PORTFOLIO MANAGEMENT/

PERFORMANCE MEASURES.
Portfolio Optimization- Group-6

Submitted By-Group-6- Vikrant Kumar(20172314), Arushi Singh

(20172289), Surbhi Miglani(20172261), Udit Bhardwaj(20172203), Anshul
Sindwani (20172371), Arun Vaidyanathan(20172205), Komal
Kashyap(20172296)
 1

Contents
Introduction .................................................................................................................................................. 2
Conventional methods .................................................................................................................................. 2
Benchmarking Comparison ....................................................................................................................... 2
Style Comparison ...................................................................................................................................... 2
Risk-adjusted comparison methods.............................................................................................................. 3
Treynor Ratio ............................................................................................................................................ 3
Example Treynor Ratio .............................................................................................................................. 4
Sharpe Ratio (Sharpe, (1966)) ................................................................................................................... 5
JENSEN MEASURE ..................................................................................................................................... 5
Example ................................................................................................................................................. 6
Critics of Jensen’s Measure................................................................................................................... 6
Modigliani and Modigliani ....................................................................................................................... 6
Comparison & cnclusion ............................................................................................................................... 7
References .................................................................................................................................................... 8

1|Page
 Introduction 2

Introduction
The portfolio performance measure is the process of determining the performance of managed
portfolio relative to a set comparative benchmark. Earlier, the managers used to determine the
success of their portfolio based on return only later on it got improvised & the assessment started
done on the basis of both risk & return. Nearly after 1960 the investors started to quantify &
calculate the variability of risk & return together. In general there are two methods of performance
measure: Conventional method & the Risk adjusted method. The conventional method includes
the benchmark & style comparison. In general, the risk adjusted methods are better than the
conventional one. The risk adjusted method takes into consideration of return to the levels of risk
in the managed vs the benchmark portfolio. The methods of calculating the risk-adjusted returns
are Sharpe-ratio, Treynor-ratio, Jensen’s-alpha, Modigilani & Modigilani & the treynor-square.
These all ratios combines the risk & the return into a single quantifiable value which helps in better
assessment of portfolio. The evaluation of portfolio plays a very important role. It helps the
investor in finding out the relative performance of its portfolio. It helps in making the investor
aware about rebalancing or modification of the portfolio is necessary or not.

Conventional methods
Conventional method generally do not involves the risk involved in the portfolio & assess solely
on the return basis. There are two conventional methods that are used to assess the portfolio:
Benchmarking & style methods.

Benchmarking Comparison
It is the comparison of the portfolio relative to any broader market index like Nifty50, BSE,
S&P500. If the return is more than the index in a same given time frame then it can be said that
the portfolio is better & has beaten the market. The problem in comparing with the passive index
(Market index) is that it does not include the risk factor. The level of risk in the benchmark index
portfolio may not be same as that of investment portfolio. So, the return of an investment portfolio
may be high because it contains riskier assets. Thus a simple comparison based on return is not
give a very valid result.

Style Comparison
It involves comparison based on return with that which have a same investment style. The various
type of styles includes the value vs the growth style. The value style prefers to do investment in
the companies which are undervalued like the companies which have low P/E ratio etc. While the
growth style prefers to invest in portfolios that includes the companies whose revenue or the
earnings are expected to grow at a faster rate. In this the comparison is made based on similar style
benchmark portfolio like a growth style is compared with growth style benchmark portfolio & the
value style with a value style benchmark portfolio. The problem in this comparison is that the risk
in the portfolio & the benchmarking portfolio may not be same so it will not give a valid result.

2|Page
 Risk-adjusted comparison methods 3

Risk-adjusted comparison methods

These methods make adjustment to return with taking into account of the various differences in risk
levels. The following are the main types of Risk-adjusted comparison methods

Treynor Ratio
Treynor ratio is based only on systematic risk. Hence, when an investor chooses to add his
investment to well diversified portfolio, Treynor ratio is considered to be more appropriate. The
Treynor’s ratio requires a good reference index because the denominator i.e. beta depends largely
on the chosen benchmark. In case the market exposure varies a lot, the beta might be distorted.
The calculation of Treynor ratio is very convenient for aggregation of portfolios, as the beta used
is the weighted sum of constituent betas. The funds to be evaluated here are specialized funds and
usually form a small composition of the investor’s portfolio. Specialized funds are funds that focus
on specific industries. These are of three types: sector funds, balanced funds, asset allocation and
target date funds.
According to standard CAPM, the expected asset return, 𝜇𝑄 − 𝑟𝑓 , for a portfolio Q with risky assets
is given by,
𝜇𝑄 − 𝑟𝑓 = 𝛽𝑄 (𝜇𝑀 − 𝑟𝑓 )

Where, 𝜇𝑀 is the mean return for market portfolio M

2
𝛽𝑄 = 𝑐𝑜𝑣(𝑟𝑄 , 𝑟𝑀 )/𝜎𝑀

In the above equation 𝛽𝑄 , is used to measure the systematic risk (non-diversifiable) for portfolio
Q, its covariance with the market.
According to CAPM, for each asset or portfolio, the excess return per unit of systematic risk is e
qual to the excess return on the market portfolio.
𝜇𝑖 − 𝑟𝑓
= 𝜇𝑀 − 𝑟𝑓
𝛽𝑖
For 𝛽𝑖 , 𝜇𝑖 , will be plotted along a straight line. The intercept of this line will be 𝑟𝑓 and slope will
be 𝜇𝑀 − 𝑟𝑓 .

