Portifolio Measure

Chapter 15
Performance
Measurement
Copyright 2000 by Harcourt, Inc. All rights reserved.
Chapter 15
Outline
Questions to be answered:
What major requirements do clients expect
from their portfolio managers?
What can a portfolio manager do to attain
superior performance?
What is the peer group comparison method of
evaluating an investors performance?
Chapter 15
Outline
What is the Treynor portfolio performance
measure?
What is the Sharpe portfolio performance
measure?
What is the critical difference between the
Treynor and Sharpe portfolio performance
measures?
Chapter 15
Outline
What is the Jensen portfolio performance
measure, and how does it relate to the Treynor
measure?
What is the information ratio and how is it
related to the other performance measures?
When evaluating a sample of portfolios, how do
you determine how well diversified they are?
Chapter 15
Outline
What is the bias found regarding the composite
performance measures?
What is the Fama portfolio performance measure
and what information does it provide beyond
other measures?
What is attribution analysis and how can it be
used to distinguish between a portfolio managers
market timing and security selection skills?
Chapter 15
Outline
What is the Roll benchmark error problem, and
what are the two factors that are affected when
computing portfolio performance measures?
What is the impact of global investing on the
benchmark error problem?
What are customized benchmarks?
What are the important characteristics that any
benchmark should possess?
Chapter 15
Outline
What are the time-weighted and dollarweighted returns and which should be
reported under AIMRs Performance
Presentation Standards?
How Should Investors Measure

Risk?
Standard Deviation
Investors with limited holdings
Beta
Investors with a wide array of holding
How Should Investors Select

Funds?
Performance Indexes
Provide a method of comparing
funds with different
risk-return characteristics
What is Required of
a Portfolio Manager?
1.The ability to derive above-average returns
for a given risk class
Superior risk-adjusted returns can be derived
from either
superior timing or
superior security selection
2. The ability to diversify the portfolio

completely to eliminate unsystematic risk
Composite Portfolio
Performance Measures
Portfolio evaluation before 1960
rate of return within risk classes
Peer group comparisons

no explicit adjustment for risk
difficult to form comparable peer group
Treynor portfolio performance measure

market risk
individual security risk
introduced characteristic line
Performance Indexes
Sharpes Performance Index (PIS)
Treynors Performance Index (PIT)
Jensens Performance Index (PIJ)
Performance Indexes With APT(PIA)
Treynors Performance Index

Based on SML
Uses Beta to measure Risk
The Higher the Index
The better the performance
Investors Hold Many Assets

For Investors Only Interested in Whether
They Beat the Market
Treynor Portfolio
Performance Measure
Treynor recognized two components of risk
Risk from general market fluctuations
Risk from unique fluctuations in the securities in the
portfolio
His measure of risk-adjusted performance

focuses on the portfolios undiversifiable risk:
market or systematic risk
Treynor Portfolio
Performance Measure
R
T
RFR
i
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
Treynor Portfolio
Performance Measure
Comparing a portfolios T value to a similar measure for
the market portfolio indicates whether the portfolio would
plot above the SML
Calculate the T value for the aggregate market as follows:
Tm
RFR
m
Treynor Portfolio
Performance Measure
Comparison to see whether actual return of
portfolio G was above or below expectations
can be made using:
E R G RFR i R m RFR
Sharpes Performance Index

Based on the Slope of the CML
Uses Standard Deviation to Measure Risk
The Higher the Index
The better the performance
Investors Only Hold the Mutual Fund
Sharpe Portfolio
Performance Measure
Risk premium earned per unit of risk
R i RFR
Si
i
Treynor versus Sharpe 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
Jensens Performance Index

Based on CAPM
Uses Beta to Measure Risk
Alpha = average return less expected return
given by CAPM / SML
Determines How Much One Fund
Outperforms or Underperforms Another Fund
Determines the Significance of Results
Investors Hold Many Assets
Jensen Portfolio
Performance Measure
Also based on CAPM
Expected return on any security or portfolio is
E R j RFR j E R m RFR
Jensen Portfolio
Performance Measure
Also based on CAPM
Expected return on any security or portfolio is
E R j RFR j E R m RFR
Where: E(Rj) = the expected return on security

RFR = the one-period risk-free interest rate
j= the systematic risk for security or portfolio j
E(Rm) = the expected return on the market portfolio of risky
assets
Performance Indexes With APT

