Investment Analysis and Portfolio Management (ACFN 632) : Chapter 5 - Performance Evaluation

Investment Analysis and
Portfolio Management
(ACFN 632)
Chapter 5 - Performance
Evaluation
1
Topics to be covered
• Performance Measurement
• Risk Adjusted Performance Measures
• Measures of Sharpe, Treynor and

Jensen
• Measures of bond performance
2
What is Required of
a Portfolio
Manager?
There are two major requirements of a portfolio
manager:
1. The ability to derive above-average returns for a
given risk class. Superior risk-adjusted returns can
be derived from either:
– superior timing or
– superior security selection
2. The ability to diversify the portfolio completely

to eliminate unsystematic risk. 3
Portfolio Performance
• Evaluation
Investors always are interested in evaluating the
performance of their portfolios. It is both expensive and
time consuming.
• How well did the portfolio do?
• How do we adjust for risk, to compare different
managers?
• Why?
• Risk
• Timing
• Asset allocation
• Security selection
4
Early Performance Measure
Techniques
• Portfolio evaluation before 1960
– Once upon a time, investors evaluated a portfolio’s
performance based purely on the basis of the rate
of return- know risk but do not know how to
quantify and measure.
– Research in the 1960’s showed investors how to
quantify and measure risk.
– Grouped portfolios into similar risk classes
5
and compared rates of return within risk
Peer Group Comparisons
• This is the most common manner of evaluating
portfolio managers.
• Collects returns of a representative universe of investors
over a period of time and displays them in a box plot
format.
There are several potential problems/Issue:
 There is no explicit/open adjustment for risk- Risk is
only considered implicitly-to the extent that all the portfolios in the
universe have essentially the same level of volatility.
Impossible to form a truly comparable peer group that is large enough to
make the percentile rankings valid and meaningful.
6
Treynor Portfolio
Performance
Measure
7
Treynor
• Treynor (1965) developed the first composite measure of portfolio
(1965)
performance that included risk.
• He postulated two components of risk: (1) risk produced by general market
fluctuations and (2) risk resulting from unique fluctuations in the portfolio
securities.
• He introduced the portfolio characteristic line, which defines a relation between
the rate of return on a specific portfolio and the rate of return on the market
portfolio.
•The beta is the slope that measures the volatility of the portfolio’s
returns relative to the market. A higher slope (beta) characterizes a
portfolio that is more sensitive to market returns and that has greater
market risk. 8 8
Treynor Measure
A risk-adjusted measure of return that divides a portfolio‘s excess
return by its beta.
The Treynor’s Measure is given by slope of portfolio
possibility line (designated T) which is equal to:
Because the numerator of this ratio (R - RFR) is the risk premium and the
denominator is a measure of risk, the total expression indicates the portfolio’s
risk premium return per unit of risk.
• The Treynor Measure is defined using the average rate of

9 9
return for portfolio p and the risk-free asset.
Treynor Measure
R
p  rp
T = p f
• A larger Tp is better for all investors, regardless of their

risk preferences.
• Because it adjusts returns based on systematic risk, it is
the relevant performance measure when evaluating
diversified portfolios held in separately or in combination
with other portfolios.
10 10
Treynor
• Beta measures Measure
systematic risk
• Hence, it implicitly assumes a completely diversified

portfolio.
• Portfolios with identical systematic risk, but different total risk,

will have the same Treynor ratio!
• Higher idiosyncratic risk should not matter in a diversified portfolio

