Tutorial 11 Solutions – Portfolio Management – II

[Readings: Ch25]

Q1 Discuss the key features of the following portfolio performance measures:

 Sharpe Ratio
 Treynor Ratio
 Jenson’s Alpha
 The Information Ratio

Ri  RFR
Sharpe Ratio measure: Si  where i represents total risk.
i

• Sharpe uses standard deviation of returns as the measure of risk - portfolio

performance is measured in relation to the CML
• Treynor measure uses beta (systematic risk) - examines portfolio
performance based on the SML.
• Sharpe therefore evaluates the portfolio manager on the basis of both rate of
return performance and diversification
• Produce relative not absolute rankings of performance
• The methods agree on rankings of completely diversified portfolios

Treynor Ratio recognised two components of risk

– Risk from general market fluctuations
– Risk from unique fluctuations in the securities in the portfolio
His measure of risk-adjusted performance focuses on the portfolio’s
nondiversifiable risk, market or systematic risk

Ri  RFR
T
i
The numerator is the risk premium (average return on security i over time less the
average risk free rate).
The denominator is a measure of systematic risk
The expression, T, is the risk premium return per unit of risk
Risk averse investors prefer to maximize this value
This assumes a completely diversified portfolio leaving systematic risk as the
relevant risk.

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Jensen Alpha
• Based on CAPM
• Expected return on any security or portfolio is:
E ( R j )  RFR   j [ E ( RM )  RFR]
Where: E(Rj) = the expected return on security j
RFR = the one-period risk-free interest rate
j= the systematic risk for security or portfolio j
E(Rm) = the expected return on the market portfolio of risky assets

E(Rj) and RFR change over time, hence a time series of rates is employed.The
empirical CAPM includes an error term, and in risk-premium format it is:

E ( R jt )  RFRt   j [ E ( Rmt )  RFRt ]  e jt

Superior portfolio managers earn higher risk premiums than those suggested by
the model. Superior performance may be measured by adding an intercept term
(alpha) to the equation as follows:

E ( R jt )  RFRt   j   j [ E ( Rmt )  RFRt ]  e jt

j indicates if the manager is superior ( >0) or inferior ( <0).
Some advantages of Jenson’s measure over Treynor & Sharpe:

 easier to interpret ~ the value of alpha indicates how good the manager is

 alpha is empirically estimated using regression, enabling tests of

significance to be applied

 Jenson’s measure is flexible enough to allow for alternative models – single

factor (such as CAPM) & multifactor (such as Fama & French 3-factor
model).

The Information Ratio measures average return in excess of benchmark

portfolio divided by the standard deviation of this excess return

R j  Rb ER j
IR j  
 ER  ER
where ER is the residual (unsystematic) risk, also called the tracking error.

 The Sharpe ratio may be seen as a special case of the IR where the risk free
asset is assumed to be the benchmark portfolio
 If excess portfolio returns are estimated with historical data using the same
single-factor regression equation used to compute Jenson’s alpha, the IR
j
simplifies to: IR j   where e is the standard error of the regression.
e

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Q2 Describe two major factors that a portfolio manager should consider before
designing an investment strategy. What types of decisions can a manager make to
achieve these goals?

The two major factors would be: (1) attempt to derive risk-adjusted returns that
exceed a naive buy-and-hold policy and (2) completely diversify - i.e., eliminate all
unsystematic risk from the portfolio. A portfolio manager can do one or both of two
things to derive superior risk-adjusted returns. The first is to have superior timing
regarding market cycles and adjust your portfolio accordingly. Alternatively, one can
consistently select undervalued stocks. As long as you do not make major mistakes
with the rest of the portfolio, these actions should result in superior risk-adjusted
returns.

Q3 An analyst wants to evaluate Portfolio X, consisting entirely of U.S. common

stocks, using both the Treynor and Sharpe measures of portfolio performance. The
following table provides the average annual rate of return for portfolio X, the
market portfolio (as measured by the S&P 500), and the U.S. Treasury bills during
the past eight years:
Average annual Standard deviation Beta
Rate of return of return
Portfolio X 10% 18% 0.6
S&P 500 12% 13% 1.0
T-bills 6% N/A N/A

(i) Calculate the Treynor and Sharpe measures for both Portfolio X and the
S&P 500. Briefly explain whether Portfolio X under-performed,
equalled, or out-performed the S&P 500 on a risk-adjusted basis using
both Treynor and Sharpe measures.

