Measurement of Portfolio Returns

Portfolio Management
Business 4179

Performance Measurement versus Performance Evaluation

Performance Measurement involves the calculation of the return realized by a portfolio manager over some time interval called the evaluation period. Performance Evaluation is an appraisal of how well a managed portfolio has done over the evaluation period.

Performance Measurement

The are only four types of transactions that occur in a portfolio: purchases sales income and distribution

Return and Risk Considerations in Portfolio Performance Measurement

Performance measurement begins with portfolio valuations and transactions translated into rate of return. In evaluating portfolio performance both the realized return and risk that was assumed must be taken into account.

Portfolio Returns Measured

When evaluating returns on an individual asset the Holding Period Return is used. This same approach can be used in the case of Portfolios as long as no there were no additions or withdrawals from the principal of the portfolio over the period being measured.

Sources of Error in Performance Measurement

Portfolio valuation is always viewed as a hypothetical liquidation of the securities without incurring transactions costs. The only fair market value of any security is what it will fetch at the time of sale. While it may be easy to use the last quoted price for active, liquid stock, it is more difficult for thinly traded stock. An excellent example where market value may be far from liquidation value is real estate. Appraisals may be as much as a year out of date, the appraisal itself may use stale data and real estate appraisal is an educated guess at best.

Sources of Error in Performance Measurement ...

When an actual trade takes place, is it trade date or settlement date that the trade is recorded? If there is no trade, do you use bid or ask price? (the bid price should be used for bonds, but often the ask or midspread price is employed for stocks) Even income valuation is subject to some lattitude. Is accrual accounting or cash accounting used? When dividends are received - the ex-dividend day or on receipt - and so forth? These variations do not introduce major effects, but nonetheless add to the uncertainty concerning performance data.

Portfolio Returns Measured

Remember we are addressing realized returns when we discuss measurement of portfolio performance. Ie. These are ex post calculations

Portfolio Performance Measurement

Investors should be concerned with the total change in wealth. If there have been no additions or withdrawals from a portfolio over an evaluation period, simply measure the market value at the beginning and end of the period. The rate of return is found using:

VE VB Rp VB

Portfolio Performance Measurement

For exampleif the market value of the portfolio at the beginning of the period was $11.2 m, and the ending value of the portfolio was $11.8 m, the holding period return would be: (NOTE: a single period return does not take time value of money into account.)

VE VB Rp VB $11.8 $11.2 $0.6 5.36% $11.2 $11.2

Portfolio Performance Measurement

If the client added funds close to the end of the period, the return could be mistakenly attributed to the effort of the portfolio manager.

VE VB Rp VB $11.8 $11.2 $0.6 5.36% $11.2 $11.2

Dollar-Weighted Returns

Equates all cash flows including ending market value, with the beginning value of the portfolio. It is equivalent to the IRR. Because the DWR is affected by cash flows it measures the rate of return to the portfolio owner. However, because the DWR is heavily affected by cash flows, it is inappropriate to use when making comparisons to other portfolios or to market indexes.

Dollar-Weighted Returns an example

An equity portfolio is worth $10,000 at the beginning of the year. After six months the portfolio pays a dividend of $100 and the investor contributes $300 more to the portfolio. Just before the contribution and dividends, the portfolio was worth $10,050. At the end of the year, the investor receives $100 in dividends and withdraws an additional $150 from the portfolio, which has an ending value of $10,700 after the withdrawal has been made. To solve for the DWR, we equate the present value of the contributions and the beginning market value, with the present value of withdrawals, cash receipts, and the ending portfolio value, and solve for the corrresponding discount rate:

Dollar-Weighted Returns an example

Present value (Beginning wealth + contributions) = Present value (cash distributions + withdrawals + ending wealth)
300 100 150 100 10 , 700 (1 r ) (1 r ) (1 r ) 2 (1 r ) 2 (1 r ) 2 which reduces to 200 10 , 950 10,000 (1 r) (1 r ) 2 r 3 . 65 percent semi annually 10 , 000 the annual effective

return (1 .0365)

1 7 . 43 percent

You can set this up on a spreadsheet and use the built-in IRR function to solve for the discount rate as well.

Time-Weighted Returns

Measures the actual rate of return earned by the portfolio manager. TWRs are unaffected by any cash flows to the portfolio, therefore, they measure the actual rate of return earned by the portfolio manager. TWR requires information about the value of the portfolios cash inflows and outflows. We calculate the return to the portfolio immediately prior to the cash flow occurring. We then calculate the return to the portfolio from that cash flow to the next, or to the end of the period. Finally, we link these rates of return together by computing the compound rate of return over time.

