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Measuring portfolio performance

Muhammad Shahid
U.U.D.M. Project Report 2007:19

Examensarbete i matematik, 20 pong


Handledare och examinator: Johan Tysk
Juni 2007

Department of Mathematics
Uppsala University

Dedications
I dedicate this thesis to my beloved parents and teacher (Prof. Abdul Hafeez Sh), who
played the most vital role in my upbringing and grooming. Today what ever I am is due
to virtue of their nurture and prays. My Degree (Master in Financial Mathematics) would
not been completed without their support and encouragement. May Allah bless them.

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Acknowledgement

All prays to Allah Almighty who induced the man with intelligence, knowledge and
wisdom. It is He who gave me ability, perseverance and determination to complete this
thesis.
Teachers are lighthouses spreading the light of knowledge and wisdom everywhere and
guiding the new generation so that they can cruise safely towards their destination. They
are really lamps that are kindling the candles of knowledge in the heart of young
generation. They are performing the job, which Allah himself acknowledge as the noblest
to all jobs; the job of teaching. They will get its reward not only from Allah but also in
the form of immense respect that every student carries for them in the core of his heart.
I offer my sincerest thanks and deepest gratitude to my research supervisor Prof. Johan
Tysk for his inspiring and valuable guidance, encouraging attitude and enlightening
discussions enabling me to pursue my work with dedication.
I would like to say a big thanks to all the teachers who taught me in the entire program.
They did not only teach me how to learn, they also taught me how to teach, and their
excellence has always inspired me.
I also wish to express my feeling of gratitude to my parents, sisters, brothers and friends,
who prayed for my health and brilliant future.
A very special thanks and appreciation goes to my dearest teacher Prof. Abdul Hafeez Sh,
though you were for away, your persistent telephone calls and the thought of you gave
me the enthusiasm to carry on with my academic work.

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iii

Table of Contents

Introduction

Portfolio Mean and Variance


2.1
Mean Return of a Portfolio
2.2
Variance of Portfolio Return
2.3
The Markowitz Problem
2.4
The Capital Market Line

3
3
3
4
8

The Capital Asset Pricing Model


3.1
History of CAPM
3.1.1 Systematic Risk
3.1.2 Unsystematic Risk
3.2
Assumption of Capital Asset Pricing Model
3.3
The Security Market Line
3.4
CAPM as a Pricing Formula
3.4.1 Linearity of Pricing and Certainty Equivalent Form

11
11
11
11
14
17
17
19

Measuring Portfolio Performance


4.1
Measuring the Rate of Return of a Portfolio
4.1.1 Time Weighted Rate of Return
4.1.2 Value Weighted Rate of Return
4.2
Risk Adjusted Performance Measure
4.2.1 Public Information
4.2.2 Private Information
4.3
Risk Adjusted Performance Indices
4.3.1 The Jensen Index
4.3.2 The Treynor Index
4.3.3 The Sharpe Index
4.4
Comparison of Three Indices
4.5
Conclusion

20
20
20
20
21
21
21
23
23
26
29
36
39

Reference

40

Measuring Portfolio Performance

Chapter 1
INTRODUCTION
Measuring of portfolio performance has become an essential topic in the financial
markets for the portfolio managers, investors and almost all that have something to do in
the field of finance and it plays a very important role in the financial market almost all
around the world.
Earlier then 1950, portfolio managers and investors measured the portfolio performance
almost on the rate of return basis. During that time, they knew that risk was a very
important variable in determining investment success but they had no simple or clear way
of measure it.
In 1952 Markowitz created the idea of Modern Portfolio Theory and proposed that
investors expected to be compensated for additional risk and provided a framework for
measuring risk. In early 1960, after the development of portfolio theory and capital asset
pricing model in subsequence years, risk was included in the evaluation process.
The capital asset pricing model of William Sharpe and John Litner marks the birth of
asset pricing theory. The attraction of capital asset pricing model was that it offered
power predictions about how to measure risk and the relation between expected return
and risk.
Treynor (1965) was the first researcher developing a composite measure of portfolio
performance. He measured portfolio risk with beta and calculated portfolio market risk
premium and later on in 1966 Sharpe developed a composite index which is similar to the
Treynor measure, the only difference being the use of standard deviation instead of beta.
In 1967 Sharpe index evaluated funds performance based on both rate of return and
diversification but for a completely diversified portfolio Treynor and Sharpe indices
would give identical ranking. Jensen in 1968, on the other hand, attempted to construct a
measure based on the security market line and he showed the difference between the
expected rate of return of the portfolio and expected return of a benchmark portfolio that
would be positioned on the security market line.
According to Prof. K. Spremann, Portfolio measurement has not only the goal to
inform about the quality of a portfolio performance__ but and thats even more
important__ to decompose and analyze the success factors of a portfolio.
This thesis is organized as fellows. In Chapter 2, we explore the concept of Mean
Variance portfolio theory with example. We also describe the Markowitz problem,
solution of the Markowitz problem and the concept of capital market line. In Chapter 3,
we describe the capital asset pricing model and prove its theorem along with
assumptions. CAPM as a pricing formula and linearity of pricing and certainty equivalent
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2
form are also explained in this chapter. Finally, in Chapter 4, we explore the concepts of
measuring portfolio performance, including definitions of measuring the rate of return of
a portfolio, time weighted and value weighted rate of returns. Finally, we discuss the risk
adjusted performance measure based on capital asset pricing model. Based on three risk
adjusted performance indices (Jensen, Sharpe and Treynor) we calculate the performance
of different portfolio and compare these indices.
The main references of this thesis are [1], [2], [4], [5], [9], [10] and [11]. In Chapter 2, we
refer to [3], [7], [8] and [16]. In Chapter 3, we also refer to [6], [12], [13] and [15]
frequently. Some data also refer to web pages listed at the end of reference section.

