BFC5935 Portfolio Management and

Theory

Lecture 10 – Portfolio Management II

Lecturer: Dr. Manapon Limkriangkrai, CFA

Learning Outcomes
▪ Relevance of past performance information for decision-
making
▪ Range of risk-adjusted performance measures for
investment portfolios
▪ Performance assessment of managed funds
▪ Evidence concerning the performance of managed
funds
▪ Impact of different portfolio management strategies
may impact on portfolio performance
▪ Morningstar Ratings
▪ Performance Attribution Analysis

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The Investment Funds Industry
• Investors typically have portfolio focus

• Fund manager acts as an intermediary between the

investor and the investment markets, and charges a fee
for their service

• Perception of better skills and management experience

• Fund manager can achieve Economies of scale

• Choice of fund(s) depends on investors'
❑Risk tolerance / Preferences
❑Holding periods
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The Investment Funds Industry

Source: www.unisuper.com.au [INV Options] 4

The Relevance of Past Performance
Key Questions:
▪ Is past performance relevant?
▪ How can fund performance be measured?
▪ What has been the evidence on fund managers
performance?
Past information is typically regarded as an important input in
investment decisions.
▪ Sweeney Research found that 54% of investors regard
long-term performance as the most important factor.
▪ (ASIC) revealed that past performance is included in 70%
of commercial advertisements.

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Performance Measures
The managed funds industry places an emphasis on
performance measures.

Examples include:
▪ the star ratings of Morningstar

▪ the publication of league tables

▪ statistics and rankings of funds based on past

performance that are regularly carried by the Australian
Financial Review and Personal Investment.

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Performance Measures
Benchmark Portfolios

▪Performance evaluation standard

▪Usually a passive index

▪May need benchmark for entire portfolio and separate

benchmarks for segments to evaluate individual managers

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Performance Measures
The Sharpe Index

▪ It is based on the CML:

Ri − RFR
Si =
i

▪ The benchmark value is the Sharpe index for the

market
▪ It does not rely on an asset pricing model
▪ It captures jointly aspects of return and risk

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Performance Measures
The Treynor Index
▪ It is based on the ex-post SML:

R i − RFR
Ti =
i

▪ Superior performance indicated where the Treynor

index exceeds the market risk premium (MRP).

▪ Problems include correct value of MRP, the need to

estimate beta, and the appropriateness of CAPM.

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Performance Measures
Jensen's Alpha
▪ Jensen’s (1968) alpha relies on the SML:

R jt − RFRt = a j +  j [ Rmt − RFRt ] + e jt

▪ If a fund is performing to expectations (relative to

the CAPM) then a would be zero.

▪ Superior performance is indicated positive a while

under-performance negative a.

▪ It relies on CAPM being the correct model.

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Performance Measures
Carhart’s Alpha
▪ A variant on Jensen’s alpha involves invoking the
assumption of an alternative asset pricing model.

▪ Carhart’s four-factor model has four return

generating factors.

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Performance Measures
Information Ratio

R j − Rb ER j
IR j = =
 ER  ER

▪ An efficiency measure

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Performance Measures
M2
M2 = rP
*
− rM
where *
rP = (1 − w )rf + w rP
w = M / P
▪ Adjusts portfolio’s risk to that of the market’s by using
lending or borrowing at the risk-free rate

▪ M2 > 0 indicates that the portfolio outperformed the

market; M2 < 0 indicates underperformance

▪ Gives identical rankings as the Sharpe measure

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Performance Measures
M2
▪ Portfolio P had a return of 10% and a standard deviation of
18%. The market had a return of 11% and a standard
deviation of 20%. Risk-free rate is 5%.

w = .20 / .18 = 1.1111

rP* = ( −0.1111)(.05) + (1.1111)(.10) = .1056
MP2 = .1056 − .11 = −.0044

▪ Portfolio P underperformed the market by 0.44% on a risk-

adjusted basis.

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Performance Measures

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Performance Measures
First, both Funds A and B are judged to be superior
performers.
▪ Their values of Jensen’s alpha are positive.
▪ Both the Sharpe and Treynor indices exceed
those of the market index.
▪ However, Fund A is considered to be the most
efficient given the values of the information ratio.

Second, Fund C is judged to have poor performance.

▪ Negative Jensen’s alpha, Sharpe and Treynor
indices for Fund C are less than those of the
market index.
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Performance Measures
Third, there is inconsistency in rankings across the
measures.

▪ Fund A is ranked highest under both Jensen’s alpha,

the Treynor index and the information ratio.
▪ Fund B is ranked highest under the Sharpe index.
▪ The inconsistency in rankings is due to differences in
the unit risk measure.
▪ The Sharpe index uses standard deviation whereas
the Treynor index uses beta risk.

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Performance Measures
Empirical Evidence

▪ Early studies found that managed funds, on average,

under-performed the benchmarks.
▪ Sharpe (1966): average Sharpe index was less than the
Dow Jones Market Index.
▪ Jensen (1968): average Jensen's alpha was -1.1%.
▪ Recent evidence is mixed.
▪ Findings depend on sample period used, benchmark
index and fees.

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Performance Attribution Analysis
Attribution analysis attempts to distinguish between the
manager’s contribution due to:

▪ Allocation Effect
▪ Selection Effect

The manager’s performance may be compared with a

predetermined benchmark portfolio and decomposed into an
allocation effect and a selection effect.

