BAO3403 Investment and Portfolio

Management

Week 11

Chapter 18
Performance evaluation of managed funds

1
 Learning objectives
• After completing this chapter you should be able
to:
– calculate a range of performance measures for
investment portfolios
– discuss and analyse various performance
measurement models and benchmarks
– appreciate the relevance of past
performance
information for decision making

2
 Learning objectives (cont.)
– understand how to assess the performance of
managed funds
– discuss the evidence concerning the performance of
managed funds
– understand how different portfolio management
strategies may impact on portfolio performance.

3
 Outline of the Lecture
1 Introduction
2 The relevance of past performance
3 Performance measures
4 Performance studies
5 Summary

4
 1 Introduction
• This chapter is concerned with the analysis of the
performance of investment portfolios.
• The focus is on managed funds industry, but analysis can
be applied to portfolios of private investors.
• Key questions include:
– Is past performance relevant?
– How can fund management be measured?
– What has been the evidence on fund managers
performance?

5
 2 The relevance of past performance

• Past performance is typically regarded as

an important input in investment decisions.
– Sweeney Research found that 54% of investors regard
long-term performance as the most important factor.
– Australian Securities and Investments Commission
(ASIC) revealed that past performance is included in
70% of commercial advertisements.
• Of these, 65% report past performance figures
based on only one year of prior data.

6
 2 The relevance of past performance
(cont.)
• Empirical research has found that past
performance correlates with future fund flows.
– That is, funds with good past performance generate
greater investor interest.
• Sirri and Tufano (1998) found that investors are
attracted to good performers in the USA.
• Sawicki (2000) and Frino, Heaney and Service
(2005) found similar results for the Australian
market.

7
 Online video activity
• Title: The Importance of History
• Location: http://www.youtube.com/watch?v=I6bOidXeaCc
• Concept: Past performance
• Clip description: When an investor is deciding whom to entrust
with their future, what is the first thing they look at? The
manager's past performance typically ranks high on the list. But
when people look at past performance how deep are they delving
into the past?
• Points to consider: As an investor, do you think that the past
performance is important? What kind of information would you
want to know?
 3 Performance measures
• The managed funds industry places an emphasis
on performance measures.
• Examples include:
– the star ratings of Morningstar
• The Morningstar Rating is a measure of a fund's risk-
adjusted return, relative to similar funds. Funds are rated
from 1 to 5 stars, with the best performers receiving 5 stars
and the worst performers receiving a single star.
– the publication of league tables
– statistics and rankings of funds based on past
performance that are regularly carried by the
Australian Financial Review and Personal Investment.

9
 3 Performance measures (cont.)
• Index benchmarks
– Comparisons are made to a pre-selected benchmark portfolio,
which is typically an index (e.g. S&P/ASX 200 or 300).
– The benchmark is related to the fund objective.
– Success is measured by average tracking error (ATP):

 T t 1
pt Bt

• where:
Rpt = portfolio return over time period t
RBt = benchmark return over time period t.

10
3 Performance measures (cont.)
 3 Performance measures (cont.)
• Index benchmarks
– The absolute average tracking performance (AATP)
measure is sometimes used.
– This measure is sensitive to errors in both directions.
– The following formula is used

pt Bt
T t 1

• where |x| = the absolute value of x.

12
 3 Performance measures (cont.)
• Index benchmarks (cont.)
– Yet another alternative is to measure the standard
deviation of tracking errors.
– The following formula is used
1
(TP)   Rpt 
T t1
R
Bt
 2

Note: It is advisable to allow for one degree of freedom lost and thus
divide by ”T-1” rather than ‘T

13
3 Performance measures (cont.)
 3 Performance measures (cont.)
• Traditional performance measures
– Jensen's alpha
• Jensen’s (1968) alpha relies upon the security market line.

p  R
p Rf  p mR

f
• Ifa R
fund is performing to expectations (relative to the
CAPM) then  would be zero.
• Superior performance is indicated positive  while
under- performance negative 
• It relies on CAPM being the correct model.

15
 3 Performance measures (cont.)
• Traditional performance measures (cont.)
– The Sharpe index
• It is based on the capital market line.

𝑅 𝑝 − 𝑅𝑓 Excess Return
𝑆𝐼𝑝 =
𝜎𝑝

• The benchmark value is the Sharpe index for the

market.
• It does not rely on an asset pricing model such as
the CAPM.
• It captures jointly aspects of return and risk.