Time-Weighted Returns an example

For the prior example, the corresponding TWR would be:

10 ,050 10 ,000 100 1 . 50 % 10 ,000 10 ,850 10 ,350 100 For period two (the next six months)r 2 5 . 80 % 10 ,350 The annual return (based on the geometric average) over the entire period is For period one (the first six months) r1 r [(1.0150)( 1.0580)] - 1 0.0739 or 7.39%

Notice that this differs from the DWR of 7.43%

Which Return Measure Should Be Used?

TWR - used when evaluating the performance of the portfolio manager. (because the manager has no control over the deposits and withdrawals made by clients.) The objective is to measure the performance of the portfolio manager independent of the actions of the client. DWR - used to find the rate of return earned by the portfolio owner.

AIMRs Presentation Standards

(United States)

The Association for Investment Management and Research has issued minimum standards for presenting investment performance. Performance Presentation Standards (PPS) are a set of guiding ethical principles with two main objectives:
to promote full disclosure and fair representation by investment managers in reporting their investment results u to ensure uniformity in reporting in order to enhance comparability among investment managers.

AIMRs Presentation Standards ...

Requirements:

TOTAL RETURN - must be used to calculate performance ACCRUAL ACCOUNTING - use accrual, not cash accounting for fixed-income and all other securities that accrue income TIME-WEIGHTED RATES OF RETURN - to be used on at least a quarterly basis and geometric linking of period returns. CASH AND CASH EQUIVALENTS - to be included in composite returns. ALL PORTFOLIOS INCLUDED - all actual discretionary portfolios are to be included in at least one composite .

AIMRs Presentation Standards ...

Requirements:

NO LINKAGE OF SIMULATED PORTFOLIOS WITH ACTUAL PERFORMANCE ASSET-WEIGHTING OF COMPOSITES - beginning-of-period values to be used ADDITION OF NEW PORTFOLIOS - to be added to a composite after the start of the next measurement period EXCLUSION OF TERMINATED PORTFOLIOs - excluded from all periods after the period in place NO RESTATEMENT OF COMPOSITE RESULTS - after a firms reorganization.

AIMRs Presentation Standards ...

Requirements:

NO PORTABILITY OF PORTFOLIO RESULTS ALL COST DEDUCTED - subtracted from gross performance 10-YEAR PERFORMANCE RECORD - minimum period to be presented PRESENT ANNUAL RETURNS FOR ALL YEARS CONVERTIBLE AND OTHER HYBRID SECURITIES - must be treated consistently across and within composite ASSET-ONLY RETURNS - must not be mixed with asset-pluscash returns.

AIMRs Presentation Standards ...

Requirements:

there are additional requirements for international portfolios, for real estate, and for venture and private placements. Performance presentations must disclose several items of investment information such as a complete list of a firms composites, whether performance results are gross or net of investment management fees, and so on.

Mutual Fund Reporting Requirements

(Canada)

TWR - used when evaluating the performance of the portfolio manager. (Required of Canadian mutual funds according to the OSC. They determine total returns based on the change in NAVPS of the fund..indicated rates of return are the historical annual compound total return(s) including changes in (share or unit) value and reinvestment of all (dividends and distributions and do not take into account sales, redemption, distributions or optional charges or income taxes payable by an security holder that would have reduced returns. Dividends or distributions are to be assumed reinvested in the mutual fund at the net asset value per security of the mutual fund on the reinvestment dates during the portfolio measurement period.

Mutual Fund Reporting Requirements

(Canada)

Since TWR are used in mutual fund reporting in Canadanotice that they are most useful in evaluating the portfolio manager. Unfortunately, many people assume that the reported return is the return that they have earned on their own portfoliothis may or may not be the case given their personal pattern of investment and redemption. Individual investors should use dollar weighted return measures tracking their own returns in order to assess their personal rate of return that has been realized.

CSC notes

The Canadian Securities Course describes the following method of computing total return. It is calculated by dividing the portfolios total earnings (income plus capital gains or losses) by the average amount invested in the portfolio:
Increase in market val ue Average amount invested Closing value - [(Opening value net contributi ons (or - net deductions )] Opening value [Net contributi ons or - Net deductions ] / 2

Total return

This approach is subject to distortions if large withdrawals or deposits are made toward the end of the measurement period.

