Chapter Twenty-Four
Portfolio Performance
Evaluation
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Overview
• Most financial assets are managed by
professional investors
• They allocate most of the capital across firms
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Overview
• Efficient allocation depends on
• Quality of these professionals
• Ability of financial markets to identify and
direct capital to the best stewards.
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Overview
• If markets are efficient, investors must be able
to measure performance of their asset
managers
• Discuss methods to evaluate investment
performance
• Conventional approaches to risk adjustment
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Introduction
• Two common ways to measure average
portfolio return:
1. Time-weighted returns
2. Dollar-weighted returns
• Returns must be adjusted for risk
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Time-Weighted Returns
• Time-weighted average
• Geometric average is a time-weighted average
• Each period’s return has equal weight
1 rG 1 r1 1 r2 ... 1 rn
n
rG 1 r1 1 r2 ... 1 rn
1/ n
1
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Dollar-Weighted Returns
(1 of 2)
• Dollar-weighted rate of return is the internal
rate of return on an investment
• Returns are weighted by the amount invested in
each period
C1 C2 Cn
PV ...
1 r 1 r
1 2
1 r n
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Example of Multiperiod Returns
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Dollar-Weighted Return
(1 of 2)
$2 $4 + $108
-$50 -$53
Dollar-weighted Return (IRR):
51 112
50
(1 r ) (1 r ) 2
1
r 7.117%
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Time-Weighted Return
53 50 2
r1 10%
50
54 53 2
r2 5.66%
53
rG = [ (1.10)×(1.0566) ]1/2 – 1 = 7.81%
The dollar-weighted average is less than the time-
weighted average in this example because more money
is invested in year two, when the return was lower
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Adjusting Returns for Risk
• Simplest and most popular way to adjust for
risk is to compare rates of return with those of
other investment funds with similar risk
characteristics
• Comparison universe is the set of money
managers employing similar investment styles,
used for assessing the relative performance of a
portfolio manager
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Universe Comparison
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Risk-Adjusted Performance: Sharpe
• Sharpe’s ratio divides average portfolio excess
return over the sample period by the standard
deviation of returns over that period
• Measures reward to (total) volatility trade-off
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Risk-Adjusted Performance: Treynor
• Treynor’s measure is a ratio of excess return
to beta, like the Sharpe ratio, but it uses
systematic risk instead of total risk
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Risk-Adjusted Performance: Jensen
• Jensen’s alpha is the average return on the
portfolio over and above that predicted by the
CAPM, given the portfolio’s beta and the
average market return
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Risk-Adjusted Performance:
Information Ratio
• Information ratio divides the alpha of the
portfolio by the nonsystematic risk of the
portfolio, called “tracking error” in the
industry
• Measures abnormal return per unit of risk that in
principle could be diversified away by holding a
market index portfolio
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Sharpe ratio for overall portfolios
• Sharpe ratio is the slope of CAL
• Investors seek to maximize the slope
• Focus on total volatility and not beta
• Benchmark is the Sharpe ratio of market index
• Sharpe ratio of actively managed portfolio
should have higher Sharpe ratio than market
index to be acceptable for investor’s optimal
risky portfolio
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2
M Measure
• Developed by Modigliani and Modigliani
• Create an adjusted portfolio P* that combines
P with Treasury Bills
• Set P* to have the same standard deviation as
the market index
• Now compare market and P* returns:
M 2 rP* rM
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2
M Measure: Example
Managed Portfolio P: rP = 35% σP = 42%
Market Portfolio: rM = 28% σM = 30%
T-bill return = 6%
P* Portfolio: 30/42 = .714 in P and .286 in T-bills
rP* = (.714)×(.35) + (.286)×(.06) = 26.7%
rP*< rM the managed portfolio underperformed
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2
M of Portfolio P
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Treynor Ratio
• Funds of funds approach
• Appropriate performance measure for fully
risky portfolio
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Portfolio Performance
Is Q better than P?
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Treynor’s Measure
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Performance Measurement for
Hedge Funds
• When the hedge fund is optimally combined
with the baseline portfolio, the improvement
in the Sharpe measure will be determined by
its information ratio:
2
H
S S
2 2
(eH )
P M
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Which Measure is Appropriate?
