury Bill) (per each unit of market risk assumed).
• The Treynor ratio (sometimes called reward-to-volatility ratio) relates
excess return over the risk-free rate to the additional risk taken;
however systematic risk instead of total risk is used. The higher the
Treynor ratio, the better the performance under analysis.
Treynor Portfolio Performance Measures
 Treynor Portfolio Performance Measures

• where
• T=Treynor ratio,
• Pr=portfolio return,
• Rf=risk free rate
• Pb=portfolio beta
• The Treynor ratio does not quantify the value added, if any, of active portfolio
management.
• It is a ranking criterion only
• A ranking of portfolios based on the Treynor Ratio is only useful if the portfolios under
consideration are sub-portfolios of a broader, fully diversified portfolio.
 Demonstration of Comparative Treynor Measures

• To understand how to use and interpret this measure of performance, suppose

that during the most recent 10-year period, the average annual total rate of
return (including dividends) on an aggregate market portfolio, such as the S&P
500, was 14 percent (Avg.R = 0.14) and the average nominal rate of return on
government T-bills was 8 percent (Avg.Rf= 0.08)
• Assume that, as administrator of a large pension fund that has been divided
among three money managers during the past 10 years, you must decide
whether to renew your investment management contracts with all three
managers.
• To do this, you must measure how they have performed.
 Demonstration of Comparative Treynor Measures

• Assume you are given the following results:

INVESTMENT MANAGER AVERAGE ANNUALRATE OF RETURN BETA

W 0.12 0.90
X 0.16 1.05
Y 0.18 1.20
 Demonstration of Comparative Treynor Measures

• You can compute T values for the market portfolio and for each of the individual
portfolio managers as follows:
 Demonstration of Comparative Treynor Measures

• These results indicate that Investment Manager W not only ranked the lowest of the three
managers but did not perform as well as the aggregate market. In contrast, both X and Y beat the
market portfolio, and Manager Y performed somewhat better than Manager X.
• Very poor return performance or very good performance with very low risk may yield negativeT
values. An example of poor performance is a portfolio with both an average rate of return below
the risk-free rate and a positive beta.
• For instance, in the preceding case, assume that afourth portfolio manager, Z, had a portfolio
beta of 0.50 but an average rate of return of only 0.07. The T value would be
 Treynor versus Sharpe Measures

• The Sharpe portfolio performance measure uses the standard deviation of returns as the
measure of total risk, whereas the Treynor performance measure uses beta (systematic
risk).
• The Sharpe measure, therefore, evaluates the portfolio manager on the basis of both rate
of return performance and diversification.
• For a completely diversified portfolio, one without any unsystematic risk, the two
measures give identical rankings because the total variance of the completely diversified
portfolio is its systematic variance.
• Alternatively, a poorly diversified portfolio could have a high ranking on the basis of the
Treynor performance measure but a much lower ranking on the basis of the Sharpe
performance measure.
 Treynor versus Sharpe Measures

• Any difference in rank would come directly from a difference in

diversification. Therefore, these two performance measures provide
complementary yet different information, and both measures should
be used.
• If you are dealing with a group of well-diversified portfolios, as many
mutual funds are, the two measures provide similar rankings.
 Treynor versus Sharpe Measures

• A disadvantage of the Treynor and Sharpe measures is that they produce relative,
but not absolute, rankings of portfolio performance.
• That is, the Sharpe measures for Portfolios E and F illustrated in Exhibit 26.3 show
that both generated risk-adjusted returns above the market.
• Further,E’s risk-adjusted performance measure is larger than F’s.
• What we cannot say with certainty,however, is whether any of these differences
are statistically significant.
Risk Adjusted Performance:
Jensen
3) Jensen’s Measure
σ p= rp - [ rf + ßp ( rm - rf) ]
α p = Alpha for the portfolio
rp = Average return on the portfolio
ßp = Weighted average Beta
rf = Average risk free rate
rm = Avg. return on market index port.
 Jensen Portfolio Performance Measures

