Portfolio Performance Evaluation

Md. Ruhul Amin

Assistant Professor, BIBM
Portfolio Performance Measure, Why?
People are always interested in evaluating the performance of
their investments.

Having spent the time and incurred the expense to design an
asset allocation strategy and select the specific set of securities
to form their portfolios, investors-whether they are individuals,
corporations or financial institutions-must periodically determine
whether their effort is worthwhile.

Investors managing their own portfolios should evaluate their
performance, as should those who pay one or several
professional money managers to make these decisions for them.
Portfolio Performance Measures over time
Before the development of portfolio and capital
market theories (before 1960s), consideration was
on return, not on risk-peer group comparison.

After 1960s, risk-adjusted techniques-composite
measures
Requirements of a portfolio managers
performance Measures
The ability to derive above-average returns for a
given risk class

The ability to diversify the portfolio completely to
eliminate all unsystematic risks, relative to the
portfolios benchmark
Treynor Portfolio Performance Measure
Treynor measure gives excess return
per unit of systematic risk.

T =
R
p
- R
f

p
Risk produced by general market fluctuations
(Systematic Risk)
Risk resulting from unique fluctuations in the portfolio
securities (Unsystematic Risk)
Treynor Portfolio Performance Measure
Characteristic Line
To identify risk due to market fluctuations, he
introduced the characteristic line, which defines the
relationship between the rates of return for a
portfolio over time and the rates of return for an
appropriate market portfolio.

Characteristic lines slope measures the relative
volatility of the portfolios returns in relation to
returns for the aggregate market.

This slope is the portfolios beta coefficient ().
Plot of Performance on SML (T Measure)
SML
T
Y

T
X

T
Z

T
M

.08
1.00 .50 00 1.5
2.00
.14
.04
.12
.16
.18
Beta
Rate of Return
Sharpe Measure
Sharpe measure divides average portfolio excess
return over the sample period by the standard
deviation of returns over that period.

It measures the reward to (total) volatility trade-off

This measure uses a benchmark on the ex post
capital market line.
This measure indicates the risk premium return
earned per unit of total risk.

In terms of capital market theory, this portfolio
performance measures total risk to compare
portfolios to the CML, whereas the Treynor measure
examines portfolio performance in relation to SML.

S =
R
p
- R
f

p
Sharpe Measure
Sharpe Measure
CML
S
F

S
D

S
E

.08
.20 .10
00 .30
.40
.14
.04
.12
.16
.18

Rate of Return
S
M


Treynor Vs Sharpe Measures
The Sharpe portfolio performance measure uses standard deviation of
returns as the measure of risk whereas Treynor performance measure
uses beta (systematic risk)

The Sharpe measure, therefore, evaluates the portfolio manager on the
basis of both rate of return performance and diversification.

For a completely diversified portfolio, one without any unsystematic risk,
the two measures give identical rankings because the total variance of
the completely diversified portfolio is its systematic variance.
Alternatively, a poor diversified portfolio could have a high ranking on the
basis of the Treynor performance measure but a much lower ranking on
the basis of the Sharpe performance measure. Any difference in rank
would come directly from a difference in diversification.

Both measures produce relative not absolute rankings of performance.
Jensen Measure
Jensen measure is the average return on the
portfolio over and above that predicted by CAPM,
given the portfolios beta and the average market
return. Jensen measure is the portfolios alpha
value.


p
= R
p
[R
f
+
p
(R
M
- R
f
)]


p
= [R
p
R
f
]

-
p
[R
M
- R
f
]

Alpha (
p
) is the difference between the actual
excess return on portfolio P during some period
and the risk premium on that portfolio that should
have been earned, given its level of systematic risk
and the use of the CAPM.

It measures the constant return that the portfolio
manager earned above, or below, the return of an
unmanaged portfolio with the same (market) risk.
Jensen Measure
If alpha is significantly positive, this is evidence of
superior performance.

If alpha is significantly negative, this is evidence of
inferior performance.

If alpha is insignificantly different from zero, this is
evidence that the portfolio manager matched the
market on a risk-adjusted basis.
Jensen Measure

p
= a positive value

p
= 0

p
= a negative value

p
[R
M
- R
f
]
[R
p
- R
f
]
Jensen Measure
The Information Ratio (Appraisal
Ratio) Performance Measure
Information ratio also known as an appraisal ratio
measures a portfolios average return in excess of
that of a comparison or benchmark portfolio divided
by the standard deviation of the excess return.
Formally, the information ratio (IR) is calculated as:

IR
i
=

ER
R
i
- R
b
=

ER
ER
i


Superior or Inferior Portfolio
Performance results from two sources
First, the manager may be able to time market turns, varying
the portfolios composition in accordance with the rise and fall
of the market (Superior Timing)
- Bigger gain in rising markets and smaller losses in
declining markets give the portfolio manager above-
average risk-adjusted returns

Second, the portfolio manager may be able to select
undervalued securities consistently enough to affect portfolio
performance (Superior Security Selection)
- A portfolio manager may try to select undervalued stocks or
bonds for a given risk class and even without superior
timing can earn above-average risk-adjusted returns.
ANY
?
Thank
You