Case Study: Portfolio Performance Evaluation

Andrew Coatsworth
Finance 466
Professor Brogaard
November 5, 2015
I. Introduction

The purpose of this report is to evaluate the performance of a portfolio constructed of

equal parts Amgen, Apple, Occidental Petroleum, Starbucks, and Yum! Brands Incorporated
stocks over the period of January 2, 2004 until December 31, 2014. In order to analyze the
individual stocks as well as overall portfolio performance, a backtesting model, a method utilized
by investment professionals to assess a given trading strategy over a past period of time, was
constructed. The backtesting model involves comparing actual stock and portfolio returns to
market returns on a daily basis. With these data points, it becomes possible to use financial
models such as the Capital Asset Pricing Model and the Fama and French Arbitrage Pricing
Theory to compare expected stock returns against actual stock returns.
Overall, both the individual stocks and the portfolio performed very well when adjusted
for risk and compared to the market. Although this measure fails to take into account exposure
to risk, a total rate of return of 1,791% over the holding period suggests very strong performance.
Throughout the course of the holding period, the portfolio increased in value from $100,000 to
$1,890,874. This performance can be attributed to the massive returns earned by Apple stock
(7,536% over the ten-year period). However, in order to fully understand the performance of the
portfolio, it is necessary to consider the level of risk required to hold these stocks.
II. Overall Performance
As stated in the introduction, the portfolio earned very lucrative returns. However, the
assets held in the portfolio were more volatile on average per day than the market. This is made
evident by the figure below.
Stock
Standard
Deviation

AMG
N
1.67

AA
PL
2.2
6

OX
Y
2.2
8

SB
UX
2.0
6

YU
M
1.7
1

Portfol
io

Mark
et

1.70

1.25

Every stock in the portfolio had a higher standard deviation of excess returns compared to the
market. As a result, the overall portfolio also had a higher standard deviation when compared to
the market. These statistics suggest that the portfolio was a riskier investment than the market
and thus must offer a higher rate of return.
Additionally, the portfolio suffers from a lack of diversification with an over CAPM Beta
of 1.09. A Beta of 1.09 suggests that for a 1% increase in the market, the portfolio will increase
in value by 1.09%. This connection to the market is undesirable for investors as the portfolio is
not expected to offer absolute returns. However, despite this lack of diversification, the portfolio
earned a total holding period return of 1,791% compared to the market rate (assuming all
$100,000 had been invested in the market) of 144%. Yet, as stated above, the portfolio had a
total average daily risk (standard deviation) of 1.70%, while the market offered a lower average
daily volatility of 1.25%. On an average annual basis, the portfolio had a standard deviation of
27.07% compared to the market standard deviation of 19.83%.
Although the portfolio had a CAPM Beta of 1.09, the stocks were chosen in an attempt to
create a diversified portfolio. The companies were intended to cover a range of industries
(biopharmaceutical, technology, energy, beverage, and food). Additionally, these are companies
that have track records of success and have shown potential for continued growth. While the
attempt at diversification failed, the success of the corporations allowed for massive portfolio
growth.
III. Risk Adjusted Performance
As previously mentioned in the analysis of the total holding period return, comparing this
for the portfolio and market fails to take into account risk. The following measures offer
adjusted perspectives on the portfolio performance.

A. Jensens Alpha
Jensens alpha is a measure of over or underperformance of actual earnings of the
portfolio when compared to the predicted CAPM earnings. On a daily average, the portfolio
outperformed the CAPM projection by .08%. When annualized (calculating the average yearly
abnormal return by multiplying the average daily abnormal return by 252 trading days and
dividing by 100 to convert to a percentage), the portfolio outperformed the CAPM projection by
20.25%. Although these figures are favorable for the portfolio performance, Jensens Alpha only
consider the depth and not breadth of investment performance as it is insensitive to unsystematic
risk.
B. Treynor Ratio
The Treynor Ratio is a risk adjusted measure that calculates the excess return of a
portfolio or security per unit of systematic risk (Excess Return divided by CAPM Beta). On a
daily basis, the portfolio had an average Treynor Ratio of .1139% suggesting that for every unit
of systematic risk, the portfolio earns a daily average return of .1139%. The market had a daily
average Treynor Ratio of .0345% suggesting that for every unit of systematic risk, the market
earned a daily average return of .0345%. These two figures prove that when adjusting for
systematic risk, the portfolio outperformed the market significantly. When annualized, the
portfolio earned a 28.71% return for every unit of systematic risk, while the market only earned
an 8.699% return for every unit of systematic risk.
However, in the case of the examined portfolio, Treynor is not an effective measure as it
is insensitive to nonsystematic risk. Treynor should be used when an investment is being added
to a well diversified portfolio as it can be safely assumed that the nonsystematic risk has already
been diversified away.

