 Portfolio performance evaluation is an essential

aspect of the investment process that allows

investors and portfolio managers to assess the
effectiveness of their investment strategies
 The main goal of performance evaluation is to
determine whether the chosen investment strategy is
achieving the desired risk and return objectives.
 The portfolio performance evaluation primarily
refers to the determination of how a particular
investment portfolio has performed relative to
some comparison benchmark.
 The evaluation can indicate the extent to which the
portfolio has outperformed or under-performed, or
whether it has performed at par with the
benchmark.
 The investor, whose funds have been invested in the
portfolio, needs to know the relative performance of
the portfolio. The performance evaluation generates
and provides information that will help the investor
to assess any need for rebalancing of his
investments.
 The management of the portfolio needs this
information to evaluate the performance of the
manager of the portfolio and to determine the
manager’s capability to build efficient portfolio.
 Portfolio performance evaluation essentially
comprises of two functions,
 1) performance measurement and
 2) performance evaluation.
 Performance measurement is an accounting function
which measures the return earned on a portfolio
during the holding period or investment period.
 Performance evaluation, on the other hand, address
such issues as whether the performance was
superior or inferior, whether the performance was
due to skill or luck etc.
 The performance evaluation methods generally fall
into two categories, namely
 1) Conventional and

 2) Risk-adjusted methods.

Conventional method
 At one time, investors evaluated portfolio

performance almost entirely on the basis of the rate

of return.
 They were aware of the concept of risk but did not
know how to measure it, so they could not consider
it openly.
 The most straightforward conventional method
involves comparison of the performance of an
investment portfolio against a broader market index.
The most widely used market index in the U.S. is the
S&P 500 index, which measures the price movements
of 500 U.S. stocks compiled by the Standard and
Poor’s Corporation.
 If the return on the portfolio exceeds that of the
benchmark index, then the portfolio is said to have
beaten the benchmark index.
 While this type of comparison with a passive index is
very common in the investment world, this creates a
particular problem.
 The level of risk of the investment portfolio may not
be the same as that of the benchmark index portfolio.
 Higher risk should leads to correspondingly higher
returns, in the long-term. This means if the
investment portfolio has performed better than the
benchmark portfolio it may be due to the investment
portfolio being more risky than the benchmark
portfolio.
 Therefore, a simple comparison of the return on an
investment portfolio with that of a benchmark
portfolio may not produce valid results.
 RISK-ADJUSTED METHODS
 The risk-adjusted methods make adjustments to
returns in order to take account of the differences in
risk levels between the managed portfolio and the
benchmark portfolio. While there are many such
methods, the most notables are the Sharpe ratio (S),
Treynor ratio (T), Jensen’s alpha (α),
 These measures along with their applications are
discussed below.
 There are two desirable attributes of a portfolio
manager’s performance:
1. The ability to derive above-average returns for a
given risk class.
2. The ability to diversify the portfolio completely to
eliminate all unsystematic risk, relative
to the portfolio’s benchmark.
As we have seen, superior risk-adjusted returns can be
derived through either superior timing or superior
security selection.
 Bigger gains in rising markets and smaller losses in
declining markets give the portfolio manager above-
average risk-adjusted returns.
 As an alternative strategy, a portfolio manager may
try consistently to select undervalued stocks or
bonds for a given risk class.
 Even without superior market timing, such a
portfolio would likely experience above-average
risk-adjusted returns.
 The second factor to consider in evaluating a
manager is the ability to diversify the portfolio
completely.
 We have seen that, on average, the market rewards
investors only for bearing systematic (market) risk.
Unsystematic risk is often not even considered when
determining required returns because it can be
eliminated in a diversified market portfolio.
 Because they can expect no reward for bearing this
uncertainty, investors typically want their portfolios
completely to be diversified.
 The level of diversification can be judged on the basis
of the correlation between the portfolio returns and
the returns for a market portfolio or some other
benchmark index.

