ReillyBrown IAPM 11e PPT Ch18

CHAPTER 18
Evaluation of
Portfolio
Performance
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 8-1
18.1 The Two Questions of Performance
Measurement (slide 1 of 3)
• The actual return a manager produces over an
investment horizon can be split into:
1. The return that should have been earned given the capital
commitment and the amount of risk in the portfolio
2. Any incremental return due to superior investment skills (alpha)
• There are three ways that investors can estimate
expected returns:
1. The average contemporaneous return to a peer group of
comparably managed portfolios
2. The contemporaneous return to an index (or index fund)
serving as a benchmark for the managed portfolio
3. The return estimated by a risk factor model, such as the CAPM
or multifactor model
• There are two main questions that an

investor attempts to answer when
assessing the performance of an
investment manager:
1. How did the portfolio manager actually
perform?
2. Why did the portfolio manager perform as he
or she did?
• Exhibit 18.1
18.2 Simple Performance Measurement
Techniques
• Developments in portfolio theory in the

early 1960s showed investors how to
quantify risk in terms of the variability of
returns
• No single measure combined both return
and risk and the two factors had to be
considered separately
18.2.1 Peer Group Comparisons
(slide 1 of 2)
• Collects the returns produced by a representative set of
investors over a specific period of time and displays
them in a simple boxplot format
• Potential problems
• No explicit adjustment for risk level of the portfolios
• Difficult to form a comparable peer group that is large
enough to make the percentile rankings meaningful
• By just focusing on relative returns, the comparison
loses sight of whether the investor in question has
accomplished his individual objectives and satisfied his
investment expectations
• Exhibit 18.2
18.2.1 Peer Group Comparisons
(slide 2 of 2)
18.2.2 Portfolio Drawdown (slide 1 of 2)
• Portfolio drawdown measures how well he

has protected the investor against losses
over time
• Maximum drawdown calculates the largest
percentage decline in value—from peak to
trough—wherever during the horizon that
occurs
• Exhibit 18.3
18.2.2 Portfolio Drawdown (slide 2 of 2)
18.3 Risk-Adjusted Portfolio Performance
Measures
• There are five major portfolio performance

measures that combine risk and return
performance into a single statistic:
• Sharpe Portfolio Performance Measure
• Treynor Portfolio Performance Measure
• Jensen Portfolio Performance Measure
• The Information Ratio Performance Measure
• Sortino Performance Measure
18.3.1 Sharpe Portfolio Performance
Measure (slide 1 of 4)
• This performance measure seeks to measure
the total risk of the portfolio by using the
standard deviation of returns
Where:
• Demonstration of Comparative Sharpe
Measures
• 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 and the average
nominal rate of return on government T-bills was 8
percent
• The standard deviation of the annual rate of return for
the market portfolio over the past 10 years was 20
percent
• Examine the risk-adjusted performance of the following portfolios:
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
• The Sharpe measures for each of these funds are as follows:
• Exhibit 18.4
18.3.2 Treynor Portfolio Performance
• Treynor (1965)
• Postulated two components of risk:
• Risk produced by general market fluctuations
• Risk resulting from unique fluctuations in the portfolio
securities
• Introduced the characteristic line
• Building on capital market theory, he introduced a
risk free asset that could be combined with different
portfolios to form a portfolio possibility line
• He showed that rational investors would always
prefer the portfolio line with the largest slope
• The slope of this portfolio possibility line

(designated T) is:
Where:
βM = slope of the fund’s characteristic line during that
time period
• Comparing a portfolio’s T value to a similar measure for
the market portfolio indicates whether the portfolio would
plot above the security market line (SML)
• Calculate the T value for the aggregate market as
follows:
Where:
βM = 1.0 (the market’s beta)
TM = slope of the SML
• Demonstration of Comparative Treynor Measures
• Assume again that RM = 0.14 and RFR = 0.08
• You are deciding between three different portfolio
managers, based on their past performance:
Average Annual
Investment Manager Beta
Rate of Return
W 0.12 0.90
X 0.16 1.05
Y 0.18 1.20
• Compute T values for the market portfolio and for each of
the individual portfolio managers as follows:
• Exhibit 18.5
18.3.3 Jensen Portfolio Performance
• The Jensen measure (Jensen, 1968) was originally
based on the capital asset pricing model (CAPM),
which calculates the expected one-period return on
any security or portfolio by the following expression:
• αj indicates whether the portfolio manager is