Measuring Performance
How well is the portfolio manager doing her job?

Peer Group Comparison

(Using Comparison Universes)

The most popular of relative performance evaluation is to compare a portfolios return to the performance of a large number of other portfolios with similar risk characteristics. The collection of portfolios that form the basis for comparison is called a performance universe or comparison universe.

Comparison Universes
(Boxplot graphic charts explained)

The appraisal firms collect performance information from a large number of managed portfolios and customarily display the information in the form of a chart such as the one presented found on the following slide. In each period, the portfolios are ranked by return, by industry convention. 100th percentile ranking is the worst. For example, the manager with the tenth best performance in a universe of 100 funds would be the 10th percentile manager. The upper and lower lines forming the rectangle represent the 5th and 95th percentile managers.

Comparison Universes ...

(Boxplot graphic charts explained)

The dotted lines are the 25th and 75th percentile rate of return and the solid line is the 50th percentile (median). The round circle in each bar represents the performance of the manager being evaluated.

Figure 8.1 Intra-universe Comparisons

Return (%)

25%

20%

15%

10% 5%

ABC Portfolio
0%

- 5%

1987-96

88-96

89-96

90-96

91-96

92-96

93-96

94-96

95-96

1996

Period

Comparison Universes ...

(Problems with comparison universes)

The contents of many comparison universes are poorly defined so the sponsor does not know exactly what the portfolio is being compared against. (For example, a balanced fund universe may contain everything ranging from essentially equity funds with a modest bond component to bond funds with small stock exposures) Broad performance universes do not do well in controlling for risk. As universe providers respond to concerns about mismatched risk by creating subuniverses that more closely reflect a managers style, the subuniverses shrink in size, thereby raising questions about statistical reliability.

Comparison Universes ...

(Problems with comparison universes)

Normally the returns are gross of management fees making it impossible to determine net asset value added performance. Survivorship bias infests all comparison universes in some form no matter how carefully they are constructed. As defunct portfolios drop out, they have to be excluded from the rankings in subsequent quarters; therefore, a performance universe is always a universe of survivors.

Comparison Universes ...

(Problems with comparison universes)

This method does not take risk into account. Even if all of these concerns were addressed universe comparison still suffers from a structural defect --REMEMBER - that one of the important characteristics of a good benchmark is that it be investable.

Suppose a client compares a managers performance with that of the median manager. Such a benchmark is not investable because no one knows before hand who the median manager will be. Moreover, the median manager changes from period to period.

Comparison Universes ...

(Conclusion)

In the popular press today, comparison universe approaches remain dominant first, second, third, and fourth quartile fund rankings are commonly used to evaluate performance and often are used in selecting portfolio managers. Despite their popularity, serious concerns about their validity remain.

Risk-Adjusted Measures of Performance

High returns earned at low risk are presumably favoured more by risk-averse wealth maximizing investors vis a vis high returns earned at high risk. A composite (risk-adjusted) measure of portfolio performance takes into account both risk and return.

Risk-adjusted Measures of Performance

The Sharpe measure The Treynor measure Jensens Differential Return Measure

The Sharpe Performance Measure

The Sharpe measure is also called the reward-to-variability ratio (RVAR). This measure uses RVAR [TR RF ] / SD a benchmark Excess return / Risk based on the Where : ex post capital TR the average TR for portfolio p during some period of time RF the average risk - free rate of return during the period market line.
p p p

SD p the standard deviation of return for portfolio p during the period TR p RF the excess return (risk premium) on portfolio p

The Treynor Measure (RVOL)

Treynor distinguishes between total risk and systematic risk Implicitly the measure assumes that portfolios are well diversified; (ie. the measure ignores any diversifiable risk) in this case we are calculating the excess return per unit of systematic risk. Treynor introduced the concept of the characteristic lineit is used in a similar manner with portfolios, depicting the relationship between the returns on a portfolio and those of the market. The slope of the line is the beta coefficient.