Measuring Portfolio Performance

Chapter 2
PORTFOLIO MEAN AND VARIANCE
2.1 Mean Return of a Portfolio
Suppose that there are n assets with rates of return r1 , r2 ,, rn and these have expected
values E (r1 ) = r1 , E (r2 ) = r2 , .. , E (rn ) = rn . We form a portfolio of these n assets
using the weights wi , i = 1,2,,n. The rate of return in terms of the individual return of
the portfolio is
r = w1 r1 + w2 r2 + + wn rn .
(1)
We find the expected rate of return by taking the weighted sum of individual expected
rates of return. Using the property of linearity, we take the expected values on the both
sides of equation (1)
E (r ) = w1 E (r1 ) + w2 E (r2 ) + + wn E (rn ) .

(2)

2.2 Variance of Portfolio Return


The variance of the return of asset i is denoted by i2 , the variance of the return of the
portfolio by 2 , and the covariance of the asset i with asset j by ij . We can perform
the following calculation,

2 = E (r r ) 2 ,
n

n
= E ( wi ri wi ri ) 2 ,
i =1

i =1
n
n

= E ( wi (ri ri ))( w j (r j r j ) ,
j =1

i =1
n

= E wi w j (ri ri )(r j r j ) ,

i , j =1

2 =

w w
i

ij

i , j =1

Equation (3) represents the Variance of the return on the portfolio.

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(3)

Example 2.1 Consider there are two assets with expected values r1 = 0.22, r2 = 0.55
and the variance are 1 = 0.80, 2 = 0.88 and 12 = 0.55 respectively. A portfolio with
weights w1 = 0.25 and w2 = 0.65 is formed. Calculate the mean and variance of the
portfolio?
Solution
Mean of the portfolio

= w1 E (r1 )

+ w2 E (r2 )

= 0.25(0.22) + 0.65(0.55)
=

0.4125.

Variance of the portfolio

w w

ij

w12 12

(0.25)2(0.80)2 + (0.65)2(0.88)2+ (0.25)(0.65)(0.01)+(0.65)(0.25)(0.01)

0.040 + 0.327 + 0.002 + 0.002

0.371.

i , j =1

w22 22

w1 w2 12

+ w2 w1 21

2.3 The Markowitz Problem


The Markowitz problem explicitly addresses the tradeoff between expected rate of return
of a portfolio and variance of the rate of return of a portfolio. This problem is mainly
used when the risk free assets as well as risky assets are available. The Markowitz
problem can be solved numerically. When we solve the problem numerically then we get
a numerical solution.
Consider that there are n assets and their expected rates of return are r1 , r2 ,..., rn and
their covariances are i j , for i = j = 1,2,, n . The portfolio is defined as a set of n
weights wi , for i = 1, 2 n , that its sum equal to 1. In order to find a minimum variance
of a portfolio, some arbitrary value r is assign to the mean value. Hence the problem can
be formulated as

Measuring Portfolio Performance

1 n
min wi w j ij ,
2 i , j =1
subject to
n

w r

=r,

= 1.

i i

i =1
n

i =1

Solution of Markowitz Problem


Lagrange Multipliers and are used to solve the problem. In the Lagrangian, first we
convert all the constraints to one with zero on the right hand side as shown below.
1 n
f =
wi w j ij ,
2 i , j =1
n

w r

r = 0,

1 = 0.

i i

i =1
n

i =1

Then the each left hand side is multiplied to its Lagrange Multiplier and subtracted from
the objective function.
Lagrangian function

L ( wi , w j ) =

1 n
wi w j ij - (
2 i , j =1

wi ri r ) - (
i =1

1 ).

i =1

Differentiate the Lagrangian with respect to wi and w j and put equal to zero. If the type
structure is unfamiliar then it is difficult to differentiate it. Here we consider the case of
only two variables and it is easy to generalize it to n variable.
Functions of two variables

L ( wi , w j ) =

1 2
wi w j ij - (
2 i , j =1

wi ri r ) - (
i =1

i =1

or

L ( wi , w j ) =

1
( w12 12 + w1 w2 12 + w2 w1 21 + w22 22 )
2
- ( r1 w1 + r2 w2 - r ) - ( w1 + w2 - 1 ).

Measuring Portfolio Performance

1 )

Differentiate the above equation with respect to w1 and w2 , we obtain


L
1
=
(2 w1 12 + w2 12 + 21 w2 ) - r1 - ,
w1
2
and
L
1
=
( 12 w1 + w1 21 + 2 w2 22 ) - r2 - .
w2
2

Now putting

L
= 0,
w1

L
= 0, and using the fact 12 = 21 , we get
w2

12 w1 + 12 w2 + r1 - = 0,
and

21 w1 + 22 w2 - r2 - = 0.
Here we have four equations, two as above and two from the constraints. These equations
can be solved for the four unknown w1 , w2 , and .

Equation for efficient set


The efficient portfolio for two Lagrange Multipliers and and the portfolio weight

wi for i = 1, 2 n having the mean rate of return r satisfy


n

ij

wi - ri - = 0,

for i = 1, 2 n

(1)

j =1

w r

i i

= r,

(2)

= 1.

(3)

i =1

and
n

i =1

From equation (1), we have n equations and two equations of the constraints. Now we
have total n + 2 linear equations, with n + 2 unknown i.e. wi ' s , and . Using the
linear algebra method these equations can be solved easily.

Example 2.2 Consider we have three uncorrelated assets. Each has variance 1 and the
mean values are 1, 2 and 3, respectively, there is a bit of simplicity and symmetry in this
situation, which makes it relatively easy to find an explicit solution.

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Using the equations,
n

ij

wi - ri - = 0,

for i = 1, 2 n

(1)

j =1

w r

i i

= r,

(2)

= 1.

(3)

i =1

and
n

i =1

we have

12 = 22 = 32 = 1

and

12 = 23 = 31 = 0.

Using all known values in equations (1) (3), we get the following five equations.

And

w1 - - = 0,
w2 - 2 - = 0,
w3 - 3 - = 0.

(4)
(5)
(6)

w1 + 2 w2 + 3 w3 = r ,

(7)

w1 + w2 + w3 = 1.

(8)

We have to find the values of and , substituting the values of w1 , w2 and w3 from
equations 4, 5 and 6 in equations 7 and 8, we obtain

( + ) + 2(2 + ) + 3(3 + ) = r ,
14 + 6 = r ,

(9)

( + ) + (2 + ) + (3 + ) = 1,
6 + 3 = 1.