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Performance Attribution Analysis
Attribution analysis typically starts from the broadest asset
allocation choices and progressively focus on ever-finer
details of portfolio choice
The attribution method explains the difference in returns
between a managed portfolio, P, and a selected benchmark
portfolio called the bogey
The ability to be in the right asset class at the right time
or choosing the relatively better-performing stocks within
a particular industry.

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Performance Attribution Analysis
Allocation Effect = i [(Wai − W pi )][( R pi − Rp )]

Selection Effect =  i [(Wai 0][( Rai − R pi )]

Wai, Wpi, = the investment proportions given to the ith market segment in
the manager’s actual portfolio and the benchmark portfolio, respectively.

Rai, Rpi, = the investment return to the ith market segment in the manager’s
actual portfolio and the benchmark portfolio, respectively.

Rp = the total return to the benchmark portfolio.

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Performance Attribution Analysis
Allocation effect
Over (+) or under (-) weight in a particular market segment
when:

(Wai − W pi ) 
 0 ( Rpi − Rp )  0
Selection effect

(
Wai  Rai − R pi )
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Performance Attribution Analysis
Benchmark Portfolio
Asset class Stocks Bonds Cash
Weights 0.55 0.30 0.15
Return 13.57% 11.58% 9.76%
Overall return 7.46% 3.47% 1.46% 12.40%
Manager’s Portfolio
Asset class Shares Bonds Cash
Weights 0.60 0.32 0.08
Return 14.43% 10. 81% 5.60%
Overall return 8.66% 3.46% 0.45% 12.56%

Manager portfolio is better than benchmark portfolio:

12.56% - 12.40% = 0.16%
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Performance Attribution Analysis
Manager's Allocation Effect
Manager Benchmark Excess Wt Benchmark Overall X-Returns
Weight Weight (M - B) Returns Benchmark (BR - OR)
ASX 0.6 0.55 0.05 13.57% 12.40% 1.17%
Bonds 0.32 0.30 0.02 11.58% 12.40% -0.82%
Cash 0.08 0.15 -0.07 9.76% 12.40% -2.64%

Manager's Allocation Effect

Manager Benchmark Excess Wt X-Returns (Excess Wt)* Attributed
Weight Weight (M - B) (BR - OR) (X-Returns) (M-B)*(BR-OR)
ASX 0.6 0.55 0.05 1.17% (0.05)(1.17%) 0.0585%
Bonds 0.32 0.30 0.02 -0.82% (0.02)(-0.82%) -0.0164%
Cash 0.08 0.15 -0.07 -2.64% (-0.07)(-2.64%) 0.1848%
0.2269%
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 Performance Attribution Analysis

Security Selection Effect

Manager Manager Benchmark Excess Return Attributed

Weight (MW) Returns Returns (MR – BR) (MW *Ex. R)

ASX 0.6 14.43% 13.57% 0.86% 0.516%

Bonds 0.32 10.81% 11.58% -0.77% -0.246%

Cash 0.08 5.60% 9.76% -4.16% -0.333%

-0.063%

Total Value Added = Allocation Effect + Selection Effect

0.227% - 0.063% = 0.164%
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Performance Attribution Analysis
Conclusions
▪ The manager has earned a positive return and therefore
has some skill at market timing and sector allocation.
However, the manager earns negative returns and
demonstrates poor skills at security selection.

▪ Different managers may have different strengths, so the

fund should employ a manager who earns positive
returns at security selection to be included on the team
and have the current manager just perform market
timing decisions.

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Performance Attribution Analysis
• Such analysis can be used to identify even further specific
roles managers are suited for
• Consider the following summaries of the manager’s
performance

Manager's Allocation Effect

Manager's Selection Effect
ASX 0.0585% ASX 0.516%
Bonds -0.0164% Bonds -0.246%
Cash 0.1848% Cash -0.333%

• have the manager perform just Allocation decisions.

• the manager has Stock Selection skill

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Performance Measurement
Morningstar was the first to introduce star ratings for managed
funds in Australia.

• Qualitative research – Recommendation from ‘Highly

Recommended’ to ‘Avoid’.

• Quantitative research – Ratings based on a fund’s Morningstar

Risk-Adjusted Return (MRAR) measure.

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Performance Measurement
Step 1: Establishing the category to which the fund belongs.
Specific categories reflect their similar risk exposure.

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Performance Measurement
Step 2: Star rating is assigned based on the fund’s risk-adjusted
performance.

Morningstar ratings are based on expected utility theory.

• Investors are more concerned about poor performance.

• Investors are willing to give up certain portion of their

expected return for greater certainty.

Funds are rated up to three periods: 3, 5 & 10 years

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Performance Measurement

Source: www.morningstar.com.au 31
Performance Measurement
Source: www.morningstar.com.a

Source: www.morningstar.com.au 32
Performance Measurement
Star Rating Limitations

• Backward looking measure

• Strictly quantitative measure

• Does not take into account of fundamentals

• Rating stays with the fund not the manager

• Not all funds with the same star rating are interchangeable

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Case Study
Hedge Fund: LTCM

▪ Founded in 1994 with the initial capital of ~ $1billion; the

capital increased to over $4billion by 1997.
▪ Partners include two Nobel Prize winners (Prof. Myron
Scholes and Prof. Robert Merton), several PhDs from
M.I.T., and others.
▪ Employ complex mathematical models to conduct fixed
income arbitrage.
▪ Over the period 1995-1997, LTCM had Avg. return over 33%
p.a. [Eicherngreen, 1999]
[LTCM]
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Case Study – LTCM Performance
Source: https://en.wikipedia.org/wiki/Long-Term_Capital_Management#/media/File:LTCM.png

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