The Treynor Performance Measure

The Treynor measure is also called the reward-to-volatility ratio (RVOL). This measure uses RVOL [TR RF ] / a benchmark Excess return / Systematic Risk based on the Where : ex post security the beta for portfolio p market line. TR RF the excess return (risk premium)
p p p p

on portfolio p

Example of Calculating Sharpe and Treynor Ratio

Return and Risk for Five Canadian Equity M utual Funds Novem b er 1, 1996 to O ctob er 31, 1998 S ta nda rd De via tion M utua l Fund AIC Divers ified Canadian Altamira Equity Inves tors Canadian Equity Roy al Canadian Equity Tem pleton Canadian E quity TSE 300 RF (30-day T-bills) Ave ra ge Re turn (%) 36.40% 3.01% 7.24% 12.03% 12.99% 13.75% 5.19% Je nse n's M utua l Fund AIC Divers ified Canadian Altamira Equity Inves tors Canadian Equity Roy al Canadian Equity Tem pleton Canadian E quity TSE 300 RVAR 1.72 -0.10 0.10 0.41 0.62 0.47 RVO L(%) 0.36 -0.02 0.02 0.08 0.12 0.09 Alpha (%) 23.76 -11.08 -6.25 -0.35 1.91 (%) 18.18% 21.64% 19.79% 16.76% 12.57% 18.05% Be ta 0.87 1.04 0.97 0.84 0.63 1

Consider the data for five Canadian equity mutual funds for the three year period from November 1, 1996 to October 31, 1998

Sharpes Measure of Performance (RVAR)

Rate of Return

35 30 25 20 15 10
Templeton

AIC

RVAR for AIC and Templeton lie above the Capital Market Line, indicating superior risk-adjusted performance.

CML

TSE 300 Royal Canadian Investors

RF 5 5 10 15 20

Altamira

25

Standard Deviation of Return

Sharpes Measure of Performance (RVAR)

In the prior diagram we are drawing the CML when we plot the markets return against its standard deviation and use the RF as the vertical intercept.

All efficient portfolios should plot on this line, and an investor with the ability to borrow and lend at the rate RF should be able to attain any point on this line.
Of course, this is the ex post and not the ex ante CML

Treynors Measure of Performance (RVOL)

Rate of Return

35 30 25 20 15 10
Templeton

AIC

Use of RVOL implies that systematic risk is the proper measure to use when evaluating portfolio performance; therefore, it implicitly assumes completely diversified portfolio

SML
TSE 300 Royal Canadian Investors

RF 5 0.2 0.4 0.6 0.8 1.0

Beta Coefficient

Altamira

1.2

Comparing the Sharpe and Treynor Measures

Given the assumptions underlying each measure, both can be said to be correct. Usually it is desirable to calculate both for the set of portfolios to be evaluated. If the portfolios are perfectly diversified - that is, the correlation coefficient between the portfolio return and the market return is 1.0 - the rankings will be identical. As the portfolio becomes less well diversified, the possibility of differences in rankings increases

RVOL assumes portfolios are well diversified while RVAR does not

Comparing the Sharpe and Treynor Measures ...

Investors who have all (or substantially all) of their assets in a portfolio of securities should rely more on the Sharpe measure because it assesses the portfolios total return in relation to total riskwhich includes any non-systematic risk assumed by the investor. However, for those whose portfolio constitutes only one (relatively ) small part of their total assets - that is, they have numerous other assets - systematic risk may well be the relevant risk. In these circumstances RVOL is appropriate because it considers only systematic or non-diversifiable risk.

Jensens Differential Return Measure (alpha)

Jensens measure, like Treynors is based on the capital asset pricing model (CAPM) According to the CAPM, the expected return on any security (i) or, in this case, portfolio (p) is given as:

E(R p ) RF p [ E ( RM ) RF ]

Jensens Differential Return Measure (alpha)

This equation covers an ex ante period, but can be applied to ex post periods if the investors expectations are realized, on averageempirically this can be approximated as follows:

E(Rp ) RF p[E(RM ) RF] ept

Ept = random error term for portfolio p in period t

Jensens Differential Return Measure (alpha)

This equation can be rewritten in the risk premium form by moving RF to the left side and subtracting it from Rpt

Rpt RF p[E(RM ) RF] ept

Where Rpt RFt is the risk premium on portfolio p This indicates that the risk premium on portfolio p is equal to the product of its beta and the market risk premium plus an error term. In other words, the risk premium on portfolio p should be proportional to that on the market portfolio if the CAPM model is correct and investor expectations were generally realized.

Jensens Differential Return Measure (alpha)

Rp - RF X Y Z
This shows the Characteristic line in excess return form.

aX aY aZ

RM - RF

Jensens Differential Return Measure (alpha)

This equation can be empirically tested by fitting a regression for some number of periods Portfolio excess returns (risk premiums) are regressed against excess returns (risk premiums) for the market. If managers earn a return proportional to the risk assumed, this relationship should holdthat is, there should be no intercept term (alpha) in the regression (the line should plot through the origin). Given these expectations Jensen argued that an intercept term, alpha, could be added to the equation to indentify superior or inferior (risk-adjusted) performance.