superior or inferior in her investment ability
• A superior manager has a significant positive α
(alpha) value, while an inferior manager’s returns
consistently fall short of expectations based on the
CAPM, leading to a significant negative α
18.3.3 Jensen Portfolio Performance
• Applying the Jensen Measure
• The Jensen alpha 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 terms of
systematic risk
• The Jensen performance measure is flexible enough to allow for
alternative models of risk and expected return than the CAPM
• Risk-adjusted performance (α) can be computed relative to any
multifactor model:
18.3.4 Information Ratio Performance
• The information ratio measures a portfolio’s average
return in excess of that for a benchmark portfolio divided
by the standard deviation of this excess return:
Where:
• Exhibit 18.6
18.3.4 Information Ratio Performance
18.3.5 Sortino Performance Measure
(slide 1 of 6)
• The Sortino measure is a risk-adjusted
performance statistic that differs from the Sharpe
ratio in two ways:
• It measures the portfolio’s average return in excess of
a user-selected minimum acceptable return threshold,
which is often the risk-free rate used in the S statistic
although it need not be
• The Sharpe measure focuses on total risk—effectively
penalizing the manager for returns that are both too
low and too high—while the Sortino ratio captures just
the downside risk (DR) in the portfolio
18.3.5 Sortino Performance Measure (slide
2 of 6)
• Sortino and Price (1994) calculate this
measure as follows:
Where:
τ = minimum acceptable return threshold specified
for the time period
Dri = downside risk coefficient for Portfolio i during
the specified time period
3 of 6)
• Downside risk:
• Is the volatility of the returns produced by a portfolio that
fall below some hurdle rate that the investor chooses
• Attempts to measure the volatility associated with the
shortfall that occurs if an investment produces a return that
is lower than anticipated
• DR comes closer than measures of total risk (σ) to
capturing what investors truly consider risky
• A popular measures is the semi-deviation, which uses the
portfolio’s average (expected) return as the hurdle rate:
4 of 6)
• Comparing the Sharpe and Sortino Ratios
• Suppose that over the past 10 years, two portfolio
managers have produced the following returns:
5 of 6)
• Using semi-deviation to compute DR for both
portfolios leaves:
and:
• When only the possibility of receiving a less-than-

expected return is considered, Portfolio A now
appears to be the riskier alternative due to the fact it
has more extreme negative returns than Portfolio B
6 of 6)
• Assuming a minimum return threshold of 2
percent to match the Sharpe measure, the
Sortino ratios for both portfolios indicate that,
by limiting the extent of his downside risk, the
manager for Portfolio B was actually the
superior performer:
18.3.6 Summarizing the Risk-Adjusted
Performance Measures (slide 1 of 2)
• Each of the risk-adjusted performance

statistics just described is widely used in
practice and has strengths and
weaknesses
• Exhibit 18.7
18.3.6 Summarizing the Risk-Adjusted
Performance Measures (slide 2 of 2)
18.4 Application of Portfolio Performance
Measures (slide 1 of 10)
• Total rate of return on a mutual fund
where
Rit = the total rate of return on Fund i during month t
EPit = the ending price for Fund i during month t
Divit = the dividend payments made by Fund i during month t
Cap.Dist.it = the capital gain distributions made by Fund i during
month t
BPit = the beginning price for Fund i during month t
• Exhibit 18.8
• Total Sample Results
• Selected 30 open-end mutual funds from the nine
investment style classes and used monthly data for
the five-year period from July 2005 to June 2010
• Active fund managers performed much better than
earlier performance studies
• A primary factor for this outcome was the abnormally
poor performance of the index during the middle of
the sample period
• The various performance measures ranked the
performance of individual funds consistently
• Exhibit 18.9, 18.10
• Measuring Performance with Multiple