One or More Factors Determine Risk
Jensens Performance Measure
Examine the Difference Between
Actual and expected average rate of return
Determines the Significance of Results

For Investors Who Want to Compare Their
Performance With Other Fund Managers
Summary
Standard Deviation Appropriate
Sharpes index
Beta Appropriate
Treynors index
Jensens index
One or More Factors Determine Risk

APT
The Information Ratio

Performance Measure
Appraisal ratio
measures average return in excess of
benchmark portfolio divided by the
standard deviation of this excess return
R j Rb ER j
IR j
ER
ER
j
U
Application of Portfolio
Performance Measures
EPit Divit Cap.Dist.it BPit
Rit
BPit
Empirical Evidence For MFs

MFs performance Fall Behind the Market
MFs can not Outperform
Buy-the-market and-hold policy
International MFs Tend to do Better

Outperform the S&P 500
Choice of market portfolio critical
Bond Funds Underperform the Indexes

Relationship
underperformance and the expense ratio
Pension Funds Outperformed By

The S&P 500
80
70
60
50
40
30
20
10
0
81
82
83
84
85
86
87
88
89
90
91
Performance Attribution
Assessing the performance of
the activities that make up
portfolio management
Levels Of Decisions Causing

Excess Returns
Top-Down Approach
Asset allocation
Sector Allocation
Industry allocation
Security selection
Flow Chart
Top -Down Money Management
Process
P o r t f o lio
A s s e t A llo c a t io n s
S to c k s
S e c t o r A llo c a t io n s
B onds
C ash
U t ilit ie s
I n d u s t r y A llo c a t io n
W a te r
S e c u r it y S e lle c t io n s
A m W a te r W o rk s
Components of Investment
Performance
Fama suggested overall performance, which
is its return in excess of the risk-free rate
Portfolio Risk + Selectivity
Further, if there is a difference between the

risk level specified by the investor and the
actual risk level adopted by the portfolio
manager, this can be further refined
Investors Risk + Managers Risk + Selectivity
Performance
The selectivity measure is used to assess the
managers investment prowess
The relationship between expected return
and risk for the portfolio is:
E m R RFR Cov R j , R m
E R RFR
Rm
Rm
Performance
The market line then becomes a benchmark
for the managers performance
Rm RFR
R x RFR
x
Rm
Selectivity Ra R x a
Performance
The selectivity component can be broken
into two parts
gross selectivity is made up of net selectivity
plus diversification
Selectivity
Diversification
Ra R x a Net Selectivity R x Ra R x a
Performance
Assuming the investor has a target level of
risk for the portfolio equal to T, the portion
of overall performance due to risk can be
assessed as follows:
Risk
Manager' s Risk Investor' s Risk
R x a RFR R x a R x T R x T RFR
Measuring Market Timing Skills

Tactical asset allocation (TAA)
Attribution analysis is inappropriate
indexes make selection effect not relevant
multiple changes to asset class weightings
during an investment period
Regression-based measurement
Can Fund Managers Time The

Market?
Newsletters Failed
Performance Attributed To
Problems with performance indexes
Potential Bias of One-Parameter

Measures
positive relationship between the composite
performance measures and the risk involved
alpha can be biased downward for those
portfolios designed to limit downside risk
Caution About Performance

Indexes
Problems
Historical performance is used to infer future performance

Difficult to measure the risk of actively traded accounts
Beta is not stable
Depends on the choice of market index
Overall performance indexes cannot identify

What activities of the portfolio manager resulted in the
performance
Performance attribution done as a separate step
What is the Market Portfolio?

Market portfolio difficult to approximate
Benchmark error
can effect slope of SML

can effect calculation of Beta
greater concern with global investing
problem is one of measurement
Sharpe measure not as dependent on market

portfolio
Benchmark Portfolios
Performance evaluation standard
Usually a passive index or portfolio
May need benchmark for entire portfolio
and separate benchmarks for segments to
evaluate individual managers
Characteristics of Benchmarks
Unambiguous
Investable
Measurable
Appropriate
Reflective of current investment opinions
Specified in advance
Building a Benchmark
Specialize as appropriate
Provide value weightings
Provide constraints to portfolio manager
Evaluation of
Bond Portfolio Performance
How did performance compare among
portfolio managers relative to the overall
bond market or specific benchmarks?
What factors explain or contribute to
superior or inferior bond-portfolio
performance?
A Bond Market Line