• Alpha is a risk-adjusted measure of the so-called "excess

return" on an investment. It is a common measure of
assessing an active manager's performance as it is the return
in excess of a benchmark index or "risk-free" investment.
• The difference between the fair and actually expected rates
of return on a stock is called the stock's alpha.
• The alpha coefficient (αi) is a parameter in the capital asset
pricing model. In fact it is the intercept of the Security
Characteristic Line (SCL). One can prove that in an efficient
market, the expected value of the alpha coefficient equals
the return of the risk free asset: E(αi) = rf.
 Jensen Portfolio Performance Measures

• Therefore the alpha coefficient can be used to determine whether an

investment manager or firm has created economic value:
• αi < rf: the manager or firm has destroyed value
• αi = rf: the manager or firm has neither created nor destroyed value
• αi > rf: the manager or firm has created value
• The difference αi − rf is called Jensen's alpha.
 Jensen Portfolio Performance Measures

• In finance, Jensen's alpha (or Jensen's Performance Index) is used to

determine the excess return of a stock, other security, or portfolio
over the security's required rate of return as determined by the
Capital Asset Pricing Model.
• This model is used to adjust for the level of beta risk, so that riskier
securities are expected to have higher returns.
• The measure was first used in the evaluation of mutual fund
managers by Michael Jensen in the 1970's.
 Jensen Portfolio Performance Measures

• To calculate alpha, the following inputs are needed:

• the realized return (on the portfolio),
• the market return,
• the risk-free rate of return, and
• the beta of the portfolio.
• Jensen's alpha = Portfolio Return - (Risk Free Rate + Portfolio Beta *
(Market Return - Risk Free Rate))
 Jensen Portfolio Performance Measures

• If this is not the case, portfolios with identical systematic risk, but
different total risk, will be rated the same. But the portfolio with a
higher total risk is less diversified and therefore has a higher
unsystematic risk which is not priced in the market.
• An alternative method of ranking portfolio management is Jensen's
alpha, which quantifies the added return as the excess return above
the security market line in the capital asset pricing model.
Appraisal Ratio

Appraisal Ratio = ap / s(ep)

Appraisal Ratio divides the alpha of the portfolio

by the nonsystematic risk
Nonsystematic risk could, in theory, be eliminated
by diversification
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
Limitations

• Assumptions underlying measures limit their

usefulness
• When the portfolio is being actively managed, basic
stability requirements are not met
• Practitioners often use benchmark portfolio
comparisons to measure performance
Market Timing

Adjusting portfolio for up and down

movements in the market
• Low Market Return - low ßeta
• High Market Return - high ßeta
Example of Market Timing
rp - r f
* *
* *
* *
* *
* **
* *
* * *
** * * rm - r f
* * *
Steadily Increasing the Beta
M2 Measure
• Developed by Modigliani and Modigliani
• Equates the volatility of the managed portfolio with the market by
creating a hypothetical portfolio made up of T-bills and the managed
portfolio
• If the risk is lower than the market, leverage is used and the
hypothetical portfolio is compared to the market
M2 Measure: Example

Managed Portfolio: return = 35%standard deviation = 42%

Market Portfolio: return = 28% standard deviation = 30% T-
bill return = 6%
Hypothetical Portfolio:
30/42 = .714 in P (1-.714) or .286 in T-bills
(.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed portfolio
underperformed
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
Process of Attributing Performance
to Components
Set up a ‘Benchmark’ or ‘Bogey’ portfolio
• Use indexes for each component
• Use target weight structure
Process of Attributing Performance
to Components
• 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
Formula for Attribution
n 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

Contributions for Performance

Contribution for asset allocation (wpi - wBi) rBi

+ Contribution for security selection wpi (rpi - rBi)
= Total Contribution from asset class wpirpi -wBirBi
Complications to Measuring Performance
• Two major problems
• Need many observations even when portfolio mean
and variance are constant
• Active management leads to shifts in parameters
making measurement more difficult
• To measure well
• You need a lot of short intervals
• For each period you need to specify the makeup of the
portfolio
PERFORMANCE MEASURES FOR 20 MF