16
 3 Performance measures (cont.)
• Traditional performance measures (cont.)
– We can use the Sharpe index to come up with
another measure called M-square or M2 or Modigliani
Risk-Adjusted Performance. The naming comes from Leah and
Franco Modigliani who invented it.
• In 1997, Modigliani and his granddaughter, Leah Modigliani,
developed a measure of the risk-adjusted returns of an
investment portfolio that was derived from the Sharpe index,
adjusted for the risk of the portfolio relative to that of a benchmark,
e.g. the "market.“

• M2p = (SIp – SIm) * 𝜎𝑚

Where
• M2p is the Modigliani Risk-Adjusted Performance of the portfolio.
• SIp is the Sharpe Index of the portfolio
• SIm is the Sharpe Index of the Market

17
 3 Performance measures (cont.)
• What the Modigliani Risk-Adjusted Performance
measure does is to calculate the incremental return over
the benchmark of a portfolio where a holding of bills is
used to match the volatility of the portfolio to the
benchmark being the market index.
• That is, the portfolio takes no more than market risk and
earns an incremental return.
• It is a theoretical measure only and nobody is saying that
the position in bills will be adopted. The calculation is
done only for the purposes of selecting between different
portfolios and understanding better the risk adjusted
returns
 3 Performance measures (cont.)
• The essence of the Modigliani Risk-Adjusted
Performance measure is in the following relationships.
– When a portfolio’s Sharpe ratio > the benchmark’s Sharpe
ratio,
M2 WILL BE > 0% . There will be an incremental return.
– When a portfolio’s Sharpe ratio < the benchmark’s Sharpe
ratio,
M2 WILL BE < 0% . There will be a decremental return.
 3 Performance measures (cont.)
• Traditional performance measures
– The Treynor index
R  R Excess Return
TI p 

p p
f
• Superior performance indicated where the Treynor
index exceeds the market risk premium (MRP).
• Problems include correct value of MRP, the need to
estimate
beta, and the appropriateness of CAPM.

20
 3 Performance measures (cont.)
• Traditional performance measures
– The information ratio
• It is claimed to be an efficiency measure.
– i.e. how much risk was taken to earn the excess return
over
the benchmark?
Portfolio Alpha. Also called Active
( R p t  R Bt ) Return
IR p  1
  R Residual SD. This is also called SD
T t 1 R p t 
Bt 2
of Tracking Error (see page 14)
• Values close to 1 indicate good performance.
Note: It is advisable to allow for one degree of freedom lost and thus
divide by ”T-1” rather than ‘T

21
3 Performance measures (cont.)
3 Performance measures (cont.)

This is in fact a negative 2.5 Slope of CML

This is in fact a negative 0.20 Market Risk

Premium
 3 Performance measures (cont.)
• Traditional performance measures (cont.)
– Example (cont.): Summary of key points:
• First, both Funds A and B are judged to be
superior performers.
– Their values of Jensen’s alpha are positive.
– Both the Sharpe and Treynor indices exceed those of
the
• market index.
– However, Fund A is considered to be the most efficient
given the values of the information ratio.
• Second, Fund C is judged to have poor
performance.
– Negative Jensen’s alpha, Sharpe and Treynor indices for
• Fund C are less than those of the market index.
24
 3 Performance measures (cont.)
• Example (cont.)
– Third, there is inconsistency in rankings across the
measures.
• Fund A is ranked highest under Jensen’s alpha,
the
Treynor index and the information ratio.
• Fund B is ranked highest under the Sharpe
index.
• The inconsistency in rankings is due to
differences
in the unit risk measure.
• The Sharpe index uses standard deviation whereas
the Treynor index uses beta risk.
25
 Online video activity
• Title: Risk-adjusted performance ratios
• Location: http://www.youtube.com/watch?v=uOoYKaPqtH4
• Concept: Performance measures
• Clip description: Treynor and Sharpe are similar: both are excess
return per unit of risk. Treynor defines risk as systematic risk
(beta) and is therefore appropriate to well-diversified portfolios
(i.e., into such portfolios idiosyncratic risk is eliminated); Sharpe
defines risk as total risk (volatility). Jensen’s alpha is
outperformance relative to expected performance under CAPM.
• Points to consider: Could you define the difference of different
performance measures mentioned in our textbooks?
 4 Performance studies
• Performance
– Early studies found that managed funds, on average,
underperformed the benchmarks.
– Sharpe (1966): average Sharpe index was less than
the Dow Jones Market Index.
– Jensen (1968): average Jensen's alpha was -1.1%.
– Recent evidence is mixed.
– Findings depend on sample period used, benchmark
index and fees.

27
 4 Performance studies (cont.)
• Performance persistence
– In essence, the research has examined whether
winners repeat over time.
– There is mild evidence of top-performing funds
exhibiting performance persistence.
– There is stronger evidence around poorly performing
funds, which tend to perform poorly in future
periods.

28
 5 Summary
• Chapter focused on traditional measures of
performance: Sharpe, Treynor and Jensen
measures.
• It also considered more advanced measures like
market timing and index tracking.
• Evidence suggests that there is little evidence of
superior fund performance.
• There is some evidence of persistence,
particularly for poorly performing
funds.

29