It depends on investment assumptions
1) If P is not diversified, then use the Sharpe measure as it
measures reward to risk
2) If the P is diversified, nonsystematic risk is negligible and the
appropriate metric is Treynor’s, measuring excess return to
beta
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The Role of Alpha in
Performance Measures
• A positive alpha is necessary to outperform
the passive market index
• Though necessary, it’s not enough to guarantee a
portfolio will outperform the index
• Most widely used performance measure
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Performance Statistics
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Interpretation of
Performance Statistics
• If P or Q represents the entire investment, Q is
better because of its higher Sharpe measure
and better M2
• If P and Q are competing for a role as one of a
number of subportfolios, Q also dominates
because its Treynor measure is higher
• If we seek an active portfolio to mix with an
index portfolio, P is better due to its higher
information ratio
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The Role of Alpha in
Performance Measures
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Performance Measurement with
Changing Portfolio Composition
• We need a very long observation period to
measure performance with any precision,
even if the return distribution is stable with a
constant mean and variance
• What if the mean and variance are not
constant? We need to keep track of portfolio
changes
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Realized Returns versus Expected
Returns
• Must determine “significance level” of a
performance measure to know whether it reliably
indicates ability
• To estimate the portfolio alpha from the SCL, regress
portfolio excess returns on the market index
• Then, to assess whether the alpha estimate reflects
true skill and not just luck, compute the t-statistic of
the alpha estimate
• Even moderate levels of statistical noise make
performance evaluation extremely difficult
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Survivorship Bias and Portfolio
Evaluation
• Regardless of the performance criterion, some
funds will outperform their benchmarks in any
year, and some will underperform
• Recall, performance in one period is not
predictive of future performance
• Limiting a sample of funds to those for which
returns are available over an entire sample
period introduces survivorship bias
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Style Analysis
• Style analysis, a tool to systematically measure the
exposures of managed portfolios, was introduced
by William Sharpe
• Idea is to regress fund returns on indexes representing a
range of asset classes
• Regression coefficient on each index would then measure the
fund’s implicit allocation to that “style”
• R2 of regression would measure percentage of return variability
attributable to style choice rather than security selection
• Intercept measures average return from security selection of
the fund portfolio
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Style Analysis for Fidelity’s
Magellan Fund
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Fidelity Magellan Fund Cumulative
Return Difference
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Average Tracking Error for 636
Mutual Funds, 1985-1989
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Performance Measurement with
Changing Portfolio Composition
• Risk-adjustment techniques all assume that
portfolio risk is constant over the relevant
time period, which isn’t necessarily true
• Performance Manipulation and the MRAR
• Managers may try to game the system, given their
compensation depends on performance
• Only measure impossible to manipulate is MRAR
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MRAR Scores with and without
Manipulation
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Market Timing
• In its pure form, market timing involves
shifting funds between a market-index
portfolio and a safe asset
• Treynor and Mazuy:
rP rf a b( rM rf ) c (rM rf ) eP 2
• Henriksson and Merton:
rP r f a b ( rM r f ) c ( rM r f ) D eP
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Characteristic Lines
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Performance of Bills, Equities, and
Perfect (Annual) Market Timers
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Valuing Market Timing as a Call
Option
• Key to valuing market
timing ability is to
recognize that perfect
foresight is equivalent
to holding a call option
on the equity portfolio
– but without having to
pay for it!
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Performance Attribution Procedures
(1 of 3)
• A common attribution system decomposes
performance into three components:
1. Allocation choices across broad asset classes
2. Industry or sector choice within each market
3. Security choice within each sector
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Performance Attribution Procedures
(2 of 3)
• Set up a ‘Benchmark’ or ‘Bogey’ portfolio:
• Select a benchmark index portfolio for each asset
class
• Choose weights based on market expectations
• Choose a portfolio of securities within each class
by security analysis
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Performance Attribution Procedures
(3 of 3)
• Calculate the return on the ‘Bogey’ and on the
managed portfolio
• Explain the difference in return based on
component weights or selection
• Summarize the performance differences into
appropriate categories
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Formulas for Attribution
n n
rB wBi rBi & rp w pi rpi
i 1 i 1
n n
rp rB w pi rpi wBi rBi
i 1 i 1
n
(w
i 1
pi pi r wBi rBi )
Where B is the bogey portfolio and p is the managed portfolio
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Performance Attribution of ith Asset
Class
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Performance Attribution
• Superior performance is achieved by:
• Overweighting assets in markets that perform well
• Underweighting assets in poorly performing
markets
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Performance Attribution: Example
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Performance Attribution Summary
• Good performance (a positive contribution) derives
from overweighting high-performing sectors
• Good performance also derives from underweighting
poorly performing sectors
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