(ii) Based on the performance of Portfolio X relative to the S&P 500

calculated in part (i), briefly explain the reason for the conflicting
results when using the Treynor measure versus the Sharpe measure.

(i) Treynor measure:

S&P500: (12 – 6)/1 = 6
Portfolio X: (10 – 6)/0.6 = 6.67

(ii) Sharpe measure:

S&P500: (12 – 6)/13 = 0.462
Portfolio X: (10 – 6)/18 = 0.222

Portfolio X outperforms the S&P500 based on the Treynor measure, but

underperforms based on the Sharpe measure. The inconsistency is due to
differences in the unit risk measure. Treynor measure uses beta risk, while
Sharpe measure is a total risk measure. This implies that Portfolio X has some
unsystematic risk in its total risk (i.e. it is not well diversified). If Portfolio X
were well diversified, then both measures will provide similar rankings.

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Q4 Consider the following table:
Average Standard
Return % p.a. Deviation % p.a. Beta
Market Index 10.7 19.0 1.00
Fund I 19.4 44.2 1.34
Fund II 13.5 21.8 1.12
Fund III 12.9 17.6 1.30
Fund IV 9.3 5.6 0.71

a) If the return on long term Commonwealth bonds is 5.6% per annum,

calculate the following performance measures for each of the funds
in the table and the market index.

(i) Jensen's alpha P  R P  R f  P  R M  R f 

SP 
R  Rf 
10.7  5.6

 0.268
(ii) Sharpe index P

P 19.0
R  R f 10.7  5.6
(iii) Treynor index TP  P   5.10
P 1

Jensen's alpha Sharpe Index Treynor Index

Market Index - 0.268 5.100

Fund I 6.966% 0.312 10.299
Fund II 2.188% 0.362 7.054
Fund III 0.670% 0.415 5.615
Fund IV 0.079% 0.661 5.211

b) Compare and comment on your answers for part a).

From part a), the performance measures provide different rankings.
Under Jensen’s alpha, Fund I is clearly preferred and the ranking is Funds
I, II, III and IV. Under the Sharpe index, all funds perform better than the
market benchmark and the ranking of funds is reversed, ie. Funds IV, III,
II and I. Under the Treynor index, the ranking is yet again reversed with
Fund I now the highest ranked, ie. Funds I, II, III and IV. The results show
that inconsistency in rankings is possible under different performance
measures.

c) Which fund has exhibited the best performance?

Given the inconsistency in rankings, it is difficult to claim one fund as
superior. Fund I is ranked best under Jensen’s alpha and the Treynor
index while Fund IV is ranked best under the Sharpe index. Both Jensen’s
alpha and the Treynor index use beta as the risk measure while the
Sharpe index uses standard deviation as the risk measure. Hence, the
ranking of funds depends upon the investor’s assessment as to the
appropriate risk measure (which may include consideration of the level
of diversification).

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 Q5

(i) Explain the circumstances in which the Sharpe and Treynor indices can
provide conflicting fund rankings.
The Sharpe and Treynor measures can provide conflicting rankings. The
inconsistency is due to differences in the unit risk measure. The Sharpe Index
uses standard deviation whereas the Treynor Index uses beta risk. However,
if the fund is well diversified then nonsystematic risk will be largely
eliminated and the Sharpe and Treynor Indices will provide very similar
rankings.

(ii) What is the Carhart (1997) model? How does it differ from the Jensen’s alpha
measure?
Carhart’s (1997) empirical model is expressed as:

Rp – Rf = αp + βpRm +spSMB +hpHML +upUMD +εp

Carhart’s model has four return generating factors: 1) Rm is the return on the
market index; 2) SMB is the return on the mimicking size portfolio; 3) HML is the
return on the mimicking book-to-market portfolio; and 4) UMD is the return on
the mimicking momentum portfolio. Carhart’s model is supposedly used to control
for market biases.