Risk Factors
• Jensen measures calculated for the 30 mutual
funds using two different versions of the
Fama–French model to estimate expected
returns:
• Jensen’s alphas are computed relative to:
• A three-factor model including the market (Rm −
RFR), firm size (SMB), and relative valuation
(HML) variables
• A four-factor model that also includes the return
momentum (MOM) variable
• The one-factor and multifactor Jensen
measures produce similar but distinct
performance rankings
• Exhibit 18.11
• Relationship among Performance

Measures
• Implications of high positive correlations:
• 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
• Exhibit 18.12
18.5 Holdings-Based Portfolio Performance
Measurement
• Two advantages to assessing performance with
investment returns:
1. Returns are usually easy for the investor to observe on a
frequent basis
2. They represent the investor actually benefits from the
manager’s investing prowess
• It is also possible to view investment performance in
terms of which securities the manager buys or sells
from the portfolio
• Using a holdings-based measure can provide
additional insights about the quality of the portfolio
manager
18.5.1 Grinblatt–Titman Performance
• Assess the quality of the services provided by money
managers by looking at adjustments they made to the
contents of their portfolios
• For a particular reporting period t, their performance
measure (GT) is:
where:
(wjt, wjt−1) = the portfolio weights for the jth security at the
beginning of Period t and Period t − 1, respectively
Rjt = the return to the jth security during Period t, which
begins on Date t − 1 and ends on Date t
• An advantage of the GT statistic is that it can be
computed without reference to any specific
benchmark, which was not true for returns-
based measures such as the information ratio
• However, the GT measure fails to reward or
penalize the manager for portfolio adjustments
in which the share price change actually occurs
in a later period
• Exhibit 18.13
18.5.2 Characteristic Selectivity
Performance Measure (slide 1 of 2)
• The 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
• Their characteristic selectivity (CS) performance statistic is
given by:
Where:
RBjt = the Period t return to a passive portfolio whose
investment characteristics are matched at the beginning of
Period t with those of Stock j
• Exhibit 25.13
18.5.2 Characteristic Selectivity
Performance Measure (slide 2 of 2)
18.6 The Decomposition of Portfolio
Returns
• The preceding risk-adjusted and holding-

based measures were designed to answer
the first question of performance
measures: how did the portfolio manager
actually perform?
• The answer to the question: why did the
manager perform as he or she did? This
requires an additional decomposition of
portfolio returns
18.6.1 Performance Attribution Analysis
(slide 1 of 7)
• Attribution analysis attempts to distinguish the source of the
portfolio’s overall performance
• Method compares the manager’s total return to the return for a
predetermined benchmark policy portfolio and decomposes the
difference into an allocation effect and a selection effect
where:
wpi, wbi = the investment proportions of the ith market segment the manager’s
portfolio and the policy portfolio, respectively
Rpi, Rbi = the investment return to the ith market segment in the manager’s
portfolio and the policy portfolio, respectively
Rbi = total return to the benchmark portfolio
(slide 2 of 7)
• An Example
• Consider an investor whose top-down portfolio
strategy consists of two dimensions:
• He decides on a broad allocation across three asset classes:
U.S. stocks, U.S. long-term bonds, and cash equivalents,
such as Treasury bills
• The investor’s second general decision is choosing which
specific stocks, bonds, and cash instruments to buy
• As a policy benchmark, he selects a hypothetical
portfolio with a 60 percent allocation to the Standard
& Poor’s 500 Index, a 30 percent investment in the
Barclays Aggregate Bond Index, and a 10 percent
allocation to three-month T-bills
(slide 3 of 7)
• An Example (continued)
• Suppose that at the start of the investment period, the investor
believes equity values are inflated relative to the fixed-income
market
• Compared to the benchmark, he decides to underweight stocks
and overweight bonds and cash with 50 percent in equity, 38
percent in bonds, and 12 percent in cash. Further, he decides to
concentrate on equities in the interest rate–sensitive sectors,
such as utilities and financial companies, while deemphasizing
the technology and consumer durables sectors
• Finally, he resolves to buy shorter-duration bonds of a higher
credit quality than are contained in the benchmark bond index,
and to buy commercial paper rather than Treasury bills
• Exhibit 18.15
(slide 4 of 7)
(slide 5 of 7)
• Performance Attribution Extension
• The attribution methodology can also be used
to distinguish security selection skills from
other decisions that an investor might make
• For instance, the manager of an all-equity
portfolio must decide which economic sectors
(for example, basic materials, consumer
nondurables, transportation) to under- and
overweight before selecting her preferred
companies in those sectors
• Exhibit 18.16
(slide 6 of 7)
(slide 7 of 7)
• Measuring Market Timing Skills
• Tactical asset allocation (TAA) attempts to produce active value-
added returns solely by adjusting their asset class exposures based
on perceived changes in the relative valuations of those classes
• Thus, the relevant performance measurement criterion for a TAA
manager is how well he is able to time broad market movements
• Two reasons why attribution analysis is ill-suited for this task:
1. First, by design, a TAA manager indexes his actual asset class
investments, and so the selection effect is not relevant
2. Second, TAA might entail dozens of changes to asset class
weightings during an investment period, which could render
meaningless an attribution effect computed on the average holdings
• Because of these problems, many analysts consider a regression-
based method for measuring timing skills to be a superior approach
18.6.2 Fama Selectivity Performance
• Fama suggested overall performance, in
excess of the risk-free rate, consists of two
components:
Overall Performance = Excess return = Portfolio Risk + Selectivity
• The selectivity component represents the

