1

Sharpe and 1reynor Measures

W 1he Sharpe and 1reynor measures
Sharpe measure
Treynor measure
where average return
risk-Iree rate
standard deviation oI returns
beta
1
1
1
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# #
#
#
o

=
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2
Sharpe and
1reynor Measures (cont'd)
W 1he 1reynor meosure evaluaLes Lhe reLurn
relaLlve Lo beLa a measure of sysLemaLlc rlsk
lL lgnores any unsysLemaLlc rlsk
W 1he orpe meosure evaluaLes reLurn relaLlve
Lo LoLal rlsk
ApproprlaLe for a welldlverslfled porLfollo buL
noL for lndlvldual securlLles
3
Sharpe and
1reynor Measures (cont'd)
Lxamp|e
Cver the |ast four months k2 Stock had excess returns of
186 S09 199 and 172 1he standard dev|at|on of
k2 stock returns |s 307 k2 Stock has a beta of 120
What are the Sharpe and 1reynor measures for k2 Stock?
4
Sharpe and
1reynor Measures (cont'd)
Lxamp|e (cont'd)
So|ut|on I|rst compute the average excess return for Stock k2
1.86 5.09 1.99 1.72
4
0.88
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+
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=
3
Sharpe and
1reynor Measures (cont'd)
Lxamp|e (cont'd)
So|ut|on (cont'd) Next compute the Sharpe and 1reynor
measures
0.88
Sharpe measure 0.29
3.07
0.88
Treynor measure 0.73
1.20
1
1
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o

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6
ensen Measure
W 1he !ensen measure sLems dlrecLly from Lhe
CAM

9 19 29 19
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|

ensen Measure (cont'd)

W 1he consLanL Lerm should be zero
SecurlLles wlLh a beLa of zero should have an
excess reLurn of zero accordlng Lo flnance Lheory
W Accordlng Lo Lhe !ensen measure lf a porLfollo
manager ls beLLerLhanaverage Lhe alpha of
Lhe porLfollo wlll be poslLlve

ensen Measure (cont'd)

W 1he !ensen measure ls generally ouL of favor
because of sLaLlsLlcal and LheoreLlcal problems
erformance ALLrlbuLlon Analysls
erformance ALLrlbuLlon
W 1he prevlously menLloned rlskad[usLed measures of performance
concenLraLe on Lhe quesLlon of PCW a porLfollo dld relaLlve Lo boLh
a benchmark and a seL of oLher porLfollos
W 1he use of quadraLlc varlable regresslon ls an aLLempL Lo evaluaLe
separaLely Lhe manager's ablllLy aL selecLlvlLy and Llmlng
W Powever a cllenL mlghL wanL Lo know more abouL WP? Lhe
porLfollo had a cerLaln reLurn over a parLlcular Llme perlod
erformance A118l8u1lCn uslng a facLor model ls one meLhod LhaL
has been used Lo Lry Lo make such a deLermlnaLlon
erformance ALLrlbuLlon Analysls
W ALLempLs Lo dlsLlngulsh whlch facLors are Lhe sources of Lhe porLfollo's
overall performance (afLer Lhe facL)
Was lL because Lhe manager was superlor aL selecLlng securlLles or dld Lhey
demonsLraLe superlor markeL Llmlng skllls by allocaLlng funds Lo dlfferenL asseL
classes or markeL segmenLs?
1hls meLhod compares Lhe LoLal reLurn of Lhe manager's acLual lnvesLmenL
holdlngs Lo Lhe reLurn for a predeLermlned benchmark porLfollo and
decomposes Lhe dlfference lnLo ollocotloo effect and a selectloo effect
W 1he mosL sLralghLforward way Lo measure Lhese Lwo effecLs ls as follows
erformance ALLrlbuLlon
Analysls
W 1he mosL sLralghLforward way Lo measure Lhese Lwo effecLs ls as follows
W Where
w
al
w
pl
Lhe lnvesLmenL proporLlons glven Lo Lhe lLh markeL segmenL (eg AsseL
class lndusLry group) ln Lhe manager's acLual porLfollo and Lhe benchmark
porLfollo respecLlvely
8
al
8
pl
Lhe lnvesLmenL reLurn Lo Lhe lLh markeL segmenL ln Lhe manager's acLual
porLfollo and Lhe benchmark porLfollo respecLlvely
8
p
Lhe LoLal reLurn Lo Lhe benchmark porLfollo

- =
- =
i
i
)| ( ) |( EIIect Selection
)| ( ) |( EIIect Allocation
# #
# #
5 , ,
5 5 5 ,
erformance ALLrlbuLlon
Analysls
W CompuLed ln Lhls manner Lhe allocaLlon effecL measures Lhe manager's declslon
Lo over or underwelghL a parLlcular markeL segmenL (le w
al
w
pl
) ln Lerms of
LhaL segmenL's reLurn performance relaLlve Lo Lhe overall reLurn Lo Lhe benchmark
(le 8
pl
8
p
)
W 1he selecLlon effecL measures Lhe manager's ablllLy Lo form speclflc markeL
segmenL porLfollos LhaL generaLe superlor reLurns relaLlve Lo Lhe way ln whlch Lhe
comparable markeL segmenL ls deflned ln Lhe benchmark porLfollo (le 8
al
8
pl
)
welghLed by Lhe manager's acLual markeL segmenL lnvesLmenL proporLlons
W When consLrucLed ln Lhls way Lhe manager's LoLal valueadded performance ls Lhe
sum of Lhe allocaLlon and selecLlon effecLs

