Lecture Presentation Software

to accompany

Investment Analysis and Portfolio Management

Eighth Edition by

Frank K. Reilly & Keith C. Brown

Chapter 25

Chapter 25 - Evaluation of Portfolio Performance

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 25 - Evaluation of Portfolio Performance

What is the Treynor portfolio performance measure? What is the Sharpe portfolio performance measure and how can it be adapted to include multifactor models of risk and expected return? What is information ratio and how it related to the other performance measures?

Chapter 25 - Evaluation of Portfolio Performance

When evaluating a sample of portfolios, how do you determine how well diversified they are?

Chapter 25 - Evaluation of Portfolio Performance

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 25 - Evaluation of Portfolio Performance

What is the benchmark error problem, and what are the two factors that are affected when computing portfolio performance measures? What are customized benchmarks and What are the important characteristics that any benchmark should possess?

Chapter 26 - Evaluation of Portfolio Performance

How do bond portfolio performance measures differ from equity portfolio performance measures?

Chapter 25 - Evaluation of Portfolio Performance

What are the time-weighted and dollar-weighted returns and which should be reported under CFAs Performance Presentation Standards? How can investment performance be measured by analyzing the security holdings of a portfolio?

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 relative to the portfolios benchmark

Early Performance Measures Techniques

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

Treynor portfolio performance measure
market risk individual security risk introduced characteristic line

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 s Composite Performance Measure

R T!

 RFR Fi

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 s Composite 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

R !

 RFR Fm

Demonstration of Comparative Treynor Measure

Comparison to see whether actual return of portfolio G was above or below expectations can be made using:

ER G ! RFR  F i R m  RFR

Sharpe Portfolio Performance Measure

Risk premium earned per unit of risk

R i  RFR Si ! Wi

Demonstration of Comparative Sharpe Measure

Portfolio D E F
SM ! 0.14  0.08 ! 0.300 0.20

Average Annual Rate of Return 0.13 0.17 0.16

SD !

Standard Deviation of Return 0.18 0.22 0.23

0.13  0.08 ! 0.278 0.18

0.17  0.08 SE ! ! 0.409 0.22

SF !

0.16  0.08 ! 0.348 0.23

The D portfolio had the lowest risk premium return per unit of total risk, failing even to perform as well as the aggregate market portfolio. In contrast, Portfolio E and F performed better than the aggregate market: Portfolio E did better than Portfolio F.

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

Jensen Portfolio Performance Measure

Also based on CAPM Expected return on any security or portfolio is

E  j ! RFR  F j ?ER m  RFR A R

Jensen Portfolio Performance Measure

Also based on CAPM Expected return on any security or portfolio is

E j ! RFR  F j ?ER m  RFR A R
Where: E(Rj) = the expected return on security RFR = the one-period risk-free interest rate Fj= the systematic risk for security or portfolio j E(Rm) = the expected return on the market portfolio of risky assets

Applying the Jensen Measure

Jensen Measure of performance requires using a different RFR for each time interval during the sample period It does not directly consider the portfolio managers ability to diversify because it calculates risk premiums in term of systematic risk

Jensen Measure and Multifactor Models

Advantages:
It is easier to interpret Because it is estimated from a regression equation, it is possible to make statements about the statistical significance of the mangers skill level It is flexible enough to allow for alternative models of risk and expected return than the CAPAM. Risk-adjusted performance can be computed relative to any of the multifactor models:

R jt  RFRt ! E j  [b j1 F1t  b j F t  L b jk Fkt ]  e jt

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 ! ! W ER W ER

WU

Application of Portfolio Performance Measures

EPit  Div it  Cap.Dist .it  BPit Rit ! BPit

Potential Bias of OneParameter 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

Measuring Performance with Multiple Risk Factors

Form of the estimation equation
R jt  RFRt ! E j  b j RMt  RFRt  b j SMBt  b j 3 HMLt  e jt

Relationship between Performance Measures

Although the measures provide a generally consistent assessment of portfolio performance when taken as a whole, they remain distinct at an individual level. Therefore it is best to consider these composites collectively The user must understand what each means

Components of Investment Performance

Fama suggested overall performance, which is its return in excess of the risk-free rate
Overall Performance=Excess return=Portfolio Risk + Selectivity

Components of Investment 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  W Rm W Rm

Evaluating Selectivity
The market line then becomes a benchmark for the managers performance

