CHAPTER EIGHTEEN

PORTFOLIO PERFORMANCE EVALUATION

MEASURES OF RETURN
MEASURES OF RETURN
complicated by addition or withdrawal of money by the investor percentage change is not reliable when the base amount may be changing timing of additions or withdrawals is important to measurement

MEASURES OF RETURN
TWO MEASURES OF RETURN
Dollar-Weighted Returns
uses discounted cash flow approach weighted because the period with the greater number of shares has a greater influence on the overall average

MEASURES OF RETURN
TWO MEASURES OF RETURN
Time-Weighted Returns
used when cash flows occur between beginning and ending of investment horizon ignores number of shares held in each period

MEASURES OF RETURN
TWO MEASURES OF RETURN
Comparison of Time-Weighted to DollarWeighted Returns
Time-weighted useful in pension fund management where manager cannot control the deposits or withdrawals to the fund

MAKING RELEVANT COMPARISONS

PERFORMANCE
should be evaluated on the basis of a relative and not an absolute basis
this is done by use of a benchmark portfolio

BENCHMARK PORTFOLIO
should be relevant and feasible reflects objectives of the fund reflects return as well as risk
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THE USE OF MARKET INDICES

INDICES
are used to indicate performance but depend upon
the securities used to calculate them the calculation weighting measures

THE USE OF MARKET INDICES

INDICES
Three Calculation Weighting Methods:
price weighting
sum prices and divided by a constant to determine average price EXAMPLE: THE DOW JONES INDICES

THE USE OF MARKET INDICES

INDICES
Three Calculation Weighting Methods:
value weighting (capitalization method)
price times number of shares outstanding is summed divide by beginning value of index EXAMPLE: S&P500 WILSHIRE 5000 RUSSELL 1000

THE USE OF MARKET INDICES

INDICES
Three Calculation Weighting Methods:
equal weighting
multiply the level of the index on the previous day by the arithmetic mean of the daily price relatives EXAMPLE: VALUE LINE COMPOSITE

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ARITHMETIC V. GEOMETRIC AVERAGES

GEOMETRIC MEAN FRAMEWORK

GM = (P HPR)1/N - 1
where P = the summation of the product of HPR= the holding period returns n= the number of periods

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ARITHMETIC V. GEOMETRIC AVERAGES

GEOMETRIC MEAN FRAMEWORK
measures past performance well represents exactly the constant rate of return needed to earn in each year to match some historical performance

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ARITHMETIC V. GEOMETRIC AVERAGES

ARITHMETIC MEAN FRAMEWORK
provides a good indication of the expected rate of return for an investment during a future individual year it is biased upward if you attempt to measure an assets long-run performance

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RISK-ADJUSTED MEASURES OF PERFORMANCE

THE REWARD TO VOLATILITY RATIO (TREYNOR MEASURE)

There are two components of risk
risk associated with market fluctuations risk associated with the stock

Characteristic Line (ex post security line)

defines the relationship between historical portfolio returns and the market portfolio
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TREYNOR MEASURE
TREYNOR MEASURE
Formula

RVOLp

arp arf

bp

where

arp = the average portfolio return arf = the average risk free rate bp = the slope of the characteristic line during the time period
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TREYNOR MEASURE
THE CHARACTERISTIC LINE
arp

SML

bp
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TREYNOR MEASURE
CHARACTERISTIC LINE
slope of CL
measures the relative volatility of portfolio returns in relation to returns for the aggregate market, i.e. the portfolios beta the higher the slope, the more sensitive is the portfolio to the market

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TREYNOR MEASURE
THE CHARACTERISTIC LINE
arp

SML

bp
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THE SHARPE RATIO

THE REWARD TO VARIABILITY (SHARPE RATIO)
measure of risk-adjusted performance that uses a benchmark based on the ex-post security market line total risk is measured by sp

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THE SHARPE RATIO

SHARPE RATIO
formula:

SRp

arp arf

sp

where

SR = the Sharpe ratio

sp = the total risk

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THE SHARPE RATIO

SHARPE RATIO
indicates the risk premium per unit of total risk uses the Capital Market Line in its analysis

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THE SHARPE RATIO

arp

CML

sp
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THE JENSEN MEASURE OF PORTFOLIO PERFORMANCE

BASED ON THE CAPM EQUATION

E (ri ) RFR b [ E (rm ) RFR ]

measures the average return on the portfolio over and above that predicted by the CAPM given the portfolios beta and the average market return
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THE JENSEN MEASURE OF PORTFOLIO PERFORMANCE

THE JENSEN MEASURE

known as the portfolios alpha value
recall the linear regression equation

y = a + bx + e
alpha is the intercept

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THE JENSEN MEASURE OF PORTFOLIO PERFORMANCE

DERIVATION OF ALPHA
Let the expectations formula in terms of realized rates of return be written
R jt RFRt b j Rmt RFRt u jt

subtracting RFR from both sides R jt RFRt b j Rmt RFRt u jt

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THE JENSEN MEASURE OF PORTFOLIO PERFORMANCE

DERIVATION OF ALPHA
in this form an intercept value for the regression is not expected if all assets are in equilibrium in words, the risk premium earned on the jth portfolio is equal to bj times a market risk premium plus a random error term

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THE JENSEN MEASURE OF PORTFOLIO PERFORMANCE

DERIVATION OF ALPHA
to measure superior portfolio performance, you must allow for an intercept a a superior manager has a significant and positive alpha because of constant positive random errors

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COMPARING MEASURES OF PERFORMANCE

TREYNOR V. SHARPE
SR measures uses s as a measure of risk while Treynor uses b SR evaluates the manager on the basis of both rate of return performance as well as diversification

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COMPARING MEASURES OF PERFORMANCE

for a completely diversified portfolio
SR and Treynor give identical rankings because total risk is really systematic variance any difference in ranking comes directly from a difference in diversification

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CRITICISM OF RISK-ADJUSTED PERFORMANCE MEASURES

Use of a market surrogate
Roll: criticized any measure that attempted to model the market portfolio with a surrogate such as the S&P500
it is almost impossible to form a portfolio whose returns replicate those over time making slight changes in the surrogate may completely change performance rankings

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CRITICISM OF RISK-ADJUSTED PERFORMANCE MEASURES

measuring the risk free rate
using T-bills gives too low of a return making it easier for a portfolio to show superior performance borrowing a T-bill rate is unrealistically low and produces too high a rate of return making it more difficult to show superior performance

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