Need a measure of risk such as beta
coefficient for equities
Difficult to achieve due to bond maturity and
coupon effect on volatility of prices
Composite risk measure is the bonds duration
Duration replaces beta as risk measure in a
bond market line
Bond Market Line Evaluation

Policy effect
Difference in expected return due to portfolio
duration target
Interest rate anticipation effect

Differentiated returns from changing duration of the
portfolio
Analysis effect
Acquiring temporarily mispriced bonds
Trading effect
Short-run changes
Decomposing Portfolio Returns

Into maturity, sector, and quality effects
Total return during a period is the income effect
and a price change effect
The yield-to-maturity (income) effect is the
return an investor would receive if nothing had
happened to the yield curve during the period
Interest rate effect measures changes in the term
structure of interest rates during the period
Decomposing Portfolio Returns

The sector/quality effect measures expected impact
on returns because of changing yield spreads
between bonds in different sectors and ratings
The residual effect is what is left after accounting
for the first three factors
A large positive residual would indicate superior
selection capabilities
Time-series plot demonstrates strengths and
weaknesses of portfolio manager
Consistency of Performance
For bond managers, no relationships between
performance in two periods, nor between past
and future performance among the best and
worst performers
Computing Portfolio Returns

To evaluate portfolio performance, we have
to measure it
From Chapter 5 we learned how to calculate
a holding period yield, which equals the
change in portfolio value plus income
divided by beginning portfolio value:
Ending
Value
HPY
1
Beginning Value
Computing Portfolio Returns

Dollar-weighted rate of return (DWRR)
Internal rate of return on the portfolios cash flows
Time-weighted rate of return (TWRR)

Geometric average return
TWRR is better
Considers actual period by period portfolio returns
No size bias - inflows and outflows could affect
results
Performance Presentation Standards

AIMR PPS have the following goals:
achieve greater uniformity and comparability among
performance presentation
improve the service offered to investment
management clients
enhance the professionalism of the industry
bolster the notion of self-regulation
Performance Presentation Standards
Total return must be used

Time-weighted rates of return must be used
Portfolios valued quarterly and periodic returns geometrically linked
Composite return performance (if presented) must contain all actual
fee-paying accounts
Performance calculated after trading expenses
Taxes must be recognized when incurred
Annual returns for all years must be presented
Disclosure requirements

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Chapter 15

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

How Should Investors Measure

Copyright 2000 by Harcourt, Inc. All rights reserved.

How Should Investors Select

Copyright 2000 by Harcourt, Inc. All rights reserved.

2. The ability to diversify the portfolio

Peer group comparisons

Treynor portfolio performance measure

Copyright 2000 by Harcourt, Inc. All rights reserved.

Treynors Performance Index

Investors Hold Many Assets

His measure of risk-adjusted performance

Copyright 2000 by Harcourt, Inc. All rights reserved.

The numerator is the risk premium

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Sharpes Performance Index

Investors Only Hold the Mutual Fund

Copyright 2000 by Harcourt, Inc. All rights reserved.

Treynor versus Sharpe Measure

Jensens Performance Index

Copyright 2000 by Harcourt, Inc. All rights reserved.

Where: E(Rj) = the expected return on security

Copyright 2000 by Harcourt, Inc. All rights reserved.

Performance Indexes With APT

Determines the Significance of Results

One or More Factors Determine Risk

The Information Ratio

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Empirical Evidence For MFs

International MFs Tend to do Better

Bond Funds Underperform the Indexes

Copyright 2000 by Harcourt, Inc. All rights reserved.

Pension Funds Outperformed By

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Levels Of Decisions Causing

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Further, if there is a difference between the

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Manager' s Risk Investor' s Risk

Measuring Market Timing Skills

Copyright 2000 by Harcourt, Inc. All rights reserved.

Can Fund Managers Time The

Copyright 2000 by Harcourt, Inc. All rights reserved.

Potential Bias of One-Parameter

Copyright 2000 by Harcourt, Inc. All rights reserved.

Caution About Performance

Historical performance is used to infer future performance

Overall performance indexes cannot identify

Copyright 2000 by Harcourt, Inc. All rights reserved.

What is the Market Portfolio?

can effect slope of SML

Sharpe measure not as dependent on market

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.