and hence is not reflected in the Treynor measure.
•Very poor return performance or very good performance with very
low risk may yield negative T values.
•A portfolio with a negative beta and an average rate of return above
the risk-free rate of return would likewise have a negative T value
(Treynor measure). 11 11
Composite Portfolio Performance Measures
• Assume the market return is 14% with beta of 1.02 and 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?
12
Composite Portfolio Performance Measures
• Solution:
• Tm= (0.14-0.08)/1.02=0.059
• Tw= (0.12-0.08)/0.9=0.044
• Tx= (0.16-0.08)/1.05=0.076
• Ty=(0.18-0.08)/1.2=0.083
13
Sharpe Portfolio Performance
Measure
14
Sharpe Measure
•The measure followed closely his earlier work on the CAPM,
dealing specifically with the capital market line (CML).
• Similar to the Treynor measure, but uses the total risk of
the portfolio, not just the systematic risk.
• The Sharpe Ratio is given by
•It seeks to measure the total risk of the portfolio by including the standard
deviation of returns rather than considering only the systematic risk i.e. beta
• The larger the measure, the better as the portfolio earned a higher excess
15
return per unit of total risk.
Sharpe Measure
• It adjusts returns for total portfolio risk, as opposed to
only systematic risk as in the Treynor Measure.
• Thus, an implicit assumption of the Sharpe ratio is that
the portfolio is not fully diversified, nor will it be
combined with other diversified portfolios.
• Sharpe originally called it the "reward-to-variability"
ratio, before others started calling it the Sharpe
Ratio. 16
Composite Portfolio Performance
Measures
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? 17
Treynor’s Vs. Sharpe’s
• measure
Treynor’s measure uses Beta, market risk
• Sharpe’s measure uses total risk, standard deviation.
• For a totally diversified portfolio, both measures give equal

rankings.
• If it is not a diversified portfolio, the Sharpe measure
could give lower rankings than the Treynor measure.
• Thus, the Sharpe measure evaluates the portfolio
manager in terms of both return performance and
diversification. 18
Price of Risk
• Both the Treynor’s and Sharp’s measures, indicate
the risk premium per unit of risk, either systematic
risk (Treynor) or total risk (Sharpe).
• They measure the price of risk in units of excess

returns per each unit of risk (measured either by beta
or the standard deviation of the portfolio). 19
Jensen Portfolio
Performance
Measure
20
Jensen’s Alpha
• Alpha is a risk-adjusted measure of superior
performance
• This measure adjusts for the systematic risk of the portfolio.

• Positive alpha signals superior risk-adjusted returns, the
manager is good at selecting stocks or predicting market turning
points.
• Unlike the Sharpe Ratio, Jensen’s method does not consider
the ability of the manager to diversify, as it is only accounts for
21 20
systematic risk.
Evaluation of Bond-Portfolio
Performance
• How did performance compare among
portfolio managers relative to the
overall bond market or specific
benchmarks?
• What factors explain or contribute to
superior or inferior bond-portfolio
22
A Bond Market Line
• The common stock risk measures have been fairly simple either
total risk (the standard deviation of returns) or systematic risk.
• A prime factor needed to evaluate performance properly is a
measure of risk, such as the beta coefficient for equities.
– This is Difficult to achieve due to bond maturity and
coupon effect on volatility of prices.
• Composite risk measure is the bond’s duration. The
bond’s duration statistic captures the net effect of
volatility in price.
– Duration replaces beta as risk measure in a bond market
line.
23
Bond Market Line
Explains differences from benchmark returns as a function
of: Evaluation
 Policy effect: The policy effect measures the difference in the
expected return for a given portfolio because of a difference in
policy regarding the duration of this portfolio compared to the
duration of the index.
Interest rate anticipation effect:
• Differentiated returns from changing duration of the

portfolio.
Analysis effect
• Acquiring temporarily mispriced bonds.
a trading effects: result of the current quarter's

24 24
End
25

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Investment Analysis and

• Risk Adjusted Performance Measures

• Measures of Sharpe, Treynor and

2. The ability to diversify the portfolio completely

• The Treynor Measure is defined using the average rate of

• A larger Tp is better for all investors, regardless of their

• Hence, it implicitly assumes a completely diversified

• Portfolios with identical systematic risk, but different total risk,

• Higher idiosyncratic risk should not matter in a diversified portfolio

• The Sharpe Ratio is given by

• For a totally diversified portfolio, both measures give equal

• They measure the price of risk in units of excess

• This measure adjusts for the systematic risk of the portfolio.

• Differentiated returns from changing duration of the

• Acquiring temporarily mispriced bonds.

a trading effects: result of the current quarter's

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