portion of the portfolio’s actual return beyond
that available to an unmanaged portfolio with
identical systematic risk and is used to assess
the manager’s investment prowess
• Evaluating Selectivity
• Formally, you can measure the return due to selectivity as:
where:
Ra = the actual return on the portfolio being evaluated
Rx(βa) = the return on the combination of the riskless asset and the
market portfolio that has risk βx equal to βa
• Overall performance can be written:
Overall Performance = Selectivity + Risk
• Exhibit 18.17
• Evaluating Diversification
• If a portfolio manager attempts to select
undervalued stocks and in the process gives
up some diversification, then it is possible to
measure the added return necessary to justify
this decision
• The portfolio’s gross selectivity is made up of net
selectivity plus diversification:
Or:
Where:
Rx(σ (Ra)) = return on the combination of the riskless asset and the
market portfolio that has return volatility equivalent to that of the
portfolio being evaluated
• Example of Fama Performance Measure
• Suppose that over a recent five-year investment period, you observed
that the average annual return on the market portfolio and the risk-free
security were 22.96 percent and 5.28 percent, respectively
• Thus, an investment portfolio with a beta of 0.815 would be expected to
deliver a return of 19.69 percent
• Suppose further that this portfolio actually returned 19.67 percent per
annum
• The return for selectivity is the difference between the actual excess
performance (19.67 − 5.28) = 14.39 and the required excess return for
risk of 14.41 (=19.69 − 5.28) or 0.02, indicating the manager fell slightly
short of matching expectations consistent with the actual risk level of the
portfolio
• What if the manager also did not fully diversify the portfolio?
• Assume that the standard deviations on the market and the manager’s
portfolio were 14.95 percent and 13.41 percent, respectively
• Example of Fama Performance Measure (continued)
• The ratio of total risk in the portfolio per unit of market total risk is 0.897
= (13.41/14.95), but because the manager’s beta (0.815) is less than
this, it appears that the portfolio contained elements of unsystematic risk
• Thus, the selectivity measure of 0.02 understates the true performance
shortfall
• To adjust the selectivity measure for the lack of complete diversification,
notice that the fund’s required return given its standard deviation is
21.14 [= 5.28 + 0.897 (22.96 − 5.28)]
• The difference of 1.45 (= 21.14 − 19.69) between the required returns
using total versus systematic risk is the added return required because
of less-than-perfect diversification
• This is subtracted from the selectivity measure to create the manager’s
net selectivity performance of −1.47 (= −0.02 − 1.45)
• After accounting for the added cost of incomplete diversification, this
manager’s performance would plot substantially below the market line
18.7 Factors That Affect Use of
Performance Measures
• The problem arises in finding a realistic proxy for
the theoretical 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
• Benchmark error
• Can effect slope of SML
• Can effect calculation of beta
• Greater concern with global investing
• Problem is one of measurement
18.7.1 Demonstration of the Global
Benchmark Problem (slide 1 of 2)
• As an illustration of the benchmark problem in global
capital markets, consider how individual measures of risk
change when the world equity market is employed as the
market portfolio proxy
• There are two major differences in the various beta
statistics:
• For many stocks, the beta estimates change a great deal
over time
• Although the mean and median values for the U.S. and world
beta estimates appear to be somewhat similar during both
time periods, the “% Diff” columns show that there are some
substantial differences in betas estimated for the same stock
over the same time period when two different definitions of
the benchmark portfolio are employed
• Exhibit 18.18
18.7.1 Demonstration of the Global
Benchmark Problem (slide 2 of 2)
18.7.2 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
18.7.3 Required Characteristics of
Benchmarks
• Bailey, Richards, and Tierney (2007)

