Chapter 10

Portfolio Performance Evaluation

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Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Introduction

• If markets are efficient, investors must be able to

measure asset management performance
• Two common ways to measure average portfolio
return:
1. Time-weighted returns
2. Dollar-weighted returns

• Returns must be adjusted for risk.

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 Dollar- and Time-Weighted Returns

Time-weighted returns

• The geometric average is a time-weighted

average.
• Each period’s return has equal weight.

1  rG 
n
 1  r1 1  r2 ...1  rn 

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 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 period:

C1 C2 Cn
PV    ...
1  r  1  r 
1 2
1  r n

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 Example of Multiperiod Returns

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 Dollar-Weighted Return

$2 $4+$108

-$50 -$53

Dollar-weighted Return (IRR):

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

r  7.117%
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 Time-Weighted Return

53  50  2
r1   10%
50
54  53  2
r2   5.66%
53
rG = [ (1.1) (1.0566) ]1/2 – 1 = 7.81%

The dollar-weighted average is less than the

time-weighted average in this example
because more money is invested in year two,
when the return was lower.

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 Dollar-Weighted Return

• Households should maintain a spreadsheet of

time-dated cash flows (in and out) to
determine the effective rate of return for any
given period.

• Examples include:
– IRA, 401(k), 529

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 Adjusting Returns for Risk

• The simplest and most popular way to adjust

returns for risk is to compare the portfolio’s
return with the returns on a comparison
universe.
• The comparison universe is a benchmark
composed of a group of funds or portfolios
with similar risk characteristics, such as
growth stock funds or high-yield bond funds.

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 Figure 24.1 Universe Comparison

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 Risk Adjusted Performance: Sharpe

1) Sharpe Index
( rP  rf )
P
rp = Average return on the portfolio

rf = Average risk free rate

p = Standard deviation of portfolio
return
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 Risk Adjusted Performance: Treynor

2) Treynor Measure
( rP  rf )
P
rp = Average return on the portfolio
rf = Average risk free rate

ßp = Weighted average beta for portfolio

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 Risk Adjusted Performance: Jensen
3) Jensen’s Measure
 P  rP   r f   P ( rM  rf ) 

p = Alpha for the portfolio

rp = Average return on the portfolio
ßp = Weighted average Beta
rf = Average risk free rate
rm = Average return on market index portfolio
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 Information Ratio

Information Ratio = p / (ep)

The information ratio divides the alpha of the

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

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 Morningstar Risk-Adjusted Return

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 M Measure
2

• Developed by Modigliani and Modigliani

• Create an adjusted portfolio (P*)that has the
same standard deviation as the market index.
• Because the market index and P* have the
same standard deviation, their returns are
comparable:

M  rP *  rM
2

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 2
M Measure: Example

Managed Portfolio: return = 35% standard deviation =

42%
Market Portfolio: return = 28% standard deviation =
30%
T-bill return = 6%
P* Portfolio:
30/42 = .714 in P and (1-.714) or .286 in T-bills
The return on P* is (.714) (.35) + (.286) (.06) = 26.7%

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Since this return is less than the market, the
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portfolio underperformed.
 2
Figure 24.2 M of Portfolio P

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 Which Measure is Appropriate?

It depends on investment assumptions

1) If P is not diversified, then use the Sharpe measure as
it measures reward to risk.
2) If the P is diversified, non-systematic risk is negligible
and the appropriate metric is Treynor’s, measuring
excess return to beta.

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 Table 24.1 Portfolio Performance

Is Q better than P?

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 Figure 24.3 Treynor’s Measure

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 Table 24.3 Performance Statistics

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 Interpretation of Table 24.3
• If P or Q represents the entire investment, Q is
better because of its higher Sharpe measure
and better M2.
• If P and Q are competing for a role as one of a
number of subportfolios, Q also dominates
because its Treynor measure is higher.
• If we seek an active portfolio to mix with an
index portfolio, P is better due to its higher
information ratio.
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 Performance Manipulation and the MRAR

• Assumption: Rates of return are independent

and drawn from same distribution.
• Managers may employ strategies to improve
performance at the loss of investors.
• Ingersoll, et al. study leads to MPPM.
• Using leverage to increase potential returns.
• MRAR fulfills requirements of the MPPM

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 Figure 24.4 MRAR scores with and w/o
manipulation

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 Performance Measurement for
Hedge Funds

• When the hedge fund is optimally combined

with the baseline portfolio, the improvement
in the Sharpe measure will be determined by
its information ratio:

2
 H 
S S 
2 2

  ( eH ) 
P M

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 Performance Measurement with Changing
Portfolio Composition

• We need a very long • What if the mean and

observation period to variance are not
measure performance constant? We need to
with any precision, even keep track of portfolio
if the return distribution changes.
is stable with a constant
mean and variance.

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 Figure 24.5 Portfolio Returns

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 Market Timing
• In its pure form, market timing involves
shifting funds between a market-index
portfolio and a safe asset.
• Treynor and Mazuy:
rP  r f  a  b ( rM  r f )  c ( rM  r f )  e P
2

• Henriksson and Merton:

rP  r f  a  b ( rM  r f )  c ( rM  r f ) D  e P

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 Figure 24.6 : No Market Timing; Beta Increases with Expected
Market Excess. Return; Market Timing with Only Two Values of
Beta.

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Figure 24.7 Rate of Return of a Perfect Market Timer

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 Style Analysis
• Introduced by William Sharpe
• Regress fund returns on indexes representing a range
of asset classes.
• The regression coefficient on each index measures
the fund’s implicit allocation to that “style.”
• R –square measures return variability due to style or
asset allocation.
• The remainder is due either to security selection or
to market timing.

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 Table 24.5 Style Analysis for Fidelity’s
Magellan Fund

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 Figure 24.8 Fidelity Magellan Fund
Cumulative Return Difference

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 Figure 24.9 Average Tracking Error for 636
Mutual Funds, 1985-1989

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 Performance Attribution
• A common attribution system decomposes
performance into three components:

1. Allocation choices across broad asset classes.

2. Industry or sector choice within each market.
3. Security choice within each sector.

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 Attributing Performance to
Components

Set up a ‘Benchmark’ or ‘Bogey’ portfolio:

• Select a benchmark index portfolio for each
asset class.
• Choose weights based on market
expectations.
• Choose a portfolio of securities within each
class by security analysis.

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 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.

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 Formulas 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

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 Figure 24.10 Performance Attribution of ith
Asset Class

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 Performance Attribution
• Superior performance is achieved by:
– overweighting assets in markets that
perform well
– underweighting assets in poorly performing
markets

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 Table 24.7 Performance Attribution

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 Sector and Security Selection

• Good performance (a positive contribution)

derives from overweighting high-performing
sectors
• Good performance also derives from
underweighting poorly performing sectors.

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