(10)

and

Solving equation (9) and (10) simultaneously, we get and as

r
- 1,
2

= 2(

1
)- r.
3

Substituting and in equations (4) to (6), we get the values of w1 , w2 and w3

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8
4
r
- ( ),
3
2
1
w2 = ,
3

w1 =

and
w3 = (

r
2
) - ( ).
2
3

The standard deviation is given by

w12 + w22 + w32

r
7
2r +
3
2

The minimum variance point is, by symmetry, at r = 2, with =

3 / 3.

2.4 The Capital Market Line


The linear efficient set of capital asset pricing model (CAPM) is known as capital market
line. It is also stated as The efficient set consisting of a single straight line, from the risk
free point and which is passing through the market portfolio, that line is known as capital
market line.

Figure 1: The Capital market line

The capital market line is illustrated above, with return p on the y-axis and risk p on xaxis. The line shows the relationship between the expected rate of return and the risk of
return for efficient portfolios of assets. It is also referred to pricing line and if the risk

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increases then corresponding expected rate of return must also increase. M is the
market portfolio and r f is the risk free rate of return.
The capital market line states that
rp = r f +

rM r f

p.

Here
rp

expected return of an efficient portfolio

rf

risk free rate of return

rM

=
=

expected return of the market portfolio


standard deviation of the efficient portfolio

standard deviation of the market portfolio.

p
M

The slope of the capital market line is given by

K =

rM r f

It is also called the price of risk. It tells us how the expected rate of return of a portfolio
must be increase if the standard deviation of that rate is increase by one unit.

Example 2.3 Consider an oil drilling venture. The price of a share of this venture is
$1750. After one year, it is expected to yield the equivalent of $2000. The standard
deviation of the return is = 45%. Currently, the risk free rate is 15%. The expected rate
of return on the market portfolio is 23% and the standard deviation of this rate is17%.
Compare this oil venture with the asset on the capital market line.
Solution
Here
r f = 15% = .15

M = 17% = .17

rM = 23% = .23

p = 45% = .45

From the capital market line, we know that


rM r f
rp = r f +
p,

= (.15) + (

Measuring Portfolio Performance

.23 .15
(.45) ),
.17

10

= (.15) + (0.47) (.45),


=

36%.

Actual expected rate of return is


r =

2000
) 1,
1750

.14,

14%.

After comparing the both values it is clear that the oil venture lies well below the capital
market line.

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Chapter 3
THE CAPITAL ASSET PRICING MODEL (CAPM)

3.1 History of CAPM


The capital asset pricing model (CAPM) was introduced by Jack Treynor (1961) while
parallel work was also performed by William Sharp (1964) and Lintner (1965). In 1990,
Sharp received the Nobel Memorial Prize in Economics with Harry Markowitz and
Merton Miller in the field of financial economics.
The Capital Asset Pricing Model is an economic model which is used for valuing the
securities, stocks and assets by relating risk and expected rate of return.
In the capital market line, the expected rate of return of an efficient portfolio relates to its
standard deviation but cannot show how the expected rate of return of an individual asset
relates to its individual risk. This relation is expressed by the capital asset pricing model
(CAPM).
The CAPM help us to calculate investment risk and what is the return on the investment.
This investment contains two types of risk.

Systematic Risk
Unsystematic Risk

3.1.1 Systematic Risk Systematic risks are market risks that cannot be diversified away.
For example, wars and interest rates are good examples of the systematic risk.
3.1.2 Unsystematic Risk Unsystematic risk is specific to each individual stocks and it
can be diversified away as the investor increases the number of stocks in portfolio. It is
also known as specific risk.
Theorem Suppose that market portfolio M is efficient, the expected return ri of any asset
i satisfies the relationship.

ri - r f = i ( rM r f ),
where
rf

risk free rate

beta of the security

rM

expected market return

( rM r f )

equity market premium

and

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iM
.
M2

Proof Suppose for any , the portfolio consisting of a portion invested in the asset i
and the remaining potion 1 - invested in the market portfolio M. The expected rate of
return of this portfolio is

r =

ri + (1 - ) rM

(1)

Standard deviation of the rate of return is

= [ 2 i2 + 2 (1 - ) iM + (1 - ) 2 M2 ]1/2

(2)

The values of are traced out as shown in the diagram below.

In particular = 0 corresponding to the market portfolio M. This curve cannot cross the
capital market line. If it crosses the capital market line then it would violate the definition
of the capital market line. The curve must be tangent to capital market line. At the point
M the slope of the curve is equal to the slope of the capital market line.
Differentiating equations (1) and (2) with respect to , we get
d r
= ri - rM .
d
Furthermore
d
1
= [ 2 i2 + 2 (1 - ) iM + (1 - )2 M2 ] 1 2
d
2
[2 i + 2(1 - ) iM + 2(1 - )(-1) M2 ],

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2 i + 2(1 ) iM + 2( 1) M2
1
2 [ 2 i2 + 2 (1 - ) iM + (1 - ) 2 M2 ]1/2

i + (1 ) iM + ( 1) M2
.
[ 2 i2 + 2 (1 - ) iM + (1 - ) 2 M2 ]1/2

(0) i + (1 0) iM + (0 1) M2
[(0) 2 i2 + 2 (1 - 0) iM + (1 - 0 ) 2 M2 ]1/2

At = 0, we get
d
d

=0

iM M2
[ M2 ]1/2
iM M2
M

=
=

Using the relation

d r d
,
d d

d r
=
d
at point = 0, we get

d
d

=
=0

ri rM
iM m2

M
=

(ri rM ) M
.
iM M2

This slope is also equal to the slope of the capital market line.
(ri rM ) M
iM M2

rM r f

and therefore,

ri M2 rM M2 =

(r

Measuring Portfolio Performance

rf

) (

iM

M2 ) ,

14

ri M2 rM M2 =

rM iM rM M2 iM r f + M2 r f .

ri M2 r f M2 =

(r

ri

rf +

i =

iM
.
M2

Thus

r f iM ,

and

(rM r f ) iM

M2

(3)

Now let

Putting the value of i in equation 3, we get

ri

r f + i rM r f .

Thus the theorem is proved.


