Portfolio performance

evaluation
Risk-adjusted rates of return:
Sharpe ratio, Treynor ratio,
Jensens alpha, M2

Portfolio performance
evaluation
What are major performance
requirements for portfolio
managers:

Derive above average

returns for a given risk
class.
Ability to diversify portfolio
completely to eliminate all
unsystematic risk.

How to achieve these goals:

Superior timing skills.

Superior security selection
skills.

Different statistics or
measures are appropriate
for different types of
investment decisions or
portfolios
Many industry and
academic measures are
different
The nature of active
management leads to
measurement problems

Treynors measure
There are two sources of risk:
Security specific risk
Market risk

Portfolio manager can

expect return compensation
only from systematic risk.
The Treynor measure gives
a securities characteristic
line.

Ti =

ri rf

Higher Ts are better.

The measure doesnt
consider security specific
risk.
(Notice relationship to
SML!)

Example: Treynors measure

T(P) = 11%/0.9

T(Q) = 19%/1.6
T(P) > T(Q)
=> P is better

Sharpe ratio

The Sharpe ratio measures

the risk premium earned per
unit of total risk.
Sharpe measure measures
(implicitly) degree of
diversification.
For well diversified
portfolios Treynor and
Sharpe measures yield
similar results.

Si =

ri rf

Higher Ss is better.
In risk return space S is the
slope of the CAL between
the asset i and the risk-free
asset.
(Notice relationship to
CML!)
5

Modigliani and Modigliani - M2

Strategy: Blend portfolio

with risk-free asset until
portfolio volatility equals
that of benchmark.
M2 is the risk adjusted
excess return beyond the
benchmark return.
Measure does not add
information beyond what
the Sharpe ratio provides.

Modigliani and Modigliani - M2

Calculating M2:
1. Calculate the risk-adjusted
rate of return of asset x:

Sharp ratio high, the high intersection

benchmark
[
rx rf ]
x
2. M2 of x is the excess
return:
rx adjusted = rf +

M 2 = rx adjusted rbenchmark

(Note the M2 can be

positive or negative.
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Jensens alpha

measures how much of

the return is attributable to
the managers ability to
derive above average
returns adjusted for risk.
Alpha is not just a number
describing the expected
return for an asset, it plays
an essential role in portfolio
management.

i = ri rf i [rM rf ]

Higher s are better.

(Notice relationship to
CAPM!)

Appraisal (Information) ratio

The appraisal ratio

measures the abnormal
return per unit of
unsystematic risk that could
be diversified away.
What is the appraisal ratio
of the market portfolio?

AR =

( e)i

Performance Measurement for

Hedge Funds

When the hedge fund is optimally combined with

the baseline portfolio, the improvement in the
Sharpe measure will be determined by its
information ratio:
Benchmark porfolio

For actively managed portfolios, it is helpful to keep

track of portfolio composition and changes in
portfolio mean and risk.
10

Performance Statistics
Sharpe's ratio and M2 give the same result => the same graph

choose Q

higher alpha

Q better
P better

Q higher risk

Stand alone strategy: don't have another portfolio

Conclusion: P much better, P can increase Sharp ratio higher based on Information ratio (Sharp
11
rario is mesured the improvement)

Changing Portfolio Risk

Return distribution changes over time as the

design of active portfolio strategies
Suppose that market Sharpe ration = 0.4; the
strategy adopted in the first year is excess return of
1% and standard deviation of 2%; and the strategy
adopted in the following year is excess return of
9% and standard deviation of 18%. Both years
= 9/18 (second yr)
exhibit a Sharpe ratio of 0.5. = 1/2 first yr
The mean and standard deviation over the 2 years
is 5% and 13.42%, and the Sharpe ratio is 0.37,
apparently inferior to the market.
= 0.37 x 13.42% = 4.9654%
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Changing Portfolio Risk

13

Measuring
market timing ability

Use both model

Treynor and Mauzay:

rP rf = a + b( rM rf ) + c( rM rf ) 2 + eP

C measures the timing ability of the

manager.

Henriksson and Merton:

rP rf = a + b( rM rf ) + c( rM rf ) D + eP

D is a dummy variable for up

markets (rM>rf)
Henriksson finds little evidence for
timing ability of mutual fund
managers because of not
significant negative c on average.

rM -rf
= excess return
14

Market Timing

Beginning with $1 at the beginning of 1926 and how many would a market timer
end at the end of 2005?
15
The imperfect timer has P1 = P2 = 0.7

Style Analysis

Introduced by William Sharpe

1992 study of mutual fund performance

91.5% of variation in return could be explained
by the funds allocations to bills, bonds and
stocks

Later studies show that 97% of the variation in

return could be explained by the funds allocation
to a broader range of asset classes
16

Style Analysis for Fidelitys

Magellan Fund

= return => so high

Coefficients of style funds are nonnegative.

Style analysis reveals the strategy that most closely tracks the funds
activities and gauges the performance relative to this strategy.

17

Style analysis and multifactor

benchmarks

Question: Suppose a growth portfolio exhibits

superior performance relative to SP500. Including
growth funds in a benchmark will eliminate the
alpha. Is it appropriate?

Conventional performance benchmark is a fourfactor model with size, book-to-market, market

index, and momentum as four factors.

The factors used in a benchmark are part of the

funds alternative passive strategies.
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Performance attribution

Decomposing overall performance into components that

may be identified
Components are related to a particular level of the
portfolio selection process
Example components
Broad Allocation
Industry
Security Choice
Up and Down Markets

19

Performance attribution
process
1. Create benchmark (bogey) portfolio against which

performance is measured.
Bogey portfolio is a passive portfolio.
Neutral sector allocation across asset classes.
Within each asset class hold index portfolio.
2. Sector selection
3. Security selection
4. Contribution of overlay strategies (derivatives/currency
hedging)

20

Performance attribution
process

Calculate the return on the Bogey and on the managed

portfolio
Explain the difference in return based on component
weights or selection
Summarize the performance differences into appropriate
categories

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Formula for Attribution

n

i =1

i =1

rB = wBi rBi ; rp = w pi rpi

n

i =1

i =1

i =1

rp rB = w pi rpi wBi rBi = ( w pi rpi wBi rBi )

Contribution from asset allocation

( w pi wBi )rBi

Contribution from security selection

w pi (rpi rBi )

Where B is the bogey portfolio and p is the managed portfolio

22

Bogey and managed portfolio

Managed portfolio invests 70% in equity, 7% in bonds, 23% in cash:

Return of managed portfolio = 0.7*7.28+0.07*1.89+0.23*0.48 = 5.34%
23

Performance Attribution

stock
bond
active port
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Sector Selection within the

Equity Market

=>very skillfull

=> rotate difft

factor 25