 A completely diversified portfolio is perfectly

correlated with the fully diversified benchmark
portfolio.
This
This section
section describes
describes inin detail
detail the
the four
four major
major
composite
composite equity
equity portfolio
portfolio performance
performance measures
measures
that
that combine
combine risk
risk and
and return
return performance
performance into
into aa
single
single value.
value. We
We also
also compare
compare thethe measures
measures and
and
discuss how they differ and why they rank portfolios
discuss how they differ and why they rank portfolios
differently.
differently.

 Treynor
TreynorPortfolio
PortfolioPerformance
PerformanceMeasure
Measure

 Sharpe
SharpePortfolio
PortfolioPerformance
PerformanceMeasure
Measure

 Jensen
JensenPortfolio
PortfolioPerformance
PerformanceMeasure
Measure

 The Information Ratio Performance
The Information Ratio Performance
Measure
Measure
Treynor (1965) developed
Treynor (1965) developed the first the first
composite
composite measure
measure ofof portfolio
portfolio
performance
performance that that included
included risk.risk. HeHe
postulated
postulatedtwotwocomponents
componentsofofrisk:
risk:
(1)risk
(1) risk produced
produced by by general
general market
market
fluctuations,
fluctuations,and
and
(2)
(2)risk
riskresulting
resultingfrom
fromunique
uniquefluctuations
fluctuations
ininthe
theportfolio
portfoliosecurities.
securities.
To identify risk due to market fluctuations, he
introduced the characteristic line, which defines the
relationship between the returns to a managed
portfolio and the market portfolio.
The slope of this line is the portfolio’s beta coefficient. A
higher slope (beta) characterizes a portfolio that is
more sensitive to market returns and has greater
market risk.
AAlarger T value indicates a better portfolio
larger T value indicates a better portfolio for all for all
investors,
investors, regardless
regardless ofof their
their risk
risk preferences.
preferences.
Because
Becausethethenumerator
numeratorofofthisthisratio
ratio(R(Ri -RFR)
-RFR) isisthe
the
i
risk
riskpremium
premiumand andthe
thedenominator
denominatorisisaameasure measureofof
risk,
risk,the
thetotal
totalexpression
expressionindicates
indicatesthe theportfolio’s
portfolio’s
risk premium return per unit of
risk premium return per unit of risk. risk.
All
Allrisk-averse
risk-averseinvestors
investorswould
wouldpreferprefertotomaximize
maximize
this
this value.
value. The
The risk
risk variable
variable beta beta measures
measures
systematic risk and it implicitly
systematic risk and it implicitly assumes a assumes a
completely
completelydiversified
diversifiedportfolio.
portfolio.

 Comparing
Comparingaaportfolio’s
portfolio’sTTvalue
valuetotoaasimilar
similarmeasure
measure
for
for the
the market
market portfolio
portfolio indicates
indicates whether
whether thethe
portfolio
portfoliowould
wouldplot
plotabove
abovethe
theSML.
SML.Calculate
Calculatethe
theTT
value
valuefor
forthe
theaggregate
aggregatemarket
marketasasfollows:
follows:


 ββM equals
equals 1.0
1.0(the
(themarket’s
market’sbeta)
beta)and
and TTM indicates
indicatesthe
the
M M
slope
slopeofofthe
theSML.
SML.Therefore,
Therefore,aaportfolio
portfoliowith
withaahigher
higher
TT value
value than
than the
the market
market portfolio
portfolio plots
plots above
above the
the
SML, indicating superior risk-adjusted performance.
SML, indicating superior risk-adjusted performance.
Treynor Portfolio Performance Measure
Suppose
Supposethatthatduring
duringthethemost
mostrecent
recent10-year
10-yearperiod,
period,
the
the average
average annual
annual total
total rate
rate ofof return
return (including
(including
dividends)
dividends)on onan anaggregate
aggregatemarket
marketportfolio,
portfolio,such
suchasas
the
the S&P
S&P 500,
500, was
was 1414 percent
percent (R (RMM == 0:14)
0:14) and
and thethe
average nominal rate of return on government
average nominal rate of return on government T-bills T-bills
was 8 percent (RFR = 0.08). As administrator
was 8 percent (RFR = 0.08). As administrator of a of a
large pension fund that has been divided
large pension fund that has been divided among among
three money managers during the past 10
three money managers during the past 10 years, you years, you
must decide whether to renew their
must decide whether to renew their investment investment
management contracts based on
management contracts based on the following the following
results:
results:
 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 on a risk-adjusted basis. In
contrast, both X and Y beat the market
portfolio, and Manager Y performed somewhat
better than Manager X.
 Both of their portfolios plotted above the SML,
as shown in Exhibit 25.2.
Sharpe (1966) 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:

where in addition to the earlier notation:

