Portfolio Performance Evaluation and Active Portfolio Management Chapter 17

Outline
Conventional Measurement Techniques
Sharpe Index and M2 Jensen Index Treynor Index

Active Management Market Timing Style Analysis

Conventional Performance Measurement

One of the first direct applications of Markowitzs portfolio theory was for risk-adjusted performance measurement Before the 1960s, risk adjustment took the form of asset-type classifications, which were imprecise and not very analytical The Three main risk-adjusted measures:
Sharpe Index (or M2) Treynor Index Jensens Alpha

Sharpe Index
Portfolio 2
Expected Return

The Sharpe measure provides an estimate of excess return per unit of standard deviation (or total risk). This can then be compared to a benchmark portfolio.

25 20 15 10 5 0 5 10 15 20 25 30 Standard Deviation

M proxy Portfolio 1

Sp =

Rp rf

Which is better: Portfolio 1 or 2?

The M2 Measure (Modigliani and Modigliani)

Uses total volatility as risk measure (like Sharpe Index) 1. Calculate the portfolio variance 2. Add T-Bills to the portfolio to make the risk the same as the Market:
Solve w2(p2) + (1-w)2(TBills2) + 2w(1-w) P, TBills= Mkt2 Or just w2(p2) = Mkt2
3.

This adjusted portfolio P* then has returns: rP* = w(rP) + (1-w)rf M2 = rP* - rM

4.

The M2 Measure
Portfolio 2
Expected Return

The The M2 Measure gives the same results as the Sharpe measure, just in different form.

25 20 15 10 5 0

+M

M proxy
-M 2

M2 = rP* - rM

Portfolio 1
5 10 15 20 25 30

Which is better: Portfolio 1 or 2?

Standard Deviation

Treynor Index
Expected Return

The Treynor measure provides an estimate of excess return per unit of beta (or market risk). Again, this can then be compared with a benchmark portfolio.

25 20 15 10 5 0

Portfolio 2

M proxy

Tp =

Rp rf

Portfolio 1
1 1.25 1.5

0.25 0.5 0.75

Which is better 1 or 2? Statistical problems?

Beta

Jensen Index
The Jensen index provides an estimate of excess return relative to what is predicted by CAPM. This is also the alpha of the security characteristic line
25 Expected Return 20 15 10 5 0 -0.5 0

Portfolio 2

p = R p r f p [R M r f

M proxy

is generated from regressions We can also define other related measures such as the appraisal ratio: alpha relative to the portfolios diversifiable risk

Portfolio 1
0.5 1 Beta 1.5 2 2.5

Criticisms of Measures
All performance measures nest within the meanvariance framework of CAPM. Thus, benchmark error is always problem
An APT-based alternative developed by Gruber accounts for other risk factors

Changing risk measures (betas and volatilities) plague all tests

Whats ahead?
New York City Trip Signup
Vicki Rollo 307 Purnell Hall Cost is $25 2 options 1. Midtownvisit Nasdaq, Protiviti, ITG and JPMorgan 2. Wall Streetvisit the NYMEX, AMEX + ??

Homework #3 due on Thursday!!! Test #2 next Wednesday, November 1

Grubers 4-Factor Model

Controlling for factor risk, i captures managerial ability to select securities.
Actively managed mutual funds outperform by 65 basis points (b.p.) or 0.65% per year Expense ratios averaged 113 b.p. (or 1.13%)! Overall, net result is that the average actively-managed mutual fund underperforms by 48 b.p. or 0.48%

Since we can buy an S&P500 index fund for about 1012 b.p., we are better off, on average, by passive indexing

The Lure of Active Management

Some portfolio managers have hot hands that appear to be better than just lucky Anomalies in past returns suggest that there may be some value in finding predictable patterns in stock returns The potential benefits are large, if we exceed the market averages
For 10% returns over 40 years (until retirement), FV = 10,000*1.10 40 = $452,593 For 10.5% returns over the same horizon, FV = 10,000*1.105 40 = $542,614

Market Timing
The act of moving in and out of the market, based on future expectations
Get price appreciation while Avoiding bad periods Enticing since potential benefits are large here too! Example in book (p. 591) Invest $1 in 1924
1. In T-bills, get $17.56 at end of 2003 2. In SP500, get $1,992.80 3. If perfect timing, get $148,472!