C. Sharpe Ratio
The Sharpe Ratio is a measure of excess return per unit of total risk. On a daily average,
the portfolio had a Sharpe Ratio of .0676% suggesting that for every unit of total risk, the
portfolio earned a daily average return of .0676%. The market had a daily average Sharpe Ratio
of .0276% suggesting that for every unit of total risk, the market earned a return of .0276%.
When comparing the portfolio Sharpe Ratio to the market Sharpe Ratio, it is clear that the
portfolio handily outperformed the market with returns adjusted for total risk. When annualized,
the portfolio earned an average yearly return of 107.31% per unit of total risk while the market
only earned an average return of 43.86% per unit of total risk.
In the case of the examined portfolio, the Sharpe Ratio is the most valuable figure to
analyze as it is sensitive to both systematic and nonsystematic risk. Since the nonsystematic risk
has not been diversified away, it is necessary to account for it when analyzing the portfolio
returns.
D. Information Ratio
The Information Ratio is a measure that compares the abnormal return (alpha) to the
nonsystematic risk of the portfolio. On a daily average, the portfolio had an Information Ratio of
.0702% suggesting that for every unit of nonsystematic risk, the portfolio earned an abnormal
return of .0702%. The market does not have an Information Ratio as it does not have
nonsystematic risk. On an annualized basis, the portfolio had an average Information Ratio of
111.43% suggesting that for every unit of nonsystematic risk, the portfolio earned an abnormal
return of 111.43%.
In the case of the examined portfolio, the information ratio is a valuable measure to
consider as it is sensitive to nonsystematic risk. Since the portfolio is not well diversified, it is

necessary to consider how to nonsystematic risk is affecting portfolio returns. These figures
suggest that the portfolio is able to consistently outperform the CAPM benchmark by holding
nonsystematic risk.
E. Modigliani-Modigliani
The M-Squared measure is a statistic that equalizes the standard deviation of the portfolio
to that of the market. This is achieved by creating a hypothetical portfolio that mixes the
portfolio in question with treasury bills and comparing this return to that of the market. In this
case, the portfolio in question when mixed with treasury bills outperformed the market by a daily
average of .1099% and 27.57% when annualized. Both of these measures indicate very positive
returns for the portfolio as it is possible to reduce the risk by mixing in treasury bills and still
beating the market.
IV. CAPM vs. Fama French
As previously discussed, the CAPM beta for the examined portfolio is 1.0116. The
market risk beta under the Fama French model is 1.09345, the small minus big beta is -.0989,
and the high minus low beta is -.3947. Under the Fama French model, the portfolio has an alpha
value of .0809% on an average daily basis and 20.396% when annualized compared to .0803%
and 20.25% under CAPM. These figures suggest that both models capture the portfolio
performance in a very similar fashion. This is confirmed by the similar R-Squared values for the
CAPM (.549) and Fama French (.564). The R-Squared values signify that 54.9% of the variation
in excess returns is explained by the CAPM model and 56.4% of the variation in excess returns is
explained by Fama French model.
Both the factor loadings under the CAPM and Fama French models show variation over
the 11-year period on an annual basis. This suggests that the portfolios exposure to the market,

small minus big, and high minus low factors change from year to year. The variation makes
sense as the portfolio variance varied more than that of the market. Additionally, the stocks did
not earn constant returns, as depicted by the figure below (the figure is not adjusted for risk, but
the excess risk of the portfolio has been previously established). Therefore, under the CAPM
and Fama French models, the betas must fluctuate.

Yearly Portfolio Returns vs. Yearly Market Returns

Yearly Portfolio Return

Yearly Market Return

V. Conclusion
In conclusion, this portfolio is evidence that a single stock can dominate the returns of a
portfolio when held for a long period of time. It is possible to purchase stock that will provide
incredibly lucrative returns. While these opportunities may be few and far between, they do
exist. Additionally, this portfolio proves that holding stocks rather than being an active trader
can provide major returns.
Although the portfolio performed incredibly well, the level of market exposure prevented
the portfolio from earning absolute positive returns. Also, there was major variability in the
yearly return, albeit mostly positive. In order to make up for these shortcomings, it is necessary
to develop a more diversified portfolio to experience less market exposure. This will minimize
risk and attempt to maintain high returns.