Rpt RF a p p[E(RM ) RF] ept

Jensens Differential Return Measure (alpha)

The CAPM asserts that equilibrium conditions should result in a zero intercept term. If alpha is significantly positive, this is evidence of superior performance

R pt RF a p p [ E ( R M ) RF ] e pt

We can rearrange that equation to better demonstration what alpha really is:

a p ( R pt RF ) - [ p ( R M RF )]

Jensens Differential Return Measure (alpha)

a p ( R pt RF ) - [ p ( R M RF )]

Where the bars above the variables indicate averages for the period measured. The alpha is the difference between the actual excess return on the portfolio during some period and the risk premium on that portfolio that should have been earned, given its systematic risk. Although the alpha may be positive or negative, it may not be significantly different (statistically) from zero if it is not, we would conclude that the manager of the portfolio being evaluated performed as expected.

Jensens Differential Return Measure (alpha)

Superior performance can come from at least two sources: u The portfolio manager may be able to selected undervalued securities consistently enough to affect portfolio performance. u The manager may be able to time market turns, varying the portfolios composition in accordance with the rise and fall of the market. u Obviously, a manager with enough ability may be able to do both.

Sharpe vs. Treynor vs. Jensen Measures

If a portfolio is completely diversified, all three measures will agree on ranking of portfolios. The reason for this is that with complete diversification, total variance is equal to systematic variance. When portfolios are not completely diversified, the Treynor and Jensen measures can rank relatively undiversified portfolios much higher than the Sharpe measure.

Problems with Portfolio Performance Evaluation

All three risk-adjusted measures are derived from capital market theory and the CAPM and are therefore dependent on the assumptions involved in this theory. Examples where reality doesnt fit with theory: u Assuming we can borrow at RF u Using the TSE 300 index as a market proxy A long evaluation period is needed to successfully determine performance that is truly superior. (note the Performance Presentation standards of AMIR reflect this need)because luck can overshadow all else in the short-term.

Benchmark Portfolios

The goal in the use of benchmark portfolios is to replicate the managers particular investment style and chosen risk lev The goal in the use el as closely as possible so that any differences in return between the two portfolios can be attributed to the managers decisions and therefore to manager skill.

Portfolio return - benchmark return = managers contribution

the managers contribution is often called active reward.

Benchmark Portfolios ...

The calculation is done quarter-by-quarter and over long periods of time the accumulative quarterly active rewards should be positive reflecting an extra return emanating from manager ability. If the portfolio return is reported gross of management fees, then the cost of managing the portfolio has to be deducted to provide the true active reward.

Benchmark Portfolios ...

The procedure of comparing portfolio returns to benchmark return assumes that risk is controlled for through style matching. After all, both portfolios contain the same (narrowly defined) type of securities and therefore respond to the same sources of fluctuation. Nonetheless, the risk adjustment procedure ignores the possibility of diversifiable risk: portfolio volatility higher than benchmark volatility.

Problems with Benchmark Portfolios ...

Style Drift

Index (benchmark) construction is a problem particularly with style indices. For example, some stocks defined as value stocks will become growth stocks, or at least not value stocks, as prices change. Unless the index is rebalanced regularly, it will suffer style drift and become increasingly inappropriate for benchmarking value portfolios. Repeated re-balancing, however, moves the index into the semi-passive category with trading requirements and transaction costs nearly on par with active management.

Problems with Benchmark Portfolios ...

Gaming

defining a benchmark index brings into play a managers natural tendency to game the benchmark. One way to game is to become a closet indexer Managers know that penalties for under-performing are more severe (they can be fired) than rewards for over-performing, particularly with asset-value based fee structures. This produces an incentive to avoid the risks inherent in security selection and market timing and instead mimic the benchmark.

Closet Indexing how is it done?

The benchmarks industry, economic sector and even individual stock weights (or duration, credit quality and issuer in bond benchmarks) are duplicated fairly closely to avoid straying too far from the benchmark knowing that no one will loose their job if only enough activity is undertaken to cover management fees. Trying to beat the benchmark net of fees is not in their interest. The sponsor pays the high fees associated with active management but gets benchmark performance.

