1

Portfolio Construction, Management, & Protection, 5e, Robert A. Strong

Copyright 2009 by South-Western, a division of Thomson Business & Economics. All rights reserved.
Performance evaluation is a critical aspect of
portfolio management

Proper performance evaluation should involve
a recognition of both the return and the
riskiness of the investment
2
When two investments returns are compared,
their relative risk must also be considered
People maximize expected utility:
A positive function of expected return
A negative function of the return variance


3
2
( ) ( ), E U f E R o
(
=

44 Wall Street and Mutual Shares both had
good returns over the 1975 to 1988 period

Mutual Shares clearly outperforms 44 Wall
Street in terms of dollar returns at the end of
1988
4
The arithmetic mean may give misleading
information
e.g., a 50 percent decline in one period followed by a
50 percent increase in the next period does not
produce an average return of zero


5
The proper measure of average investment
return over time is the geometric mean:

6
1/
1
1
where the return relative in period
n
n
i
i
i
GM R
R i
=
(
=
(

=
[
The geometric means in the preceding example
are:
44 Wall Street: 7.9 percent
Mutual Shares: 22.7 percent

The geometric mean correctly identifies Mutual
Shares as the better investment over the 1975 to
1988 period


7
Example

A stock returns 40% in the first period, +50% in the
second period, and 0% in the third period. [The average
rate of return is 3.3%]

What is the geometric mean over the three periods?




8
Example

Solution: The geometric mean is computed as follows:




| |
% 45 . 3 0345 . 0
1 ) 00 . 1 )( 50 . 1 )( 60 . 0 (
1
3 / 1
/ 1
1
= =
=

(
(

=
[
=
n
n
i
i
R GM
9
Assume two funds:
Fund A has $40 million in investments and earned
12 percent last period

Fund B has $250,000 in investments and earned 44
percent last period
10
The correct way to determine the return of both
funds combined is to weigh the funds returns
by the dollar amounts:


11
$40, 000, 000 $250, 000
12% 44% 12.10%
$40, 250, 000 $40, 250, 000
| | | |
+ =
| |
\ . \ .
Sharpe Measure
Treynor Measures
Jensen Measure
Performance Measurement in Practice
12
The Sharpe and Treynor measures:

13
Sharpe measure
Treynor measure
where average return
risk-free rate
standard deviation of returns
beta
f
f
f
R R
R R
R
R
o
|
o
|

=
=
=
=
=
The Sharpe measure evaluates return relative
to total risk
Appropriate for a well-diversified portfolio, but not
for individual securities
The Treynor measure evaluates the return
relative to beta, a measure of systematic risk
It ignores any unsystematic risk

14
Example

Over the last four months, XYZ Stock had excess returns
of 1.86 percent, 5.09 percent, 1.99 percent, and 1.72
percent. The standard deviation of XYZ stock returns is
3.07 percent. XYZ Stock has a beta of 1.20.

What are the Sharpe and Treynor measures for XYZ
Stock?




15
Example (contd)

Solution: First, compute the average excess return for
Stock XYZ:





16
1.86% 5.09% 1.99% 1.72%
4
0.88%
R
+
=
=
Example (contd)

Solution (contd): Next, compute the Sharpe and Treynor
measures:






17
0.88%
Sharpe measure 0.29
3.07%
0.88%
Treynor measure 0.73
1.20
f
f
R R
R R
o
|

= = =

= = =
The Jensen measure stems directly from the
CAPM:

18
( )
it ft i mt ft
R R R R o |
(
= +

The constant term should be zero
Securities with a beta of zero should have an excess
return of zero according to finance theory

According to the Jensen measure, if a portfolio
manager is better-than-average, the alpha of
the portfolio will be positive



19
The use of Treynor and Jensen performance
measures relies on measuring the market
return and CAPM
Difficult to identify and measure the return of the
market portfolio
Evidence continues to accumulate that may
ultimately displace the CAPM
Arbitrage pricing model, multi-factor CAPMs,
inflation-adjusted CAPM

20
Portfolio managers are hired and fired largely
on the basis of realized investment returns with
little regard to risk taken in achieving the
returns