The ri r f is expected excess rate of return of asset i , it is defined as the amount by
which the rate of return is expected to exceed the risk free rate. Similarly, rM r f is the
expected excess rate of return of the market portfolio. The capital asset pricing model
(CAPM) tells us that the expected excess rate of return of an asset is proportional to the
expected excess rate of return of the market portfolio.

3.2 Assumptions of Capital Asset Pricing Model (CAPM)


The capital asset pricing model (CAPM) is valid within a special set of assumption.
These assumptions are

All investors have homogenous expectations about the assets.


Investor may borrow and lend unlimited amount of risk free asset.
The risk free borrowing and lending rates are equal.
The quantity of assets is fixed.
Perfectly efficient capital markets.
No market imperfections such like taxes and regulation and no change in the level
of interest rate exists.
There are no arbitrage opportunities.
There is a separation of production and financial stocks.
Returns (assets) are distributed by normal distribution.

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15

Example 3.1 Suppose the rate of return of the market has an expected value 14% and a
standard deviation of 15%, let the risk free rate be 10%. Using the capital asset pricing
model formula calculate an expected rate of return.
Solution Consider an asset has covariance of .045 with the market; first, we have to find
the value of the (beta).

Here

iM
,
M2
0.045

(0.15)2

2.

r f = 10% = .10

rM

= 14%

= .14

The capital asset pricing model formula is

ri = r f + i ( rM r f ),
r = (.10) + 2(.14-.10),
= (.10) + (.08),
= .18,
= 18%.

Example 3.2 Assume that the risk free rate is 8% and the expected market return is 12%.
Find the expected rate of return when (a) = 0 (b) = 2.
r f = .08,

Solution
Case (a)
When = 0

ri = r f + i ( rM r f ),
= .08 + 0 (.12-.08),
= .08.

Measuring Portfolio Performance

rM = .12

16
Case (b)
When = 2

ri = r f + i ( rM r f ),
= .08 + 2(.12-.08),
= .08 + .08

.16.

This example shows that the higher the degree of the systematic risk , the higher the
return on a given security demanded by investors.

Example3.3 Consider that you have $30,000 in the following 4 stocks.


Security

Amount

Beta

Xi

Stock A
Stock B
Stock C
Stock D

5,000
10,000
8,000
7,000

0.75
1.10
1.36
1.88

5/30
10/30
8/30
7/30

R = r + i ( Rm r )
0.1225
0.1610
0.1896
0.2468

The risk free rate is 4% and the expected return on the market portfolio is 15%. Using the
capital asset pricing market, what is the expected return on the above portfolio?

Solution
Here

r f = .04

rM = .15.

Here i denotes the beta coefficient of the stock i . We calculate the beta coefficient i
for the portfolio and get the expected return on the portfolio from the capital asset pricing
model equation.
Here

xA A

xB B

xC C

+ xD D

= (5/30)(0.75) + (10/30)(1.10) + (8/30)(1.36) + (7/30)(1.88)


=
1.29
Capital asset pricing model equation is

ri

= r f + i ( rM r f ),
= .04 + (1.29) (.15-.04),
= .04 + 0.15,
= 0.19.

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3.3 The Security Market Line


The security market line is the graphical representation of the capital asset pricing model.
The capital asset pricing model equation describes a linear relationship between risk and
return. This linear relationship is termed as the security market line.

The graph shows the relation in the form of beta. In this case, the market portfolio to the
point beta is equal to one. According to the capital asset pricing model this line expresses
the risk reward structure of assets. The expected rate of return increases linearly as beta
increases.
It is a useful tool in determining if an asset being considered for a portfolio offers a
reasonable expected return for risk on the security market line. We plotted individual
securities, if the securitys risk versus expected return is plotted above the security market
line, then it is undervalued and the investor can expect a higher return for the inherent
risk. If a securitys risk versus expected return is plotted below the security market line,
then it is overvalued and the investor would be accepting less return for the amount of
risk assumed.

3.4 CAPM as a Pricing Formula


CAPM is a pricing model. It only contains the expected rate of return but cannot contain
price explicitly. We want to see why the CAPM is called a pricing model.
Consider an asset is being purchased at price P and after some time it is sold at price Q .
(Q P )
Then r =
is the rate of return, Here P is known and Q is random (unknown),
P
the CAPM formula is
r

r f + i rM r f .

Putting the value of r in equation (1), give us

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(1)

18

(Q P )
P

r f + rM r f ,

QP

P ( r f + rM r f ),

P + P ( r f + rM r f ),

P (1 + ( r f + rM r f ),

Q
.
(1 + (r f + (rM r f )))

(2)

It is the price of the asset according to the CAPM. Here is the beta of the asset.

Example 3.4 Let us consider an oil drilling venture. The possibility of investing in a
certain oil share that produces a payoff, it is random because of the uncertainty in future
oil price. The expected payoff is $1200 and standard deviation of return is 40%.The of
the asset is 0.8 that is relatively low. The risk free rate is 20% and the expected return on
the market portfolio is 70%. What is the value of this share of the oil venture using the
CAPM?
Solution

We know that
P =

here

Q
(1 + (r f + (rM r f )))

Q = $1200

r f = 20% = 0.20

rM = 70% = 0.70

= 0.8

putting this value in above equation (1)


P =

P =
P

1200
,
1 + 0.20 + 0.8(0.70 0.20)
1200
,
1 .6
$750.

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(1)

19

3.4.1 Linearity of Pricing and the Certainty Equivalent Form


Linearity of the pricing formula is a very important property. Its mean that the price of
the sum of two assets is the sum of their prices, similarly, the price of a multiple of an
asset is also the same multiple of the price. The formula does not look linear, in the case
of sums. Consider the example
Suppose

P1 =

Q1

1 + r f + 1 (rM r f )

P2 =

Q2

1 + r f + 2 (rM r f )

Adding P1 and P2 , we get

P1 + P2 =

Q1

1 + r f + 1 (rM r f )
Q1 + Q2

1 + r f + 1+ 2 (rM r f )

Q2

1 + r f + 2 (rM r f )

It is the sum of assets 1 and 2, here 1+ 2 is the beta value of the new asset.