σi = the standard deviation of the rate of return
for Portfolio i during the time period
 This performance measure clearly is similar to the
Treynor measure; however, it seeks to measure the
total risk of the portfolio by using 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. As such, this portfolio
performance measure uses the CML to compare
portfolios, whereas the Treynor measure examines
portfolio performance in relation to the SML
 Again, assume that RM = 0:14 and RFR = 0:08.
Suppose you are told that the standard deviation of
the annual rate of return for the market portfolio
over the past 10 years was 20 percent (σM = 0.20). You
want to examine the risk-adjusted performance of
the following portfolios:
 Sharpe Portfolio Performance Measure
 Portfolio D had the lowest risk premium return per
unit of total risk, failing to perform as well as the
market portfolio. In contrast, Portfolios E and F
performed better than the aggregate market:
Portfolio E did better than Portfolio F. Given the
market portfolio performance, it is possible to draw
the CML. If we plot the results for Portfolios D, E,
and F on this graph, as shown in next figure, we see
that Portfolio D plots below the line, whereas the E
and F portfolios are above the line, indicating
superior riskadjusted performance.
Sharpe Portfolio Performance Measure
Like the T and S measures just discussed, 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:
The expected return and the risk-free return vary for
different periods. Consequently, we are concerned with the
time series of expected rates of return for Security or
Portfolio j. Moreover, you can express the above equation in
terms of realized rates of return as follows:

This equation states that the realized rate of return on a

security or portfolio during a given time period should be a
linear function of the risk-free rate of return during the
period, plus a risk premium that depends on the systematic
risk of the security or portfolio during the period plus a
random error term (ejt).
Subtracting the risk-free return from both sides, we
have:

So that the risk premium earned on the jth portfolio is

equal to βj times a market risk premium plus a random
error term. An intercept for the regression is not
expected if all assets and portfolios were in equilibrium
Subtracting the risk-free return from both sides, we have:

So that the risk premium earned on the jth portfolio is

equal to βj times a market risk premium plus a random
error term. An intercept for the regression is not expected
if all assets and portfolios were in equilibrium
Closely related to the statistics just presented is a fourth
widely used performance measure: the information ratio.
This statistic measures a portfolio’s average return in
excess of that of a comparison or benchmark portfolio
divided by the standard deviation of this excess return.
Formally, the information ratio (IR) for portfolio j is
calculated as:
Assume that during the previous 10-year period, the risk-free rate was 8 percent, and four portfolios had the
following characteristics:
Portfolio Return Beta St. Deviation
P 0.16 1.20 0.08
Q 0.21 1.50 0.12
R 0.12 0.75 0.07
S 0.18 1.30 0.10
Market 0.12 1.00 0.06
i) Compute the Treynor measure of portfolio performance for each portfolio and indicate which
portfolio had the best performance? How did the four portfolios fare in relation to the market
portfolio?
ii) Compute the Sharpe measure of portfolio performance for each portfolio and rank the portfolios.
iii) Is there any difference in the ranks determined by the Treynor measure versus those determined by
the Sharpe measure?
Portfolio Return Beta St. Deviation Treynor Rank Sharpe Rank

P 0.16 1.2 0.08 0.067 3 1.000 2

Q 0.21 1.5 0.12 0.087 1 1.083 1

R 0.12 0.75 0.07 0.053 4 0.571 3

S 0.18 1.3 0.1 0.077 2 1.000 2

Market 0.12 1 0.06 0.040 0.667