contend that any useful benchmark should
have the following characteristics:
• Unambiguous
• Investable
• Measurable
• Appropriate
• Specified in advance
• Owned
18.8 Reporting Investment Performance
• The performance measures described represent

the essential elements of how any investor’s
performance should be evaluated
• How should the returns used in the evaluation
process be reported to the investor?
• Two dimensions:
• Consider the issue of how returns should be computed for a
portfolio that experiences infusions and withdrawals of cash
during the investment period
• The performance presentation standards created by the CFA
Institute
18.8.1 Time-Weighted and Money-
Weighted Returns
• The holding period yield (HPY) for any investment position was determined
by that position’s market value at the end of the period divided by its initial
value:
• The dollar-weighted and time-weighted returns are the same when there are
no interim investment contributions within the evaluation period
• When there are contributions, a method for adjusting holding period yields
is:
Where:
DW = factor represents the portion of the period that the contribution is
actually held in the account
18.8.2 Performance Presentation Standards
(slide 1 of 5)
• CFA Institute introduced PPS in 1987
• In 1999 adopted the companion Global Investment
Performance Standards (GIPS), which were intended to
accomplish the following goals:
• To establish investment industry best practices for calculating
and presenting investment performance
• To obtain worldwide acceptance of a single standard for the
calculation and presentation of investment performance
• To promote the use of accurate and consistent investment
performance data
• To encourage fair, global competition among investment firms
without creating barriers to entry
• To foster the notion of industry “self-regulation” on a global basis
(slide 2 of 5)
• Fundamental Principles of GIPS
• 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
(slide 3 of 5)
• In addition to these requirements, the CFA

Institute also encourages managers to
disclose the volatility of the composite
return and to identify benchmarks that
parallel the risk or investment style the
composite tracks
• Exhibit 18.19
(slide 4 of 5)
(slide 5 of 5)
Appendix A (slide 1 of 5)
• Demonstrate your mastery of the investment
analysis and decision-making skills most needed for
a competitive career in the global investment
management profession
• The Chartered Financial Analyst® (CFA) credential
is the professional standard of choice for more than
31,000 investment firms worldwide
• When hiring leading firms demand investment
professionals with real-world analytical skills,
technical competence, and the highest professional
standards, often requiring the CFA credential for
consideration
Appendix B
Code of Ethics and Standards of Professional Conduct (slide 1 of
8)
Appendix B
8)
Appendix B
8)
Appendix B
8)
Appendix B
8)
Appendix B
8)
Appendix B
8)
Appendix B
8)
Appendix C
Interest Tables (slide 1 of 4)
Appendix C
Appendix C
Appendix C
Appendix D
Standard Normal Probabilities

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CHAPTER 18

• There are two main questions that an

• Developments in portfolio theory in the

• Portfolio drawdown measures how well he

• There are five major portfolio performance

• The Sharpe measures for each of these funds are as follows:

• The slope of this portfolio possibility line

• αj indicates whether the portfolio manager is

• When only the possibility of receiving a less-than-

• Each of the risk-adjusted performance

• Measuring Performance with Multiple

• Relationship among Performance

• The preceding risk-adjusted and holding-

• The selectivity component represents the

• Bailey, Richards, and Tierney (2007)

• The performance measures described represent

• In addition to these requirements, the CFA

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