FINA2004 Unit 8

U U N IT
8
Evaluation of Portfolio
Performance
Overview
In this chapter we will examine the theory and practice of evaluating an investment
portfolio. The portfolio manager is not only required to derive portfolio returns,
but also required to diversify the portfolio risk. We will first examine the objectives
of portfolio managers, and then the composite performance measures for portfolio
performance.
Unit 8 Learning Objectives

By the end of this unit, students should be able to:
• Calculate portfolio performance using performance indices.
• Compare the performance indices
This Unit is divided into two sessions as follows:
Session 8.1: Portfolio Manager Requirements
Session 8.2: Composite Portfolio Performance Measures
Readings and Resources

Required Reading
Faure, P. D. (2013). The Financial System. In Investments: An Introduction. Quoin
Institute (Pty) Ltd. and bookbook.com. Retrieved from
http://bookboon.com/en/investments-an-introduction-ebook
26  © 2015 University of the West Indies Open Campus

SSession 8.1
Portfolio Manager Requirements
Introduction
In order to achieve returns on an investment portfolio, a portfolio manager must have
a thorough understanding of his job requirements.
Session Objectives
By the end of this session, you will be able to:
• Describe the requirements of a portfolio manager
Portfolio Manager Attributes

Two desirable attributes of a portfolio manager performance
– The ability to derive above-average returns for a given risk class. The superior
risk-adjusted returns can be derived from either
• Superior timing
• Superior security selection
– The ability to diversify the portfolio completely to eliminate unsystematic risk

relative to the portfolio’s benchmark
• A completely diversified portfolio is perfectly correlated with the fully

diversified benchmark portfolio
Session Summary
Now that we have covered the basic attributes of a portfolio manager, we can move on
to the examination of a portfolio’s performance.
27  FINA2004 Portfolio Management – UNIT 5

SSession 8.2
Composite Portfolio Performance

Measures
Introduction
Performance evaluation is an essential part of the process of managing investment
portfolios. There are two indices to be considered for measuring portfolio performance:
Treynor and Sharpe.
Treynor Portfolio Performance Measure
Treynor portfolio performance measure considers:
• market risk
• individual security risk.
The security market line was put forward by Treynor.
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 market or systematic risk
The Formula
Ri - RFR ( )
Ti = βi
The numerator is the risk premium
The denominator is a measure of risk
The value 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.

Example
Assume the market return is 14% and the risk-free rate is 8%. The average annual returns
for Managers W, X, and Y are 12%, 16%, and 18% respectively. The corresponding
betas are 0.9, 1.05, and 1.20. What are the T values for the market and managers?
The T Values
TM = (14%-8%) / 1 =6%
TW = (12%-8%) / 0.9 =4.4%
TX = (16%-8%) / 1.05 =7.6%
TY = (18%-8%) / 1.20 =8.3%
Video
The following video explains the calculation of the Treynor Ratio:
https://www.youtube.com/watch?v=lgx1rH5qTaI
Sharpe Portfolio Performance Measure

Sharpe portfolio performance measure:
• Shows the risk premium earned over the risk free rate per unit of standard deviation
• Sharpe ratios greater than the ratio for the market portfolio indicate superior
performance
The formulae
S = Ri - RFR
( )
i
δi
where
δi = the standard deviation of the rate of return for Portfolio i
Example
Assume the market return is 14% with a standard deviation of 20%, and risk-free rate
is 8%. The average annual returns for Managers D, E, and F are 13%, 17%, and 16%
respectively. The corresponding standard deviations are 18%, 22%, and 23%. What are
the Sharpe measures for the market and managers?

SM = (14%-8%) / 20% =0.300
SD = (13%-8%) / 18% =0.273
SE = (17%-8%) / 22% =0.409
SF = (16%-8%) / 23% =0.348
ACTIVITY 8.1
Exercise:
1. Compute the Sharpe Ratio for a portfolio with a return of 0.15, beta
of 1.0 and standard deviation of 0.05.
Treynor versus Sharpe Measure

A comparison of Treynor and Sharpe Measure is illustrated in the table below
Characteristic Treynor Measure Sharpe Measure

Measure of risk Standard deviation Beta (systematic risk)
Portfolio Evaluation Rate of return performance Rate of return performance
and diversification and diversification
Rankings for diversified Similar Similar
portfolios
Rankings for performance Relative not absolute Relative not absolute
Session Summary
Now that we know how to determine performance of an investment portfolio, we can

apply this to making investment decisions and diversifying an investment portfolio.
Unit 8 Summary
Unit 8 has provided students with the information needed to evaluate investment
portfolios.

References
HedgeFundGroup. (2011, September 19). The Treynor Ratio [Video File]. Retrieved
from https://www.youtube.com/watch?v=lgx1rH5qTaI
Reilly, F. K., & Brown, K. C. (2012). Investment Analysis and Portfolio Management. South-
Western Cengage Learning.

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U U N IT

Unit 8 Learning Objectives

• Calculate portfolio performance using performance indices.

• Compare the performance indices

This Unit is divided into two sessions as follows:

Session 8.1: Portfolio Manager Requirements

Session 8.2: Composite Portfolio Performance Measures

Readings and Resources

26  © 2015 University of the West Indies Open Campus

Portfolio Manager Requirements

• Describe the requirements of a portfolio manager

Portfolio Manager Attributes

• Superior security selection

– The ability to diversify the portfolio completely to eliminate unsystematic risk

• A completely diversified portfolio is perfectly correlated with the fully

27  FINA2004 Portfolio Management – UNIT 5

Composite Portfolio Performance

Treynor Portfolio Performance Measure

Treynor portfolio performance measure considers:

• individual security risk.

The security market line was put forward by Treynor.

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 market or systematic risk

The numerator is the risk premium

The denominator is a measure of risk

28  FINA2004 Portfolio Management – UNIT 5

TW = (12%-8%) / 0.9 =4.4%

TX = (16%-8%) / 1.05 =7.6%

TY = (18%-8%) / 1.20 =8.3%

Sharpe Portfolio Performance Measure

δi = the standard deviation of the rate of return for Portfolio i

29  FINA2004 Portfolio Management – UNIT 5

SD = (13%-8%) / 18% =0.273

SE = (17%-8%) / 22% =0.409

SF = (16%-8%) / 23% =0.348

Treynor versus Sharpe Measure

Characteristic Treynor Measure Sharpe Measure

Now that we know how to determine performance of an investment portfolio, we can

30  FINA2004 Portfolio Management – UNIT 5

31  FINA2004 Portfolio Management – UNIT 5

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