3|Page
 Risk-adjusted comparison methods 4

Linearity for portfolio Q, with weights 𝑥𝑖 , i=1,2…, N

The beta of a portfolio of assets is calculated by the weighted average of betas of the portfolio’s
components.
The Treynor ratio (𝑇𝑄 ) is defined by the excess return per unit of systematic risk as:
𝝁 𝑸 − 𝒓𝒇
𝑻𝑸 =
𝜷𝑸

If the value of T is greater than the value of 𝜇𝑀 − 𝑟𝑓 , the fund manager will outperform the
benchmark. The values of T can also be utilized for the ranking of portfolios of investment
managers.

Example Treynor Ratio

Suppose that the 10 year return from NSE 50(Market index return) is 10% & the return of treasury
bill is 5%(a measure of systematic risk, 𝑟𝑓 ). We will then evaluate for three distinct investor as
shown in table-1. We have assumed the return per annum & the beta for all three investors.

Return per Govt. bond Treynor

Investor annum(rp) return(rf) Beta Ratio
Market(NSE-
50) 10% 0.05 1 0.050
Investor-1 10% 0.05 0.91 0.055
Investor-2 13% 0.05 1.01 0.079
Investor-3 15% 0.05 1.4 0.071
TABLE 1- TREYNOR RATIO
As we can see that although the return in Investor-3 is highest but the risk adjusted return is highest
in case of Investor-2. This says that the investor -2 is better according to risk adjusted return
compared to Investor-3 which only considers the return. So, a portfolio manager handling investor-
2 is better.

4|Page
 Risk-adjusted comparison methods 5

Sharpe Ratio (Sharpe, (1966))

This ratio calculates the assessment based on risk premium per unit of portfolio total risk. It is
similar to the Treynor Measure except in this the risk is quantified in terms of standard deviation
of the portfolio & not only considering the beta(systematic risk). It uses total risk to do the
comparison between the portfolio to the capital market line.
Sharpe ratio = (Portfolio return-risk free rate of return)/Standard deviation of the portfolio

S= (𝐫𝐩 − 𝐫𝐟)/𝝈𝟐𝑴
Here, S= Sharpe Ratio, rp= Portfolio return, rf= The risk free rate of return
Here, the numerator is catching the benefits of investing in risky asset & the denominator catches
the risk i.e. the variation in the return from the portfolio. So, the Sharpe ratio is also known as the
reward-to-variability” ratio.
Example- Sharpe Ratio
Suppose that the 10 year return from NSE 50(Market index return) is 10% & the return of treasury
bill is 5%(a measure of systematic risk, rf). We will then evaluate for three distinct investor as
shown in table-2.

Return per Govt. bond Standard deviation Sharpe

Investor annum(rp) return(rf) of portfolio Ratio
Market (NSE-
50) 10% 0.05 0.17 0.29
Investor-1 14% 0.05 0.11 0.82
Investor-2 16% 0.05 0.21 0.52
Investor-3 20% 0.05 0.3 0.50

As we can see that the return is coming highest in case of investor-3 but when we consider the risk
adjusted return then Investor-1 is considered better as its Sharpe ratio is highest. So, this shows
that a portfolio with lower return can be better in a risk adjusted return.

JENSEN MEASURE
Jensen Measure it the test to check efficiency of the market weather manager has added value to
the portfolio. It is a statistical method to measure that part of return which is not explained and
determined by the market or in relation with market but rather than performance of the portfolio
manager or investor. It is also called alpha/ Jensen alpha measure, represents the average return on
portfolio/investment. Returns above and below the average rate of return are predicted using
CAPM (Capital Asset Pricing Model)

5|Page
 Risk-adjusted comparison methods 6

To check the performance of portfolio, investor focus not only on the returns but also look how
investment/portfolio manager look at the risk of that portfolio and how it is going to compensate
for risk he is willing to take. It is the perfect measure of return at different level of risk. If a>0,
positive value means portfolio manager beating the market with his stock basket skills, earning
excess returns.
Jensen’s Alpha Calculated as
Alpha=Portfoli0 return −benchmark portfoli0 return

