Chapter 25 - Evaluation of Portfolio

Performance
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?
What is the critical difference between the
Treynor and Sharpe portfolio performance
measures?
Chapter 25 - Evaluation of Portfolio
Performance
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 25 - Evaluation of Portfolio
Performance
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 25 - Evaluation of Portfolio
Performance
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?
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
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
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
)
i
i
RFR R
T

=
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:
)
m
m
m
RFR R
T

=
Treynor Portfolio
Performance Measure
Comparison to see whether actual return of
portfolio G was above or below expectations
can be made using:
) ) RFR R RFR R E
m i G
+ =
Sharpe Portfolio
Performance Measure
Risk premium earned per unit of risk
i
i
i
RFR R
S
W

=
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
) ) . J RFR R E RFR R E
m j j
+ =
Jensen Portfolio
Performance Measure
Also based on CAPM
Expected return on any security or portfolio is
Where: E(R
j
) = the expected return on security
RFR = the one-period risk-free interest rate

j
= the systematic risk for security or portfolio j
E(R
m
) = the expected return on the market portfolio of
risky assets
) ) . J RFR R E RFR R E
m j j
+ =
The Information Ratio Performance
Measure
Sharpe appraisal ratio- measures average
return in excess of benchmark portfolio
divided by the standard deviation of this
excess return
ER
j
ER
b
j
j
ER R R
IR
W W
=

=
U
j
W
E
=
Application of Portfolio Performance
Measures
it
it it it it
it
BP
BP Dist Cap Div EP
R
+ +
=
. .
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
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
Components of Investment
Performance
The selectivity measure is used to assess
the managers investment ability
The relationship between expected return
and risk for the portfolio is:
)
)
)
)
)
m m
m
R R
RFR R E
RFR R E
W W
m j
R

, R

Cov

+ =
Components of Investment
Performance
The market line then becomes a
benchmark for the managers performance
)
x
m
m
x
R
RFR R
RFR R
W

+ =
)
a x a
R R = y Selectivit
Components of Investment
Performance
The selectivity component can be broken
into two parts
gross selectivity is made up of net selectivity
plus diversification
) ) ) ) . J
a x a x a x a
R R R R R W + = y Selectivit Net
ation Diversific y Selectivit
Components of Investment
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:
) . J ) ) . J ) . J RFR R R R RFR R
T x T x a x a x
+ =
+ =

Risk s Investor' Risk s Manager' Risk
Relationship Among Performance
Measures
Treynor
Sharpe
Jensen
Information Ratio
Fama net selectivity measures
Highly correlated, but not perfectly so
Performance Attribution Analysis
Allocation effect
Selection effect
) ) . J
p pi pi ai i
R R W W - L =
) ) . J
pi ai ai i
R R W - L =
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
. J 0 , , max
t bt t st t pt
RFR R RFR R RFR R + =
) ) )
. J ,
t t bt t st
st s t bt b t pt
U RFR R RFR R
RFR R RFR R RFR R
+ +
+ + =
0 , , max K
E
Factors That Affect Use of
Performance Measures
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
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