Rm  RFR R x ! RFR  F x W Rm
Selectivity ! Ra  R x F a

Evaluating Diversification
The selectivity component can be broken into two parts
gross selectivity is made up of net selectivity plus diversification

electivity

iversi ication
a

Ra  R x F a ! Net electivity  ?R x  Ra  R x  W

Holding Based Performance Measurement

There are two distinct advantages to assessing performance based on investment returns
Return are usually easy for the investor to observe on a frequent basis Represent the bottom line that the investor actually takes away from the portfolio managers investing prowess

Holding Based Performance Measurement

Returns-based measures of performance are indirect indications of the decision-making ability of a manager Holdings-based approach can provide additional insight about the quality of the portfolio manager

Grinblatt -Titman (GT) Performance Measure

Among the first to assess the quality of the services provided by money managers by looking at adjustments they made to the contents of their portfolios

GTt !

(w
j

jt

 w jt 1 )R jt

verage T !
t

Tt

Characteristic Selectivity (CS) Performance Measure

CS performance measure compares the returns of each stock held in an actively managed portfolio to the return of a benchmark portfolio that has the same aggregate investment characteristics as the security in question

CSt !

w
j

jt ( R jt

 R jt )

verage !
t

Performance Attribution Analysis

Allocation effect ! 7 i Wai  W pi v R pi  R p Selection effect
i ai ai pi

 A ?  A ! 7 ?W v   R R

Performance Attribution Extensions

Attribution methodology can be used to distinguish security selection skills from any of several other decisions that investor might make

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

Measuring Market Timing Skills

R pt ! RFRt  max?Rst  RFRt , Rbt  RFRt ,0A

pt

 RFRt ! E  F b Rbt  RFRt  F s Rst  RFR

a  K _ ?Rst  RFRt , Rbt  RFRt ,0A  U t max

Factors That Affect Use of Performance Measures

Market portfolio is 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

Demonstration of the Global Benchmark Problem

Two major differences in the various beta statistics:
For any particular stock, the beta estimates change a great deal over time. There are substantial differences in betas estimated for the same stock over the same time period when two different definition of the benchmark portfolio are employed.

Implications of the Benchmark Problems

Benchmark problems do not negate the value of the CAPM as a normative model of equilibrium pricing There is a need to find a better proxy for the market portfolio or to adjust measured performance for benchmark errors Multiple markets index (MMI) is major step toward a truly comprehensive world market portfolio.

Required Characteristics of Benchmarks

Unambiguous Investable Measurable Appropriate Reflective of current investment opinions Specified in advance

Selecting a Benchmark
Must be selected at two levels: A global level that contains the broadest mix of risky asset available from around the world A fairly specific level consistent with the management style of an individual money manager (i.e., a customized benchmark).

Evaluation of Bond Portfolio Performance

Returns-Based Bond Performance Measurement
Early attempts to analyze fixed-income performance involved peer group comparisons Peer group comparisons are potentially flawed because they do not account for investment risk directly. Fama and French addressed the flaw
jt

b j1 

mt

b j2

b j3

b j4TE

b j4 E t

e jt

Bond Performance Attribution

How did the performance levels of portfolio managers compare to the overall bond market? What factors lead to superior or inferior bond-portfolio performance?

Bond Performance Attribution

A Bond Market Line
eed 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 Performance Attribution

This technique divides the portfolio return that differs from the return on the Lehman Brothers Index into four components: Policy effect Difference in expected return due to portfolio duration target Rate anticipation effect Differentiated returns from changing duration of the portfolio Analysis effect Acquiring temporarily mispriced bonds Trading effect Short-run changes

Reporting Investment Performance

Time-Weighted and Dollar-Weight Returns
A better way to evaluate performance regardless of the size or timing of the investment involved. The dollar-weighted and time-weighted returns are the same when there are no interim investment contributions within the evaluation period.
HPY = Ending Value of Investment -1 Beginning Value of Investemnt

djusted

Ending alue o Investment - 1 - W  ontribution Beginning alue o Investemnt

W  ontribution

1

Reporting Investment Performance

Performance Presentation Standards (PPS)
The goals of the AIMR-PPS are: 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

Reporting Investment Performance

Performance Presentation Standards
Fundamental principles
Total return must be used Time-weighted rates of return must be used Portfolios must be valued at least monthly and periodic returns must be geometrically linked Composite return performance (if presented) must contain all actual fee-paying accounts Performance must be calculated after deduction of trading expenses Taxes must be recognized when incurred Annual returns for all years must be presented Disclosure requirements must be met

The Internet Investments Online

http://www.nelsons.com http://www.styleadvisor.com http://www.morningstar.com http://www.cfainstitute.org

End of Chapter 25
Evaluation of Portfolio Performance