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20

Chapter 4
MEASURING PORTFOLIO PERFORMANCE
4.1 Measuring the rate of return to a portfolio
The rate of return of a portfolio is measured as the sum of cash received (dividend) and
the change in the portfolios market value (capital gain or loss) divided by the market
value of the portfolio at the beginning of the portfolio, mathematically,

Return of a portfolio =

Cash( Dividend ) + Capital ( gain or loss)


Market value of a portfolio( purchase price)

The rate of return is the most important outcome from any investment. It works well for
static portfolio. Managed portfolios receive additional amount to be invested in the period
(a month or a quarter) and their investors can also withdraw fund from the portfolio.
Suppose that the market value of a portfolio $ 1 million invested for the period of a
quarter and $1 million is added at the end of the first month and then $1.5 million is
withdrawn at the end of 2nd month. How is the return to be calculated for the quarter?
There are two methods to calculate this return.

Time Weighted rate of return


Value Weighted rate of return

4.1.1 Time Weighted rate of return


The first method is called time weighted rate of return. The time weighted rate of return
measures the performance of the portfolio manager. The amount of funds invested is
neutralized in the calculation of time weighted return because the funds have deposits and
withdrawals by the investors are not under the control of the fund manager but their
return are computed on the basis of cash distributions and the changes in the market value
of a single share in the fund but the time weighted return is calculated by dividing the
beginning value of a share into the cash distribution and the change in the value of a
share during the period. However, to calculate the time weighted rate of return, divide the
portfolio into shares and compute the return to a single share in the portfolio across the
period. In the same way we can calculate the rate of return of a mutual fund.

4.1.2

Value Weighted rate of return

The second method is called value weighted rate of return. The time weighted method
ignored the deposits and withdrawal to and from the portfolio during the period over
which return to be measured but the value weighted method takes deposits and
withdrawal into its account. Suppose that wT is a withdrawal at time T and Dt is a

Measuring Portfolio Performance

21
deposit at time t and further assumed that cash (dividend) to the portfolio are received at
the end of the period. The value weighted rate of return r is found by solving the
following particular equation.
n

m
Dt
wT
+

t
t
t =1 (1 + r )
t =1 (1 + r )
Total ending value of portfolio
.
+
(1 + r )t

Beginning portfolio Value =

Here m is number of withdrawals, t is the length of time in years and n is number of


deposits during the period.

4.2 Risk Adjusted performance Measure (Based on Capital Asset pricing model)
Suppose that for a set of information relevant to any given stock, we can divide this
information into two major types.

4.2.1 Public information it is also called open end information. These pieces of
information are available to everyone and the manager can offer new shares at any time.
4.2.2 Private information This information is available for selected individuals only.
Suppose that if we were to estimate the expected returns, variance and covariance based
on the analysis of the public available information alone, we would see the market
portfolio positioned on the capital market line shown in the Figure 4.1 and every stocks
and portfolio would be positioned on the security market line shown in the Figure 4.2.
Figure 4.1
E(r)
0
14

Jensen Index

12

Expected return

10
8
0

SML

rf

.50

1.00
0

Beta

Measuring Portfolio Performance

1.50

22

Figure 4.2
E(r)

E(Tm)
Expected return

CML

A`

A
0

rf

Standard deviation

(rm)

(r)

Standard deviation

Consider two professionally managed portfolio, Alpha fund and Omega fund. In the
Alpha fund, the managers have private information relating to a single company and this
private information is favorable in the sense that expected rate of return to the stock is
higher then we think about the public information alone. Suppose that the managers of
the Alpha fund invest 100% of money in their portfolio in single stock of this company.
If we plot the portfolio position based on the public information alone. Its point label A in
figures 4.1 and 4.2 as shown above. Alpha fund plot at point A/ in the above two figures,
based on the both public and private information and it is above the security market line.
With the 2% additional increment in its expected rate of return, its still position inside the
efficient set.
In the Omega fund, the managers are more skillful because they have able to acquire
private information on many other companies. Suppose in this case, the private
information affects only in the estimate of expected return but not in the estimate of risk.
In the Figures 4.1 and 4.2 the Omega is point at O and O/ based on public information
alone and both public and private information respectively. Omega does not look like
very special to those of us who only have public information to make one estimates.
The typical structure of a risk adjusted performance measure is

Risk adjusted performance = performance / Risk

Measuring Portfolio Performance

23

4.3 Risk-Adjusted Performance Indices


There are three indices available for measuring the risk-adjusted performance.

The Jensen Index (Jensen, 1968)


The Sharp Index (Sharp, 1966)
The Treynor Index (Treynor, 1965)

All three indices are based on the capital asset pricing model and they are in widespread
use. The Jensen Index is a measure of relative performance based on the security market
line, whereas the Treynor and Sharp indices are based on the ratio of the return to risk. It
is generally assumed in the Jensen and Treynor Indices that stocks are priced according to
the capital asset pricing model. We know that capital asset pricing model theory proposes
that the expected return on a risky investment is composed of the risk free rate and a risk
premium, where the risk premium is the excess market return over the risk free rate
multiplied by beta. The Jensen and Treynor indices deal with risk-adjusted performance
stickle based within the framework of capital asset pricing model and both are bounded
by capital asset pricing model assumptions. We have already discussed these assumptions
in Chapter 3.

4.3.1

The Jensen Index

An index that uses the capital asset pricing model (CAPM) to determine whether a money
manager outperformed a market index.
In finance, Jensens index is used to determine the required (excess) return of a stock,
security or portfolio by the capital asset pricing model. Jensen index utilizes the security
market line as a benchmark. In 1970s, this measure was first used in the evaluation of
mutual fund managers. This model is used to adjust the level of beta risk, so that riskier
securities are expected to have higher returns. It allows the investor to statistically test
whether portfolio produced an abnormal return relative to the overall capital market.
An important issue regarding the use of Jensen Index is the choice of the market index,
because the portfolio performance will be compared with the market portfolio.
According to capital asset pricing model (CAPM), in an equilibrium risk return model
(Levy and Sarnat, 1984) the expected rate of return on an asset or portfolio is expressed
as
Erp = rp + ( Erm rf ) p .