Benchmark-return(CAPM)= Rf +Beta(Return from market risk-free rate of return)

Alpha = R(i) –R(f) + B*{ (R(m) – R(f)}

Where,
R(i) = Realized return of the portfolio/ investment
R(m) = Realized return of the appropriate market index
R(f) = Risk free rate of return
B = The beta of the portfolio/investment with respect to market index

Example
assume a mutual fund realized a return of 15% last year. The appropriate market index for this
fund returned 12%. The beta of the fund versus that same index is 1.2 and the risk-free rate is 3%.
The fund's alpha is calculated as:
Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%.
Given a beta of 1.2, the mutual fund is expected to be riskier than the index, and thus earn more.
A positive alpha in this example shows that the mutual fund manager earned more than enough
return to be compensated for the risk he took over the course of the year. If the mutual fund only
returned 13%, the calculated alpha would be -0.8%. With a negative alpha, the mutual fund
manager would not have earned enough return given the amount of risk he was taking.

Critics of Jensen’s Measure

It generally believes in EMH, Efficient market hypothesis by Eugene fama says that the excess
returns are the result of random choice and luck rather than manager experience and skills, they
believe that there is information symmetry in the market and accurately priced. Furthermore, it
says that manager is not left with anything to bring new on the table. On the other side, it is
supporting in the way that many managers failed to beat the market any more than those who invest
their clients’ money in passive funds.

Modigliani and Modigliani

Modigliani and Modigliani had developed the risk-adjusted performance measure (RAP) also
known as M-squared in 1997. RAP is now widely used and practiced by many managers. Risk-
adjusted performance measure uses standard deviation to measure the extent of risk. Therefore,

6|Page
 Comparison & cnclusion 7

RAP is beneficial to investors who want to invest their complete amount into a single fund. It is
commonly used to measure the performance of investment funds.
Modigliani and Modigliani’s method of measuring risk creates the same degree of total risk as the
market index by de-leverage. The RAP expresses the average return of resulting risk-adjusted fund
in basis points. The RAP can be calculated as follows:
𝜎𝑀
𝑅𝐴𝑃𝑖 = 𝜇𝑅𝐴𝐹 𝑖 = (𝜇 − 𝑟𝑓 ) + 𝑟𝑓
𝜎𝑖 𝑖
= 𝑆𝑅𝑖 𝜎𝑀 + 𝑟𝑓

The risk-adjusted performance modifies the Sharpe ratio into an absolute performance measure.
This can be used to rank the funds without relying on the market index that has been chosen.

Comparison & cnclusion

The portfolio assessment must include the risk factor. A portfolio assessment only on the basis of
return will not yield a better result. So, a portfolio performance based on risk adjusted return is
better. Table 1 shows a Jigsaw puzzle of basic risk-adjusted performance measures. This table
helps us to understand the difference between the mentioned performance measures in a better
way. It has segregated the performance measures on the basis of type of risk they take into account
i.e. total risk or market risk. The comparison between different ratio has been shown in table.

Interpretation/Risk Total Risk Market Risk

Ratio dividing the excess return of the fund by
its risk. Sharpe Ratio Treynor Ratio

Differentiated return between fund and risk

adjusted market index Total Risk Alpha Jensen Alpha

Return of the risk adjusted fund RAP MRAP

The various portfolio performance measures have been compared in Figure 4. The left most
column depicts the interpretation of the performance measures, and the ratios have been segregated
on the basis of total risk and market risk. The main difference between Sharpe ratio and Treynor
ratio is that Sharpe ratio takes into account the total risk, whereas, Treynor ratio takes into account
the market risk because it takes into consideration the systematic risk. Similarly, Jensen Alpha also
takes into account the market risk. Modigliani and Modigliani’s risk-adjusted performance (RAP)
measure takes into account the total risk. The modified version of RAP takes into account the
market risk and is known as market risk-adjusted performance measure (MRAP).

7|Page
 References 8

References

1. Cogneau, P., & Hübner, G. (2009). The 101 ways to measure portfolio performance. Available at
SSRN 1326076.

2. Modigliani, F., & Leah, M. (1997). Risk-adjusted performance. Journal of portfolio management, 23(2),
45.

3. Nielsen, L. T., & Vassalou, M. (2004). Sharpe ratios and alphas in continuous time. Journal of
Financial and Quantitative Analysis, 39(1), 103-114.

4. Sharpe, W. F. (1994). The sharpe ratio. Journal of portfolio management, 21(1), 49-58.

5. Scholz, H., & Wilkens, M. (2005). A jigsaw puzzle of basic risk-adjusted performance
measures. Journal of performance measurement, 57.

6. Scholz, H., & Wilkens, M. (2005). Investor-Specific Performance Measurement: A Justification of

Sharpe Ratio and Treynor Ratio. International Journal of Finance, 17(4).

8|Page