A Second Form of Benchmark Gaming

(Hold assets outside of the benchmark universe)

This form of gaming is to hold assets that are not part of the benchmark universe, and in effect, the manager is intentionally reducing the relevance of the benchmark to make the portfolios performance seem better. For example, a large-cap equity manager may move part of the portfolio into small companies if an opportunity for improving performance is seen there. A manager being graded against a bond index may hold mostly mortgage-backed securities if they are doing well. Managers playing this game are taking on what is termed benchmark risk because the excursion outside of the standard universe of securities can be taken at the wrong time so that they appear considerably less skilled than their more conservative competitors.

Performance Benchmarks

Benchmark choice is critical as it has a direct impact on measuring a managers investment skills. The wrong choice can lead to incorrectly punishing a good manager and inappropriately rewarding a poor one. A good standard of comparison fairly evaluates the manager and provides a passive alternative.

Characteristics of a good Performance Benchmark

Investable - a benchmark is a passive investment alternative. The client can always choose to forgo active management and simply hold the benchmark. Unambiguous Composition - part of being investable is knowing the construction of the benchmark.

Characteristics of a good Performance Benchmark ...

Appropriate The benchmark has the same risk as the manager and is consistent with the managers investment style or biases. Attainable by manager - the manager has current investment knowledge of the securities that make up the benchmark and can invest in all securities.

Characteristics of a good Performance Benchmark ...

Specified in advance - the benchmark is operational before the start of an evaluation period. This reduces the chances of biased benchmark selection and makes the benchmark investable. Objectively constructed - the benchmark is not tilted in favour of or against the manager Easily measurable - it is possible to readily observe the performance in order to calculate benchmark return on a reasonably frequent basis.

Other Issues in Performance Evaluation

Performance Attribution
u

performance evaluation is concerned with more than determining whether the money manager added value by outperforming the established benchmark. Ascertaining how the money manager achieved the measured performance is equally important. Performance attribution seeks to determine, after the fact, why a particular portfolio had a given returniewas the performance a result of superior market timing or superior security selection? Equally significant is finding out what part of calculated return is due to the policy decisions of the portfolios sponsor and what portion is generated by the managers actions.

Performance Attribution Analysis

The decomposition of the performance results to explain why those results occurred is called performance attribution analysis.

Application of Jensens Alpha Technique to evaluate Timing Performance

Composite benchmarks do not measure a managers market timing skills in fact, market timing can invalidate their results on security selection. (ie. they may generate positive returns because of superior security selectionbut if they choose the wrong times to enter and leave the marketthose positive returns can be negated.) Despite the theoretical problems with Jensens alpha technique Treynor and Mazuy proposed modifying the Jensen formula to address Market Timing (as long as the type of timing procedure changes the portfolio beta in anticipation of market movements)

Market Timing

Tactical asset allocation alters a portfolios beta as does moving into high beta securities when anticipating a bull market. If sectors are favoured because of their relation with general market movements, then sector rotation will also show up under this type of analysis. If the portfolio manager does not engage in market timing, then a plot of po

Market Timing ...

If the portfolio manager does not engage in market timing, then a plot of portfolio returns against market returns should scatter around a straight line.as shown in the following graph.

Figure 8.3 No Evidence of Market Timing

rp

rM

Market Timing Assessed...

If, however, the manager could correctly time the market and shift funds into it in periods when the market does well, the characteristic line would plot as follows...

Figure 8.4 Evidence of Superior Market Timing

rp

rM

Market Timing ...

The idea is that if the timer can predict bull markets, the portfolios beta will be increased when the market is about to go up. Therefore, the portfolio beta and the slope of the characteristic line will be higher when rM is higher. When the manager expects a market decline, portfolio sensitivity to the market will be reduced and the characteristic line becomes flatter. Successful market timing results in the curved line.

Market Timing Assessed Using Jensens Model

Treynor and Mazuy proposed measuring timing effects by estimating a quadratic equation (modified Jensen model) returns are put into excess return form

Rpt RF a p p [E(RM ) RF] C[E(RM ) RF] ept

2

the estimated coefficient C measures the amount of the curvature in the line. If C is positive the line is curved. If C is negative the characteristic line gets flatter as E(RM -RF) gets larger, in other words, the manager is doing the wrong thing at the wrong time. Notice of C is zero, the manager has no timing ability but at least is not doing the wrong thing either.and the equation reduces to a pure Jensens alpha analysis.

Figure 8.5 Bond Market Line

Return Bond Market Line

15

Bond Index

6 Treasury Bills 3

0
3 6 9 12

Duration (years)