- =
- =
i
i
)| ( ) |( EIIect Selection
)| ( ) |( EIIect Allocation
# #
# #
5 , ,
5 5 5 ,
erformance ALLrlbuLlon
Analysls (An Lxample)
lnvesLmenL WelghLs 8eLurns
AsseL Class AcLual 8enchmark Lxcess AcLual 8enchmark Lxcess
SLock 030 060 010 9 6 110
8onds 03 030 00 910 92 010
Cash 012 010 002 36 34 020
1hus Lhe manager beaL Lhe benchmark by 32 basls polnLs ( 009 0046) over Lhls
parLlcular Llme horlzon
8.46
0.054) (0.10 0.092) (0.3 0.086) (0.60 Return Benchmark Overall
8.98
0.056) (0.12 0.091) (0.38 0.097) (0.50 Return Actual Overall
=
- + - + - =
=
- + - + - =
erformance ALLrlbuLlon
Analysls (An Lxample)
lnvesLmenL WelghLs 8eLurns
AsseL Class AcLual 8enchmark Lxcess AcLual 8enchmark Lxcess
SLock 030 060 010 9 6 110
8onds 03 030 00 910 92 010
Cash 012 010 002 36 34 020
1he goal of aLLrlbuLlon analysls ls Lo lsolaLe Lhe reason for Lhls valueadded performance 1he manager's
allocaLlon effecL can be compuLed by mulLlplylng Lhe excess asseL class welghL by LhaL class's relaLlve
lnvesLmenL performance
1hls shows LhaL lf Lhe lnvesLor had made [usL hls markeL Llmlng declslons and noL plcked dlfferenL securlLles
Lhan Lhose represenLed ln Lhe benchmark hls performance would have lagged Lhe LargeL reLurn by Lwo
basls polnLs
02 . 0 )| 0846 . 0 054 . 0 ( ) 02 . 0 |(
)| 0846 . 0 092 . 0 ( ) 08 . 0 |( )| 0846 . 0 086 . 0 ( ) 10 . 0 |(
= -
+ - + -
erformance ALLrlbuLlon
Analysls (An Lxample)
1hls LoLal allocaLlon effecL can be broken down furLher lnLo an equlLy allocaLlon reLurn of 2
basls polnLs (010)(006 0046)
a bond allocaLlon reLurn of 6 basls polnLs
(00)(0092 0046)
and a cash allocaLlon reLurn of 6 basls polnLs
(002)(0034 00460
1herefore Lhe declslon Lo underwelghL sLock and overwelghL cash ( asseL classes LhaL
generaLed reLurns above and below Lhe benchmark respecLlvely) resulLed ln dlmlnlshed
performance LhaL was more Lhan enough Lo offseL Lhe beneflL of emphaslzlng bonds
Slnce Lhe lnvesLor knows LhaL he ouLperformed Lhe benchmark overall a negaLlve allocaLlon
effecL necessarlly lmplles LhaL he exhlblLed poslLlve securlLy selecLlon skllls
erformance ALLrlbuLlon
Analysls (An Lxample)
Slnce Lhe lnvesLor knows LhaL he ouLperformed Lhe benchmark overall a negaLlve allocaLlon
effecL necessarlly lmplles LhaL he exhlblLed poslLlve securlLy selecLlon skllls
Pls selecLlon effecL can be compuLed as
ln Lhls example Lhe lnvesLor formed superlor sLock and cash porLfollos alLhough hls bond
selecLlons dld noL perform qulLe as well as Lhe Lehman Long 8ond lndex
Cne lMC81An1 caveaLbecause Lhe reLurns are noL rlskad[usLed lL ls posslble LhaL Lhe asseL
class porLfollos formed by Lhe lnvesLor are rlskler Lhan Lhelr benchmark counLerparLs
54 . 0 )| 054 . 0 056 . 0 ( ) 12 . 0 |(
)| 092 . 0 091 . 0 ( ) 38 . 0 |( )| 086 . 0 097 . 0 ( ) 50 |(.
= -
+ - + -
erformance ALLrlbuLlon
Analysls (An Lxample)
1C1AL vALuL AuuLu ALLCCA1lCn LllLC1 + SLLLC1lCn LllLC1
032 (002) + (034)
02 . 0 )| 0846 . 0 054 . 0 ( ) 02 . 0 |(
)| 0846 . 0 092 . 0 ( ) 08 . 0 |( )| 0846 . 0 086 . 0 ( ) 10 . 0 |(
= -
+ - + -