Session 18 & 19

Instructor: Nivedita Sinha

Email : nivedita.sinha@nmims.edu
Agenda of Session 18 & 19
Portfolio Performance measures
 What is Required of a Portfolio
Manager

The ability to derive above-average returns for a given risk class

The ability to diversify the portfolio completely to eliminate

unsystematic risk relative to the portfolios benchmark
 Composite Portfolio Performance
Measures

Treynor Portfolio Performance Measure

Sharpe Portfolio Performance Measure

Jensen Portfolio Performance Measure

The Information ratio Performance Measure

Treynor Portfolio Performance
Measure Where R bar is average rate of

R RFR
i
return for Portfolio i during the
specified time period,
RFR bar is avg. ror on risk-free

T i investment during that period

i
i Betai is slope of the funds
characteristic line during that period

The numerator is the risk premium

The denominator is a measure of risk

The expression is the risk premium return per unit of risk

Risk averse investors prefer to maximize this value

This assumes a completely diversified portfolio leaving systematic

risk as the relevant risk
 Treynors measure -Illustration
Assume the market return is 14% and risk-free rate is 8%. The average
annual returns for Managers W, X, and Y are 12%, 16%, and 18%
respectively. The corresponding betas are 0.9, 1.05, and 1.20. What are the
T values for the market and managers?
The T Values
TM = (14%-8%) / 1 =6%
TW = (12%-8%) / 0.9 =4.4%
TX = (16%-8%) / 1.05 =7.6%
TY = (18%-8%) / 1.20 =8.3%

If beta is negative and risk premium is positive, we get

negative T values. To compare portfolio performance,
compare the expected return to actual return
Sharpe Portfolio Performance
Measure
Shows the risk premium earned over the risk free rate per unit of
standard deviation
Sharpe ratios greater than the ratio for the market portfolio indicate
superior performance

The Formula
R i RFR
Si
si
where:
i = the standard deviation of the rate of return for Portfolio I
Or recently used standard deviation of the portfolio returns in excess of
a risk free rate
Sharpe Measure - Illustration
Assume the market return is 14% with a standard deviation of 20%, and
risk-free rate is 8%. The average annual returns for Managers D, E, and
F are 13%, 17%, and 16% respectively. The corresponding standard
deviations are 18%, 22%, and 23%. What are the Sharpe measures for
the market and managers?

The Sharpe Measures

SM = (14%-8%) / 20% =0.300
SD = (13%-8%) / 18% =0.273
SE = (17%-8%) / 22% =0.409
SF = (16%-8%) / 23% =0.348
Sharpe Measure versus Treynor
measure
Sharpe uses standard deviation of returns as the measure of risk

Treynor measure uses beta (systematic risk)

Sharpe therefore evaluates the portfolio manager on the basis of both

rate of return performance and diversification

The methods agree on rankings of completely diversified portfolios

Produce relative not absolute rankings of performance

Jensen Portfolio Performance
Measure
Jensen Portfolio Performance Measure
The Formula
Rjt - RFRt = j + j [Rmt RFRt ] + ejt
where:
j = Jensen measure
Jensen measure represents the average excess return of the portfolio
above that predicted by CAPM
Superior managers will generate a significantly positive alpha;
inferior managers will generate a significantly negative alpha
Jensen measure is flexible enough to allow for alternative models of
risk and expected return than the CAPM. Risk-adjusted performance
can be computed relative to any of the multifactor models
Information Ratio Performance
measure
The Formula

R j Rb ER j
IR j
s ER s ER
where:

Rb = the average return for the benchmark portfolio

ER = the standard deviation of the excess return
Information ratio measures the average return in excess that of a
benchmark portfolio divided by the standard deviation of this excess
return
ER can be called the tracking error of the investors portfolio and it
is a cost of active management
IR is a benefit to cost ratio
Comparing the Composite Performance
Measures
Sortinos measure Performance
measurement with downside risk
The Sortino measure is a risk-adjusted measure that differs from
the Sharpe ratio in two ways
It measures the portfolios average return in excess of a user-
selected minimum acceptable return threshold
It captures just the downside risk (DR) in the portfolio rather
than the total risk as in Sharpe measure

Ri t
STi
DRi
where: = the minimum acceptable return threshold
DRi = the downside risk coefficient for Portfolio i
Sortinos measure Performance
measurement with downside risk
Downside Risk measure
It is the volatility of returns produced by a portfolio that fall
below some hurdle rate that the investor chooses.
This measure implicitly assumes that investor tries to
minimize the damage from returns less than some target level
Volatility associated with the shortfall that occurs if
investment produces a return that is lower than anticipated.
One measure is semi-deviation
Semi-deviation =

For all R<Rbar

Where n is number of portfolio returns falling below the

expected return
Problem 6
Problem 6
 What is Required of a Portfolio
Manager

The ability to derive above-average returns for a given risk class

The ability to diversify the portfolio completely to eliminate

unsystematic risk relative to the portfolios benchmark
What is Required of a Portfolio
Manager

The ability to derive above-average returns for a given risk class.

The superior risk-adjusted returns can be derived from either

Superior Market timing

Superior Security selection (Ability to pick best securities of a

given level of risk)

The ability to diversify the portfolio completely to eliminate

unsystematic risk relative to the portfolios benchmark

A completely diversified portfolio is perfectly correlated with

the fully diversified benchmark portfolio
 Market Timing
Buying low and selling high

In its pure form it means shifting funds between a market index

portfolio and safe asset such as T-bills or money market fund
depending on whether the market as a whole is expected to outperform
the safe asset

Suppose investor holds only the market index portfolio and T-bills.
If proportion invested in the market were constant say 0.6, portfolio
beta will also be constant and SCL will plot as a straight line with
slope 0.6

Now if investor correctly times the market and moves funds into it
when the market does well. How will the SCL look like?
Market Timing contd.
The effect of correctly timing the market would be to increase the
portfolio beta in up markets and decrease it in down markets. For the
purpose of this discussion, an up market is one in which the market
return exceeds the risk-free rate, and a down market is one in which the
market return is less than the risk-free rate.

Adjusting portfolio weights for up and down movements in market

returns, we would have:

Low Market Return - low weight on the market - low eta

High Market Return high weight on the market - high eta
 Market Timing and Characteristic Lines

No Market Timing

Beta Increases with Return

Two Values of Beta
Components of Investment
Performance - Fama
Components of Investment
Performance - Fama
Components of Investment Performance

Fama suggested overall performance, in excess of the risk-free rate,

consists of two components:
Overall Performance =Excess return
=Portfolio Risk + Selectivity

The selectivity component represents the portion of the portfolios

actual return beyond that available to an unmanaged portfolio with
identical systematic risk and is used to assess the managers
investment prowess
Problem 5