Here
Erp = expected return of an asset or portfolio
rf

= risk free rate of return

Erm = expected return on the market portfolio

Measuring Portfolio Performance

(1)

24

p = beta or systematic risk of the asset or portfolio.


We want to obtain the Jensen Index, a time series regression of the securitys return
( rp rf ) is regressed against the market portfolio excess return ( rm rf ) .
Now

(r

rf ) = p + ( rm rf ) p + p .

(2)

Here
rp =

return on the portfolio

rf =

risk free rate of return

p =
p =

Jensen Index measure of the performance of the portfolio


beta or systematic risk of the portfolio

rm =

return of the market portfolio

p = portfolio random error term.


Now by taking mean on the both sides of equation (2), we obtain

(r

rf ) = p + ( rm rf ) p .

(3)

By Levy and Sarnat 1984, the average error term p is always zero.
So equation (3) become

p = rp ( rf + ( rm rf ) p ) .

(4)

In the framework of capital asset pricing model (CAPM), p should be zero. It means
that the stock has performed exactly same as the market expected based on its systematic
risk.
The Jensen Index ( p ) for a particular portfolio is identified by the vertical intercept of
the regression model described in equation (4), from the equation (4) it is clear that the
higher the vertical intercept ( p ), the greater the abnormal return achieved by the
portfolio in the excess of the market return.
Here we discussed three scenarios of super market performance along with the diagrams.
In all the scenarios, the excess returns on the fund are plotted against the excess returns
on the market.

Measuring Portfolio Performance

25

First Scenario

The excess returns on the fund are plotted against the excess returns on the market as
shown above. The regression line in the first scenario has a positive (+ve) intercept. This
is the abnormal performance.

Second Scenario

The second scenario shows what is known as market timing. If the portfolio manager
knows when the stock market is going up, he will shift into high beta stocks. If the
portfolio manager knows the market is going down, he will switch into low beta market.
In the high beta stocks, these stocks will go up even further then the market and in the
case on low beta stocks, these stocks will go down less then the market. Here we notice
that the Jensen measure is positive signaling superior performance.

Measuring Portfolio Performance

26

Third Scenario

The third scenario shows market timing, suppose the manager is so good that there are no
negative returns. The managers know the good market timing abilities. Suppose that the
market goes up. In this case, the fund goes up by more than the market, which is
indicating that it shifts into high beta stocks. It is important to notice that the Jensen
measure in this case is negative. Even though the manager has exhibited strong market
timing abilities, the performance evaluation criteria tells that he is not doing a superior
job. It is a major problem in the Jensen measure.

4.3.2

The Treynor Index

In 1965, Treynors was the first researcher who computed measure of the portfolio
performance. A measure of a portfolio excess return per unit of risk is equal to the
portfolio rate of return minus the risk free rate of return, dividing by the portfolio beta.
This is useful for assessing the excess return, evaluating investors to evaluate how the
structure of the portfolio to different levels of systematic risk will affect the return.
Symbolically, the Treynor Index ( Tp ) is presented as
Tp =

rp rf

Here
rp =

portfolio rate of return

rf =

risk free rate of return

p =

portfolio beta.

When rp > rf and p > 0 , we get a larger Treynor value. It means a better portfolio for
all the investors regarding of their individual risk performance.

Measuring Portfolio Performance

27
We discuss two cases, in which we may have a negative Treynor Value.

When rp < rf The Treynor is negative because rp < rf , we judge the portfolio
performance very poor.
When p < 0 The negativity becomes from beta, the funds performance is
superb.

There is another very important case, suppose that when rp rf and p are both negative,
then Treynor will become positive but in order to qualify the funds performance as good
or bad we should see whether rp lies above or below the security market line.
The Treynor index uses the security market line as a benchmark. This index has a
geometric interpretation which is similar to the sharp index. It measures the slope of a
line that starts at the risk free rate and connects with the point that marks the fund beta
and expected return.
All risk averse investors would like to maximize this, while a high and positive (+ve)
Treynor index shows a superior risk adjusted performance of a fund, while a low and
negative (-ve) Treynor Index shows an unfavorable risk adjusted performance of a fund.

The excess returns on the fund are plotted against the beta. The security market line is
drawn with excess returns on the vertical axis. The security market line is the dashed line
that starts from zero in the excess return axis. Notice that the mutual funds distributed
randomly above and below the security market line.

Demonstration with example


As we discuss above, when rp rf and p are both negative, then Treynor will be
positive (+ve). In order to find the fund performance as good or bad we should see
whether rp above or below the market line. Consider the following example.

Measuring Portfolio Performance

28
Assume that we have the following data for three funds namely, ABC, DEF and GHI,
with their rate of return and beta. The risk free rate is 12%. The risk for market (M) is 1.0
and the rate of return for the market (M) is 18%.

Manager
Market
ABC
DEF
GHI

Rate of Return
18%
16%
20%
22%

Beta
1.00
0.90
1.05
1.20

Now by using the Treynor index equation, we can calculate the value of each manager

For Market
We know that
Tmarket =

rp rf

Here
rp = 18%, rf = 12%,
Putting these values in equation (1)
(0.18 0.12)
Tmarket =
1.0
Tmarket = 0.06

Manager ABC
(0.16 0.12)
0.90
= 0.044

TABC =
TABC

Manager DEF
(0.20 0.12)
1.05
= 0.076

TDEF =
TDEF

Manager GHI
(0.22 0.12)
1.20
= 0.083

TGHI =
TGHI

(1)

Measuring Portfolio Performance

M = 1.0

29

Values of each Manager


Tmarket = 0.06

TABC = 0.044

TDEF = 0.076

TGHI = 0.083

Treynors SML

Return

0.2

GHI

0.15

DE
F

0.1

ABC

0.05
0
0

Beta

Securities Market line It can be calculated as


0.12 + (0.06 * Value of beta)
Manager ABC =
=

0.12 + (0.06 * 0.90)


0.174

Manager DEF =
=

0.12 + (0.06 * 1.05)


0.183

Manager GHI =
=

0.12 + (0.06 * 1.20)


0.192

These results show that GHI had the best performance and ABC did not beat the market
and DEF also beat the market as shown in the above figure.