Practical performance measures typically
involve a comparison of the funds
performance with that of a benchmark
21
Famas return decomposition can be used to
assess why an investment performed better or
worse than expected:
The return the investor chose to take
The added return the manager chose to seek
The return from the managers good selection of
securities
22
Diversification is the difference between the
return corresponding to the beta implied by the
total risk of the portfolio and the return
corresponding to its actual beta
Diversifiable risk decreases as portfolio size
increases, so if the portfolio is well diversified the
diversification return should be near zero
23
Net selectivity measures the portion of the
return from selectivity in excess of that
provided by the diversification component
24
Portfolio managers want to minimize the
impact of their trading on share price
A buy order increases demand and price
Portfolio managers frequently take the opposite
position in the pre-market trading
Volume weighted average price compares the
average market price to the average price paid
by (or received) by a manager

25
Implementation shortfall is the difference between the
value of a on-paper theoretical portfolio and
portfolio purchased
On-paper portfolio is based upon price of last
reported trade
Actual purchases are likely to lead to higher costs due
to
Commissions
Bid-Ask Spread the prior trade may have been at a bid,
while your trade may be at the ask price (reverse if selling)
Market trend are prices moving higher?
Liquidity impact your demand may exceed share available a
lower price
Or, shares sold may exceed the number purchased at higher price
26
The dollar-weighted rate of return is
analogous to the internal rate of return in
corporate finance
It is the rate of return that makes the present
value of a series of cash flows equal to the cost of
the investment:

3
3
2
2 1
) 1 ( ) 1 ( ) 1 (
cost
R
C
R
C
R
C
+
+
+
+
+
=
27
The time-weighted rate of return measures
the compound growth rate of an investment
It eliminates the effect of cash inflows and
outflows by computing a return for each period
and linking them (like the geometric mean
return):


1 ) 1 )( 1 )( 1 )( 1 ( return weighted - time
4 3 2 1
+ + + + = R R R R
28
The time-weighted rate of return and the
dollar-weighted rate of return will be equal
if there are no inflows or outflows from the
portfolio


29
The owner of a fund often takes periodic
distributions from the portfolio, and may
occasionally add to it

The established way to calculate portfolio
performance in this situation is via a time-
weighted rate of return:
Daily valuation method
Modified BAI method
30
The daily valuation method:
Calculates the exact time-weighted rate of return
Is cumbersome because it requires determining a
value for the portfolio each time any cash flow
occurs
Might be interest, dividends, or additions to or
withdrawals
31
The daily valuation method solves for R:

32
daily
1
1
where
n
i
i
i
i
R S
MVE
S
MVB
=
=
=
[
MVE
i
= market value of the portfolio at the end
of period i before any cash flows in period i but
including accrued income for the period

MVB
i
= market value of the portfolio at the
beginning of period i including any cash flows at
the end of the previous subperiod and including
accrued income


33
The modified BAI method:
Approximates the internal rate of return for the
investment over the period in question

Can be complicated with a large portfolio that might
conceivably have a cash flow every day

34
It solves for R:

35
1
0
(1 )
where the sum of the cash flows during the period
market value at the end of the period,
including accrued income
market value at the start of the period
to
i
n
w
i
i
i
i
MVE F R
F
MVE
F
CD D
w
CD
CD
=
= +
=
=
=

=
=

tal number of days in the period

number of days since the beginning of the period
in which the cash flow occurred
i
D =
An investor has an account with a mutual fund
and dollar cost averages by putting $100 per
month into the fund

The following slide shows the activity and
results over a seven-month period
36
Date Description $ Amount Price Shares
Total
Shares Value
January 1 balance
forward
$7.00 1,080.011 $7,560.08
January 3 purchase 100 $7.00 14.286 1,094.297 $7,660.08
February 1
purchase 100 $7.91 12.642 1,106.939 $8,755.89
March 1 purchase 100 $7.84 12.755 1,119.694 $8,778.40
March 23 liquidation 5,000 $8.13 -615.006 504.688 $4,103.11
April 3 purchase 100 $8.34 11.900 516.678 $4,309.09
May 1 purchase 100 $9.00 11.111 527.789 $4,750.10
June 1 purchase 100 $9.74 10.267 538.056 $5,240.67
July 3 purchase 100 $9.24 10.823 548.879 $5,071.64
August 1 purchase 100 $9.84 10.163 559.042 $5,500.97
August 1 account value: $559.042 x $9.84 = $5,500.97
37
The daily valuation method returns a time-
weighted return of 40.6 percent over the seven-
month period
See next slide
38
Date Sub Period MVB Cash Flow
Ending
Value MVE MVE/MVB
January 1 $7,560.08
January 3 1 $7,560.08 100 $7,660.08 $7,560.08 1.00
February 1
2 $7,660.08 100 $8,755.89 $8,655.89 1.13
March 1 3 $8,755.89 100 $8,778.40 $8,678.40 0.991
March 23 4 $8,778.40 5,000 $4,103.11 $9,103.11 1.037
April 3 5 $4,103.11 100 $4,309.09 $4,209.09 1.026
May 1 6 $4,309.09 100 $4,750.10 $4,650.10 1.079
June 1 7 $4,750.10 100 $5,240.67 $5,140.67 1.082
July 3 8 $5,240.67 100 $5,071.64 $4,971.64 0.949
August 1 9 $5,071.64 100 $5,500.97 $5,400.97 1.065
Product of MVE/MVB values = 1.406; R = 40.6%
39
The BAI method requires use of a computer