Now if we assume that Carhart’s model is an accurate one, then the error returns
can be assumed away, allowing the estimation of alpha for any portfolio:

αp = (Rp – Rf) – (βpRm +spSMB +hpHML +upUMD)

Carhart’s alpha, as described above, is a measure of superior performance after

controlling for the forces generated by the market return, size premium, value
premium and especially momentum premium (many funds utilise the momentum
strategy in their portfolio management).. Hence, any fund managers that construct
portfolios designed to capture these premiums will find that their returns are captured
within the model, and so they will not exhibit any alpha performance. Rather,
managers that have strategies that do not follow mainstream premiums are expected
to have alpha performance. In this sense, Carhart’s alpha is regarded in the industry as
a more appropriate measure of individual performance. Jensen’s alpha, on the other
hand, assumes that the CAPM is the appropriate benchmark, to the extent that the
CAPM is valid. Hence, Jensen’s alpha relies upon an estimate of beta that may be
problematic. Further, the measure is claimed to only measure depth and not breadth.
For instance, a fund manager may have invested in a large number of stocks on which
several losses have been made, but also picked a stock on which a substantial profit
was made. The resultant value of Jensen’s alpha could be positive, but this is due to one
lucky winner and not consistent performance across the portfolio. In such a case, it
could be incorrectly concluded that the manager had superior skills.

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(iii) A substantial amount of evidence on the performance of funds has provided
inconsistent results. What are some examples of this inconsistency? What are some
of the explanations for the inconsistency?

Early studies in this area typically found that funds, on average, under-performed the
benchmarks. The conclusion from studies was strong evidence against the ability of fund
managers to out-perform market benchmarks. Subsequent studies, especially in the USA
revealed inconsistent results. Some studies found evidence of positive alphas indicating
superior fund performance. But the results are sensitive to the sample, time-period and
the market index. Specifically, the use a value-weighted market index appears to result in
lower values of Jensen’s alpha than an equal-weighted market index.

Research during the 1980s focussed on more specific performance attributes such as
market timing, consistent with the advancement in the theoretical performance models.
This research has generally shown that fund managers do possess market timing ability
but again the results are mixed. The likely explanation for the conflicting results is in
different samples over different time periods and different performance benchmarks.
Data from different funds and over different time periods indicates sensitivity in the
results. Moreover, depending on the selected performance benchmark, different funds
and indeed funds in aggregate perform differently.

Q6 Consider the following information regarding the performance of a money

manager in recent month. The table represents the actual return of each
sector of the manager’s portfolio in column 1, the fraction of the portfolio
allocated to each sector in column 2, the benchmark or neutral sector
allocations in column 3, and the returns of sector indices in column 4.

Actual Actual Benchmark Index

return weight Weight return
Equity 2% 0.7 0.6 2.5% (S&P 500)
Bonds 1% 0.2 0.3 1.2% (Salomon Brothers index)
Cash 0.5% 0.1 0.1 0.5%

(i) What was the manager’s return in the month? What was her over-
performance or under-performance?
(ii) What was the contribution of security selection to relative performance?
(iii) What was the contribution of asset allocation to relative performance?
Confirm that the sum of selection and allocation contribution equals her
total “excess” return relative to the bogey.
(iv) Which investment decisions would you allow this manager to make?

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 (i) Benchmark: 0.6(2.5%) + 0.3(1.2%) + 0.1(0.5%) = 1.91%
Actual: 0.7(2.0%) + 0.2(1.0%) + 0.1(0.5%) = 1.65%
Underperformance - 0.26%

(ii) Security selection:

(1) (2) (1)x(2) = (3)
Market Excess return Manager’s portfolio Contribution
(Manager – index) weight to performance
Equity -0.5% 0.70 -0.35
Bond -0.2% 0.20 -0.04
Cash 0 0.10 0

Contribution of security selection -0.39%

(iii)
Asset allocation:
(1) (2) (1)x(2) = (3)
Market Excess weight Index return Contribution
(Manager – benchmark) - Index Overall to performance
Equity 0.10 0.59 0.059
Bond -0.10 -0.71 0.071
Cash 0 -1.14 0
Contribution of asset allocation 0.13%

Summary:
Security selection -0.39%
Asset allocation 0.13%
Excess performance -0.26%

(iv) This manager should only be allowed to make equity and bond asset allocation
decisions.