4.3.3

Sharpe Index

In 1966 Sharpe developed a composite measurement of portfolio performance which is


very similar to the Treynor measure. The only difference being the use of standard
deviation instead of beta. The Sharpe index is a measure in which we may measure the
performance of our portfolio in a given period of time.

Measuring Portfolio Performance

30
In Sharpe index, we must know three things, the portfolio return, and the risk free rate of
return and the standard deviation of the portfolio. Another thing is that for the risk free
rate of return, we may use the average return (over the given period of time). The
standard deviation of the portfolio is measure the systematic risk of the portfolio.
The Sharpe index is computed by dividing the risk premium of the portfolio by its
standard deviation or total risk. Symbolically, the Sharpe index is presented as
SP =

rp rf

Here
rp =

portfolio rate of return

rf =

risk free rate of return

p=

standard deviation.

The Sharpe index uses the capital market line as a benchmark. Suppose that mutual fund
is positioned on the capital market line then the fund has natural performance. This
makes sense under capital asset pricing model, because on the basis of the public
information only, any investor can construct a portfolio that is positioned on the capital
market line. The higher the Sharpe measure indicates a better performance because each
unit of total risk (standard deviation) is rewarded with greater excess return.

Demonstration with example


Rate of return and standard deviation for three portfolios are given below, the risk free
rate is 0.12. The systematic risk for the market (M) is1.0 and the rate of return for market
(M) is 18%.
Portfolio
Market
UV
WX
YZ

Rate of Return
18%
17%
21%
20%

Sharpe Measure
The Sharpe index equation is
SP =

rp rf

For Market
S market =
rp =

0.18,

rp rf

rf =

0.12,

Measuring Portfolio Performance

p = 2.0

SDEV
2.00
0.18
0.22
0.23

31
Putting in above equation
(0.18 0.12)
S market =
0.20
S market = 0.300

Portfolio UV
SUV =

(0.17 0.12)
0.18

SUV = 0.278

Portfolio WX
SWX =

(0.21 0.12)
0.22

SWX = 0.409

Portfolio YZ
SYZ =

(0.20 0.12)
0.23

SYZ = 0.348

Values of each Portfolio


S market = 0.300

SUV = 0.278

SWX = 0.409

SYZ = 0.348

Capital Market line It can be calculated as


0.12 + (0.30 * SDEV)
Portfolio UV =
0.12 + (0.30 * 0.18)
=
0.174
Portfolio WX =
=

0.12 + (0.30 * 0.22)


0.186

Portfolio YZ

=
0.12 + (0.30 * 0.23)
=
0.189
Thus, the portfolio YZ did the best performance and UV failed to beat the market and
WX also beat the market.

Measuring Portfolio Performance

32

Example 4.1 Suppose a portfolio manager achieved a return of 15% his portfolio has
standard deviation of 0.3 and a market achieved a return of 14.6%, and a risk free rate of
return of 7%. Calculate the Sharpe Index.
Solution
The Sharpe index equation is
SP =
Here

rp =

rp rf

p
0.15,

rf =

0.07,

p = 0.3

Putting in above equation


(0.15 0.07)
0.3
S p = 0.267
Sp =

Example 4.2 Suppose we have to ask to analyze two portfolios having the following
characteristics.
Portfolio
1
2

Observed r
0.18
0.12

Beta
1.8
0.7

Residual Variance
0.04
0.00

The return on the market portfolio is 0.14.


The risk free rate is 0.07.
The standard deviation of the market portfolio is 0.02.

Compute
The Jensen Index for portfolios 1 and 2.
The Treynor Index for portfolios 1 and 2 and the market portfolio.
The sharp Index for portfolios 1 and 2 and the market portfolio.

a)
b)
c)
Solution

Part (a) Jensen index


Portfolio 1
We know that
p = rp ( rf + ( rm rf ) p )

Measuring Portfolio Performance

(1)

33
Here
rp =

0.18

p = 1.8

rf =

0.07

rm = 0.14

putting all values in above equation

p = 0.18 0.07 + ( 0.14 0.07 )1.8


p = 0.18 0.196
p = 0.016
p = 1.6%

or

Portfolio 2
Here
rp =

0.12

p = 0.7

rf =

0.07

rm = 0.14

again putting this values in equation (1)

p = 0.12 0.07 + ( 0.14 0.07 ) 0.7


p = 0.12 0.119
p = 0.001
p = 0.1%

or

Part (b) Treynor Index


Portfolio 1
We know that
rp rf
Tp =

(2)

Here

rp =

18%,

rf =

putting these values in equation (2).


(0.18 0.07)
1.8
Tp = 6.11
Tp =

Measuring Portfolio Performance

7%,

p = 1.8

34

Portfolio 2
Here

rp =

12%,

rf =

p = 0.7

7%,

Again putting these values in equation (2)


(0.12 0.07)
0.7
Tp = 7.14
Tp =

Treynor index for the market


T =
Here

rm =

rm rf

m
0.14,

rf =

m = 1.25

0.07,

putting these values in above equation.


(0.14 0.07)
1.25
T = 5.6
T=

Part (C) Sharpe Index


Portfolio 1
Standard deviation for portfolio 1 is given by the following equation.

p2 = p2 m2 + p2
p = [ p2 m2 + p2 ]1/ 2
1/ 2

p = (1.8) 2 (0.02) 2 + (0.04)


p = 0.0538
= 5.38%
Sharpe index for portfolio 1
SP =
Here

rp =

rp rf

(3)

p
0.18,

rf =

Measuring Portfolio Performance

0.07,

p = 0.0538

35

Putting values in equation (3)


(0.18 0.07)
0.0538
S p = 2.044
Sp =

Portfolio 2
Standard deviation for portfolio 1, we know that

p2 = p2 m2 + p2
p = [ p2 m2 + p2 ]1/ 2
p = (0.7)2 (0.02 + 0.00)

1/ 2

p = 0.0989 = 9.89%
Here

rp =

0.12,

rf =

Putting values in equation (3)


