Portfolio Performance

Evaluation

Measuring Portfolio Return

Time-Weighted Returns
The geometric average is a time-weighted average.
Each period return has equal weight.

1 rG

1 r1 1 r2 ...1 rn

Dollar-Weighted Returns
Internal rate of return considering the cash flow to and from
investment
Returns are weighed by the amount invested in each period.

Cn
C1
C2
PV

...
1
2
n
1 r 1 r
1 r

Example

Dollar Weighted Return

51
112
50

1
(1 r ) (1 r ) 2
r 7.117%

Example
Time Weighted Return

53 50 2
r1
10%
50
54 53 2
r2
5.66%
53
rG = [ (1.1) (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.

Problem with TWR and DWR

Do not control for risk!!
Frequently used in investment reports, media and news.
Easiest way to adjust for risk is to compare

investments with similar risk characteristics.

For example a fund investing in technology stocks is

compared to another fund investing in technology stocks.
Then time-weighted returns of each fund are ordered
(among comparison universe) and receive a percentile
ranking.
The problem with this approach is to hard to determine a
good comparable fund. For example, one fund investing in
technology stocks could be investing in internet start-ups,
another could be investing in telephone companies.

Risk Adjusted Performance

Sharpe Measure:

(rP rF )

P
rp = Average return on the portfolio
rf = Average risk free rate
P = Standard deviation of portfolio return
Assumptions needed (same as during portfolio
optimization)

No changes in portfolio composition

Securities have constant means, variances and covariances over
evaluation period.
Held for significant time

If investors can be summarized by mean-variance

preferences, investors want to maximize their Sharpe

ratio!

M2 Measure
It can be hard to interpret Sharpe Measure. If one

portfolio has a Sharpe ratio of 0.69 and another has a

Sharpe ratio of 0.73, what is the economic difference?
M2 helps make the Sharpe measure economically
intuitive:

Match volatility of the managed portfolio to that of the

index/portfolio which we are comparing to.
This can be done by creating a new imaginary portfolio, which
includes a positive/negative proportion of a risk free investment.
If the managed portfolio has higher volatility than index, a positive
proportion invested in the risk-free rate will reduce volatility.

M rP* rM
2

When to use Sharpe ratio/M2

If the portfolio represents the entire investment.
Assume that past security performance is representative of
expected performance
Determine the benchmark portfolio in the case of a passive
strategy
Compare Sharpe/M2 of benchmark to investment portfolio

Is P better or Q?

How would you choose between P & Q when one of

them is to be added to a portfolio which includes
numerous other investment funds?

Is P better or Q

When your portfolio consists of many funds, non-

systematic risk gets diversified away.

Beta is the appropriate risk measure!

Using Treynors Measure

TP =Portfolio with P and Tbills (risk free investment).
TQ =Portfolio with Q and Tbills (risk free investment).

Risk Adjusted Performance

Treynor Measure: (rP rF )

rp

= Average return on the portfolio

rf = Average risk free rate
P = Beta of portfolio return
Normally used when the fund is a small part of the
total investor portfolio.
Non-systematic risk is diversified away in a large
portfolio, therefore this measure only uses
systematic risk

Risk Adjusted Performance

Jensens Alpha: P rP rf P (rM rf )
rp = Average return on the portfolio
rf
rM

= Average risk free rate

= Average return on the market portfolio
= Beta of portfolio return

Used in both Treynor and Sharpe Measure, but

ranking of portfolios will be different.

Mispriced assets-review
When choosing the weight of a portfolio of mispriced

assets, the following equation is used:

H
2

( eH )
o
wH
E ( RM )
2M
The improvement in Sharpe ratio of the total

portfolio is:
H
S S

(
e
)
H

2
P

2
M

Risk Adjusted Performance

Information Ratio:

P
( eP )

The information ratio divides the alpha of the portfolio

by the nonsystematic risk.

Useful for actively managed funds, e.g. hedge funds.
These funds are usually additions to core positions in

more traditional portfolios.

eP is the residual from single index model regressions.

Risks in Hedge Fund Investing

Risk Profile may change rapidly

Hedge funds tend to invest in illiquid assets.

Apparent profits over the long term, but

possibility of infrequent, but large losses.

Also called as tail risk.
Survivorship bias in a major consideration
because turnover is far higher than that of
investment companies.

Is P better than Q?

If P and Q are each going to be used as the ONLY investment?

If P and Q are competing for a role as one of a number of subportfolios?
If we seek an active portfolio to mix with an index portfolio?

Market Timing
Imagine the fund manager is fully invested in a risk-

free asset and a market-index portfolio.

A sign of manager skill would be the ability to time
bull and bear markets accurately and allocate funds
appropriately between the two assets .
Here timing ability is defined as the ability to
recognize when the stock market is going to have
positive returns and increasing the proportion of
funds invested in the market-index portfolio.

Characteristic Line
Characteristic Line is the equation of the line for the

regression single index model.

rP rf

rM rf

In this example, no market timing. Beta is constant

Market Timing(Henrikkson and Merton)

Add a dummy variable to the single index model:

rP rf a b(rM rf ) c (rM rf ) D eP
rP rf

rM rf

D is a dummy variable that equals 1 when rM >rF .

Beta of the portfolio is b in bear markets and b+c in bull

markets.
c needs to be positive for an indication of superior timing
ability.

Market Timing(Treynor and Mazuy)

Add a square term to the single index model :

rP rf a b(rM rf ) c(rM rf ) eP
2

rP rf

rM rf

The investor adds funds to the stock market while it

is going up and withdraws when it is going down.

This would give the investor a higher beta when rM is
high, giving the line a steeper slope. c needs to be
positive for an indication of superior timing ability.

Asset allocation and security selection

Market timing was an example of shifting

proportions in the market and risk-free assets. This

is an asset allocation decision.
If the risky asset is not the market-index portfolio,
but a portfolio of selected stocks, then the decision to
pick certain stocks is called security selection.
Now we will look at two methods to distinguish
between asset allocation and security selection
ability.

Performance attribution
In this case we are trying to attribute performance to

asset allocation or security selection.

Here we will examine the difference in returns
between a managed portfolio, P, and a selected
benchmark portfolio, B, called the bogey.
For each asset class, a benchmark and weight in the
asset class is chosen. The return of the bogey portfolio
can be broken down into:
n

rB wBi rBi
i 1

Performance attribution
The fund manager will choose weights in each asset

class and securities within each asset class.

n

rp w pirpi
i 1

The difference between the two rates of return is:

n

i 1

i 1

i 1

rp rB wpirpi wBi rBi ( wpirpi wBi rBi )

Asset Allocation vs. Security Seleciton

The last part of the previous equation: wPi rPi wBi rBi
This can be simplified into two parts:
Contribution from asset allocation: ( wPi wBi )rBi
Contribution from security selection: wPi (rPi rBi )

Example: Performance Attribution

Consider a managed fund which has invested 70%,

7% and 23% in equity, fixed income and money

markets respectively.
The bogey portfolios has weights of 60/30/10.
The managed fund returned 5.34%. The bogey
portfolio returned 3.97%. What explains the
difference of 1.37%?
The equity, fixed income and cash benchmarks
returned 5.81%,1.45% and 0.48% respectively
The managed fund returned 7.28% and 1.89% for the
equity and fixed income portfolios respectively.

Example: Performance Attribution

Problems with portfolio evaluation

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.
Shifting parameters when portfolios are actively
managed makes accurate performance evaluation
all the more elusive.