The BAI method returns a time-weighted
return of 42.1 percent over the seven-month
period (see next slide)

40
Proposed by the American Association of
Individual Investors:

41
1
0
0.5(Net cash flow)
1
0.5(Net cash flow)
where net cash flow is the sum of inflows and outflows
P
R
P

=
+
Using the approximate method in Table 17-6:

42
1
0
0.5(Net cash flow)
1
0.5(Net cash flow)
5, 500.97 0.5( 4, 200)
1
7, 550.08 0.5(-4, 200)
0.395 39.5%
P
R
P

=
+

=
+
= =
Inclusion of options in a portfolio usually
results in a non-normal return distribution
Beta and standard deviation lose their
theoretical value if the return distribution is
nonsymmetrical
Consider two alternative methods when
options are included in a portfolio:
Incremental risk-adjusted return (IRAR)
Residual option spread (ROS)

43
The incremental risk-adjusted return (IRAR)
is a single performance measure indicating the
contribution of an options program to overall
portfolio performance
A positive IRAR indicates above-average
performance
A negative IRAR indicates the portfolio would have
performed better without options
44
Use the unoptioned portfolio as a benchmark:
Draw a line from the risk-free rate to its realized
risk/return combination

Points above this benchmark line result from
superior performance
The higher than expected return is the IRAR
45
The IRAR calculation:

46
( )
where Sharpe measure of the optioned portfolio
Sharpe measure of the unoptioned portfolio
standard deviation of the optioned portfolio
o u o
o
u
o
IRAR SH SH
SH
SH
o
o
=
=
=
=
A portfolio manager routinely writes index call
options to take advantage of anticipated
market movements
Assume:
The portfolio has an initial value of $200,000
The stock portfolio has a beta of 1.0
The premiums received from option writing are
invested into more shares of stock
47
The IRAR calculation (next slide) shows that:
The optioned portfolio appreciated more than the
unoptioned portfolio

The options program was successful at adding 11.3
percent per year to the overall performance of the
fund
48
IRAR can be used inappropriately if there is a
floor on the return of the optioned portfolio
e.g., a portfolio manager might use puts to protect
against a large fall in stock price
The standard deviation of the optioned
portfolio is probably a poor measure of risk in
these cases
49
The residual option spread (ROS) is an
alternative performance measure for portfolios
containing options
A positive ROS indicates the use of options
resulted in more terminal wealth than only
holding the stock
A positive ROS does not necessarily mean that
the incremental return is appropriate given the
risk
50
The residual option spread (ROS) calculation:

51
1 1
1
where /
value of portfolio in Period
n n
ot ut
t t
t t t
t
ROS G G
G V V
V t
= =

=
=
=
[ [
The worksheet to calculate the ROS for the
previous example is shown on the next slide

The ROS translates into a dollar differential of
$1,452
52
Unoptioned Portfolio
(0.95)(1.03)(1.04)(0.98)(0.97)(1.04)(1.03) = 1.03625

Optioned Portfolio
(0.9727)(1.0217)(1.0255)(0.9926)(0.9854)(1.0272)(1.0191) = 1.04351

ROS = 1.04351 1.03625 = 0.00726

Given an initial investment of $200,000, the ROS
translates into a dollar differential of $200,000 x 0.00726 =
$1,452.

53
IRAR and ROS both focus on whether an
optioned portfolio outperforms an unoptioned
portfolio
Can overlook subjective considerations such as
portfolio insurance
54