(0.12 0.07)
0.0989
S p = 0.505
Sp =

Sharpe Index for Market


S=

rm rf

(0.14 0.07)
0.02
S = 3.5
S=

Measuring Portfolio Performance

0.07,

p = 0.0989

36

4.4 Comparison of three indices


While studying the composite performance measurement of the funds, we see that Sharpe
uses Standard deviation as a measurement of risk; on the other hand, Treynor uses Beta.
If we are examining a well diversified portfolio, the ranking should be similar for all
these indices.
For my analysis, I have chosen the data from the Paper Performance Evaluation of the
Mutual Funds, by Hewad Walasmel, but he took the data from the JP Morgan Global
index bond as the risk free rate. In his paper, he has chosen around about 80 international
mutual funds, but I take only 30 and compare of these. All of the funds have been in the
market at least 10 year period.
In the first table mentioned below, we show the values of Mean, standard deviation and
beta value against each fund.
Table 4.1

Fund

Mean

SDEV

Beta

ABBE
ABFA
ASNA
BHUM
CISE
CITY
COMM
FPSI
FPSE
KBCE
NPIP
ROBU
TSB
VARL
VGRN
CAVE
INGG
POST
SEBA
WAAA
HSBC
CONS
DRGE
LLOY
WALS
CERA
UBSM
LAKE
SEBG
DNBR

0.001
0.001
0.001
0.003
0.002
0.001
0.001
0.001
0.002
0.003
0.004
0.001
0.003
0.004
-0.001
0.001
0.004
0.004
0.004
0.002
0.005
0.002
0.001
0.004
0.003
-0.002
0.002
0.003
0.002
-0.001

0.015
0.016
0.016
0.029
0.015
0.020
0.022
0.011
0.013
0.020
0.016
0.025
0.020
0.028
0.031
0.019
0.025
0.024
0.029
0.030
0.024
0.015
0.015
0.023
0.023
0.034
0.020
0.018
0.022
0.032

0.460
0.140
0.760
1.020
0.530
0.140
0.630
0.370
0.400
0.770
0.610
0.140
0.750
0.950
0.410
0.120
1.010
0.920
1.010
1.020
0.900
0.080
0.110
0.730
0.810
1.240
0.460
0.730
0.920
0.980

Measuring Portfolio Performance

37

The first step of analysis is to measure the performance of all listed above 30 funds
according to the performance measurement of Sharpe, Treynor and Jensen. We know the
formulas how to calculate the Sharpe, Treynor and Jensen indices. The table 4.2 shown
below provides an analysis of the performance of the given funds. The first, second and
third columns report the Sharpe, Treynor and Jensen respectively.

Table 4.2 Performance of the given funds

Fund

Sharpe

Treynor

Jensen

ABBE
ABFA
ASNA
BHUM
CISE
CITY
COMM
FPSI
FPSE
KBCE
NPIP
ROBU
TSB
VARL
VGRN
CAVE
INGG
POST
SEBA
WAAA
HSBC
CONS
DRGE
LLOY
WALS
CERA
UBSE
LAKE
SEBG
DNBR

0.088
0.097
0.097
0.110
0.174
0.071
0.057
0.158
0.189
0.176
0.243
0.049
0.191
0.140
-0.010
0.046
0.168
0.174
0.137
0.093
0.201
0.156
0.108
0.169
0.163
-0.053
0.114
0.206
0.093
-0.004

0.0028
0.0112
0.0020
0.0031
0.0047
0.0099
0.0020
0.0046
0.0060
0.0044
0.0063
0.0087
0.0050
0.0041
-0.0008
0.0074
0.0042
0.0045
0.0039
0.0027
0.0054
0.0320
0.0141
0.0053
0.0047
-0.0015
0.0046
0.0052
0.0023
-0.0001

0.0002
0.0012
0.0032
0.0008
0.0012
0.0011
-0.0003
0.0005
0.0011
0.0015
0.0024
0.0009
0.0020
0.0017
-0.0012
0.0006
0.0018
0.0019
0.0015
0.0003
0.0027
0.0022
0.0013
0.0021
0.0018
-0.0048
0.0001
0.0020
-0.0001
-0.0025

Measuring Portfolio Performance

38
After measuring the ratio of these funds, we separated top 15 funds according to each
measure. It is shown in table 4.3.1, 4.3.2 and 4.3.3. This shows whether there is identical
ranking for these three ratios.

Table 4.3.1 Top 15 ranking of funds using Sharpe index


Ranking
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Sharpe
NPIP
LAKE
HSBC
TSB
FPSE
KBCE
POST
CISE
LLOY
INGG
WALS
FPSI
CONS
SEBA
UBSE

Value
0.243
0.206
0.201
0.191
0.189
0.176
0.174
0.174
0.169
0.168
0.163
0.158
0.156
0.137
0.114

Table 4.3.2 Top 15 ranking of funds using Treynor index


Ranking
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Treynor
CONS
DRGE
ABFA
CITY
ROBU
CAVE
NPIP
FPSE
HSBC
LLOY
LAKE
TSB
CISE
WALS
FPSI

Measuring Portfolio Performance

Value
0.0320
0.0141
0.0112
0.0099
0.0087
0.0074
0.0063
0.0060
0.0054
0.0053
0.0052
0.0050
0.0047
0.0047
0.0046

39

Table 4.3.3 Top 15 ranking of funds using Jensen index


Ranking
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

Jensen
ASNA
HSBC
NPIP
CONS
LLOY
LAKE
TSB
POST
WALS
INGG
VARL
KBCE
SEBA
DRGE
UBSM

Value
0.0032
0.0027
0.0024
0.0022
0.0021
0.0020
0.0020
0.0019
0.0018
0.0018
0.0017
0.0015
0.0015
0.0013
0.0001

Tables 4.3.1, 4.3.2 and 4.3.3 show that each fund in the above 15 ranking has a different
rank according to the different performance measurements. We find that none of the
funds are fully diversified.

4.5 Conclusion
From the above tables we conclude that there is no identical ranking of the three
measurements for any funds. This also shows that these funds are not completely
diversified because we know that completely diversified funds have the similar ranking
for the composite performance measurement of Sharpe, Treynor and Jensen. It means that
there is still some degree of unsystematic risk that any manager can remove by
diversification.

Measuring Portfolio Performance

40

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Measuring Portfolio Performance