CHAPTER 24

Portfolio Performance Evaluation

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McGraw-Hill/Irwin

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Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

24-2

Introduction
Two common ways to measure
average portfolio return:
1. Dollar-weighted returns
2. Time-weighted returns
Returns must be adjusted for risk.

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Example of Multiperiod
Returns

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Dollar-Weighted Return
$4+$108

$2

-$50

-$53

Dollar-weighted Return (IRR):

51
112
50

1
(1 r ) (1 r ) 2
r 7.117%
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Time-Weighted Return
53 50 2
r1
10%
50
54 53 2
r2
5.66%
53
rG = [ (1.1) (1.0566) ]1/2 1 = 7.81%
The dollar-weighted average is less than the
time-weighted average in this example
because more money is invested in year two,
when the return was lower.
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Risk Adjusted Performance:

Sharpe

1) Sharpe Index

(rP rf )

P
rp

= Average return on the portfolio

rf

= Average risk free rate

= Standard deviation of portfolio
return

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Risk Adjusted Performance:

Treynor
2) Treynor Measure
(rP rf )

rp = Average return on the portfolio

rf = Average risk free rate
p = Weighted average beta for portfolio
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Risk Adjusted Performance:

Jensen
3) Jensens Measure
P rP rf P (rM rf )

= Alpha for the portfolio

rp = Average return on the portfolio

p = Weighted average Beta
rf = Average risk free rate
rm = Average return on market index portfolio
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24-9

Information Ratio
Information Ratio = p / (ep)
The information ratio divides the alpha of the
portfolio by the nonsystematic risk.
Nonsystematic risk could, in theory, be
eliminated by diversification.

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M Measure
Developed by Modigliani and
Modigliani
Create an adjusted portfolio (P*)that
has the same standard deviation as
the market index.
Because the market index and P*
have the same standard deviation,
their returns are
comparable:
2

M rP* rM

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M Measure: Example
Managed Portfolio: return = 35%
standard
deviation = 42%
Market Portfolio: return = 28% standard deviation =
30%
T-bill return = 6%
P* Portfolio:
30/42 = .714 in P and (1-.714) or .286 in T-bills
The return on P* is (.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed
portfolio underperformed.
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Figure 24.2 M of Portfolio P

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Which Measure is Appropriate?

It depends on investment assumptions
1)If the portfolio represents the entire risky
investment , then use the Sharpe
measure.
2) If the portfolio is one of many combined
into a larger investment fund, use the
Jensen or the Treynor measure. The
Treynor measure is appealing because it
weighs excess returns against systematic
risk.
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Table 24.1 Portfolio

Performance

Is Q better than P?
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Figure 24.3 Treynors

Measure

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Table 24.3 Performance

Statistics

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Interpretation of Table 24.3

If P or Q represents the entire investment, Q is
better because of its higher Sharpe measure
and better M2.
If P and Q are competing for a role as one of a
number of subportfolios, Q also dominates
because its Treynor measure is higher.
If we seek an active portfolio to mix with an
index portfolio, P is better due to its higher
information ratio.
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Performance Measurement with

Changing Portfolio Composition
We need a very long What if the mean
observation period
and variance are not
to measure
constant? We need
performance with
to keep track of
any precision, even
portfolio changes.
if the return
distribution is stable
with a constant
mean and variance.
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24-19

Market Timing
In its pure form, market timing
involves shifting funds between a
market-index portfolio and a safe
asset.
Treynor and Mazuy:

rP rf a b(rM rf ) c (rM rf ) eP
2

Henriksson and Merton:

rP rf a b(rM rf ) c (rM rf ) D eP
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Figure 24.5 : No Market Timing; Beta Increases with

Expected Market Excess. Return; Market Timing with
Only Two Values of Beta.

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Figure 24.6 Rate of Return of a Perfect

Market Timer

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Style Analysis
Introduced by William Sharpe
Regress fund returns on indexes
representing a range of asset classes.
The regression coefficient on each index
measures the funds implicit allocation to
that style.
R square measures return variability due
to style or asset allocation.
The remainder is due either to security
selection or to market timing.
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Table 24.5 Style Analysis for Fidelitys

Magellan Fund

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Figure 24.7 Fidelity Magellan Fund

Cumulative Return Difference

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Figure 24.8 Average Tracking Error

for 636 Mutual Funds, 1985-1989

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Evaluating Performance
Evaluation

Performance evaluation has two key

problems:
1. Many observations are needed for
significant results.
2. Shifting parameters when portfolios
are actively managed makes
accurate performance evaluation
all the more elusive.
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24-27

Performance Attribution
A common attribution system decomposes
performance into three components:
1. Allocation choices across broad asset
classes.
2. Industry or sector choice within each market.
3. Security choice within each sector.

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Attributing Performance to
Components
Set up a Benchmark or Bogey
portfolio:
Select a benchmark index portfolio for
each asset class.
Choose weights based on market
expectations.
Choose a portfolio of securities within
each class by security analysis.
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Attributing Performance to
Components
Calculate the return on the Bogey and on
the managed portfolio.
Explain the difference in return based on
component weights or selection.
Summarize the performance differences
into appropriate categories.

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Formulas for Attribution

n

i 1

i 1

rB wBi rBi & rp w pi rpi

n

i 1

i 1

rp rB w pi rpi wBi rBi

n

(w
i 1

r wBi rBi )

pi pi

Where B is the bogey portfolio and p is the managed

portfolio
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24-31

Figure 24.10 Performance Attribution

of ith Asset Class

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Performance Attribution
Superior performance is achieved by:
overweighting assets in markets that
perform well
underweighting assets in poorly
performing markets

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Table 24.7 Performance Attribution

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Sector and Security Selection

Good performance
(a positive
contribution)
derives from
overweighting
high-performing
sectors

Good performance
also derives from
underweighting
poorly performing
sectors.

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