Actual Market Timing Results

See Wall Street Journal article on actual mutual fund investment returns Average investor falls victim to psychological biases
Buys more after prices run up Doesnt sell to minimize losses

Net result is that the average investor dramatically underperforms even the average mutual fund return
Even before fees!

Bottom Line: Market timing can be hazardous to your wealth

Style Analysis
Process of benchmarking fund returns to the style of assets that comprise the portfolio Sharpe comes up with 12:
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. T-Bills Intermediate bonds Long-term bonds Corporate bonds Mortgages Value stocks Growth stocks Mid-cap stocks Smalll stocks Foreign stocks European stocks Japanese Stocks

Style becomes the benchmark

Compare fund returns to weighted average of the style portfolio Fidelity Magellan, for instance,
47% growth stocks 31% mid-cap stocks 18% small stocks 4% European stocks

Analogous to factors being other portfolio returns Regress fund returns on these style portfolios Residual returns signal under- or over-performance
Like the alpha in CAPM or APT models

Average residual = -0.074% per month! (over 636 funds)

International Investing
Chapter 18

Summary
Global Markets offer unique risk/return tradeoffs
Should be included in true CAPM analyses May be quantified as unique APT factors

Home country bias

Most investors notoriously overweight home country stocks compared to international stocks Many investors actually hold no foreign equities

Unique Risk Factors

Exchange rate risk Country-specific (political) risk

Exchange Rate Risk

International investing gives returns denominated in foreign currencies Even if stock returns in the foreign currency are large, dollar-denominated returns may not be
Exchange rate can make $-denominated returns higher or lower

Can be hedged away using derivativesusually futures

See FINC416 Derivative Securities See FINC415 International Finance

International mutual funds offer exchange rate hedged returns

Benefits of International Diversification

Easy to over-estimate benefits
Recent history of country-specific risk might suffer from survivor bias Unknown political risk makes recent actual performance exceed the expected performance Historic covariances underestimate future covariances Past diversification benefits are over-estimated

Simple rule would be to invest in two other countries

Same benefits as 44 countries Benefits amount to 1% less standard deviation than the simple U.S. index portfolio

Behavioral Finance and Technical Analysis Chapter 19

Returns and Behavioral Explanations

Calendar effects
1. Seasonal flow of funds gets translated into stock purchases (end of year bonuses, end of month paychecks). 2. Window dressing by institutional traders each quarter SEC requires quarterly reporting Managers, wanting to be seen as smart, load up on good stocks, dump bad stocks before reporting 3. Good and bad news released around calendar year turns.

Technical Analysis--Overview
Using past stock prices and volume information to predict future stock prices
The premise is that there would be predictable patterns in returns

Charting Techniques Technical Indicators Value Lines System

Charting
The Dow Theory
1. Primary trend (long-term) Last for several months, years 2. Secondary (intermediate) trend Shorter term deviations get corrected when prices revert back to trend values 3. Tertiary (minor) trends Unimportant daily fluctuations

Other Charting Techniques

Point and Figure Charts
Traces up and down movements without regard to time See Figure 19.4, Table 19.2 in book Buy and sell signals when prices penetrate previous highs and lows

Candlestick Charts
Used to identify support and resistance Used to identify rallies, trends

Technical Indicators
Sentiment Indicators give bullish/bearish signals
Trin statistics use advances, declines and volume Odd-lot theory assumes that individual investors miss key market turning points Confidence index is the ratio of 10 top-rated bond yields to 10 intermediate-grade yields Put/Call ratios look at options market activity Mutual fund cash positions assumes that mutual fund investors miss key market turning points

Technical Indicators
Flow of Funds
Short Interest (reflects smart money) Credit Balances in brokerage accounts (signals intent for future purchases)

Market Structure
Moving averages Breadth (advances minus declines cumulated over time) Relative strength (momentum)

The Value Line system

1. Relative earnings momentum 2. Earnings surprises 3. Value index (a 3 factor model of value)