Chapter Seven

EVALUATION OF PORTFOLIO PERFORMANCE

7.1 WHAT IS REQUIRED OF A PORTFOLIO MANAGER?

• Two desirable attributes

1. The ability to derive above-average returns for a given
risk class. The superior risk-adjusted returns can be
derived from either
• Superior timing
• Superior security selection
2. The ability to diversify the portfolio completely to
eliminate unsystematic risk relative to the portfolio’s
benchmark
• A completely diversified portfolio is perfectly correlated with
the fully diversified benchmark portfolio
7.1 WHAT IS REQUIRED OF A PORTFOLIO MANAGER?

35% 20%
7.2 EARLY PERFORMANCE MEASURES TECHNIQUES

• Portfolio evaluation before 1960

• Evaluate portfolio performance almost entirely on the
basis of the rate of return
• Rate of return within risk classes, but don’t know how to
measure it and could not consider it explicitly
• Peer group comparisons
• Collects the returns produced by a representative
universe of investors over a specific period of time
• Potential problems
§ No explicit adjustment for risk
§ Difficult to form comparable peer group
7.3 COMPOSITE PORTFOLIO PERFORMANCE MEASURES

• Treynor (1965)

• Sharpe (1966)

• Jensen (1968)

• The information ratio performance measure

7-5
7.3 COMPOSITE PORTFOLIO PERFORMANCE MEASURES

• Treynor (1965) portfolio performance measure

• market risk
• individual security risk
• introduced characteristic line
• Treynor recognised two components of risk
1. Risk from general market fluctuations
2. Risk from unique fluctuations in the securities in the portfolio
• His measure of risk-adjusted performance focuses on the
portfolio’s undiversifiable risk: market or systematic risk

7-6
 TREYNOR PORTFOLIO PERFORMANCE MEASURE

• Treynor’s Formula

where:
Ri = the average rate of return for Portfolio i during a specified time
period
RFR = the average rate of return on a risk-free investment during
the same time period
βi = the slope of the fund’s characteristic line during that time
period
TREYNOR PORTFOLIO PERFORMANCE MEASURE

Example:
What is the Treynor Index for a portfolio that returned 12.88%
when the risk-free rate of return is 2.7% and the portfolio’s beta
is 1.05?
TREYNOR PORTFOLIO PERFORMANCE MEASURE
• Demonstration of comparative Treynor measures
Assume the market return is 14% and risk-free rate is 8%.
The average annual returns for Managers W, X and Y are
12%, 16% and 18% respectively. The corresponding betas
are 0.9, 1.05 and 1.20. What are the T values for the
market and managers?
TREYNOR PORTFOLIO PERFORMANCE MEASURE
• Demonstration of comparative Treynor measures
Assume the market return is 14% and risk-free rate is 8%.
The average annual returns for Managers W, X and Y are
12%, 16% and 18% respectively. The corresponding betas
are 0.9, 1.05 and 1.20. What are the T values for the
market and managers?
EXHIBIT 7.2
SHARPE PORTFOLIO PERFORMANCE MEASURE

• Shows the risk premium earned over the risk free

rate per unit of standard deviation
• Sharpe ratios greater than the ratio for the market
portfolio indicate superior performance
• The Formula

R i - RFR
Si =
where:
si
σi = the standard deviation of the rate of return for Portfolio i
 SHARPE PORTFOLIO PERFORMANCE MEASURE

Example:
What is the Sharpe index for a portfolio that returned 12.88%, when
the risk-free rate of return was 2.7% and the portfolio’s standard
deviation was 8.95%?
SHARPE PORTFOLIO PERFORMANCE MEASURE
• Demonstration of Comparative Sharpe Measures
Assume the market return is 14% with a standard deviation of
20% and risk-free rate is 8%. The average annual returns for
Managers D, E and F are 13%, 17% and 16% respectively. The
corresponding standard deviations are 18%, 22% and 23%.
What are the Sharpe measures for the market and managers?
SHARPE PORTFOLIO PERFORMANCE MEASURE
• Demonstration of Comparative Sharpe Measures
Assume the market return is 14% with a standard deviation of
20% and risk-free rate is 8%. The average annual returns for
Managers D, E and F are 13%, 17% and 16% respectively. The
corresponding standard deviations are 18%, 22% and 23%.
What are the Sharpe measures for the market and managers?
COMPOSITE PORTFOLIO PERFORMANCE MEASURES
• Treynor versus Sharpe Measure
• Sharpe uses standard deviation of returns as the measure
of risk
• Treynor measure uses beta (systematic risk)
• Sharpe therefore evaluates the portfolio manager on the
basis of both rate of return performance and
diversification
• The methods agree on rankings of completely diversified
portfolios
• Produce relative not absolute rankings of performance
JENSEN PORTFOLIO PERFORMANCE MEASURE
• The Formula
Rjt - RFRt = αj + βj [Rmt – RFRt ] + ejt
where:
αj = Jensen measure

• Jensen measure represents the average excess return

of the portfolio above that predicted by CAPM
• Superior managers will generate a significantly
positive alpha; inferior managers will generate a
significantly negative alpha
• See Exhibit 7.3
EXHIBIT 7.3

7-18
JENSEN PORTFOLIO PERFORMANCE MEASURE

• Applying the Jensen measure

§ Jensen measure requires using a different RFR for each time
interval during the sample period
§ It does not directly consider the portfolio manager’s ability to
diversify because it calculates risk premiums in term of systematic
risk
§ Jensen measure is flexible enough to allow for alternative models
of risk and expected return than the CAPM. Risk-adjusted
performance can be computed relative to any of the multifactor
models:

R jt - RFRt = a j + [b j1F1t + b j 2 F2t + b jk Fkt ] + e jt

THE INFORMATION RATIO PERFORMANCE MEASURE

• The Formula
R j - Rb ER j
IR j = =
where: s ER s ER
Rb = the average return for the benchmark portfolio
σER = the standard deviation of the excess return

• Information ratio measures the average return in excess

that of a benchmark portfolio divided by the standard
deviation of this excess return

• σER can be called the tracking error of the investor’s

portfolio and it is a ‘cost’ of active management
THE INFORMATION RATIO PERFORMANCE MEASURE

3 steps process to calculate the information ratio

• Step 1: Determine portfolio outperformance
• Determine the annualized return of the portfolio and benchmark by
creating an INDEX of returns
• An index commences at a nominal value, say $1, or $100
• We compound returns for each period to give us a total return over
the period.
𝑷𝒏 = 𝑷𝒏"𝟏 × (𝟏 − 𝒓𝒏 )
• We then calculate the annualized return
𝟏
𝑷𝒏 𝒏
𝑹= -1
𝑷𝟎
• Subtract the difference to determine the alpha
α = 𝑅! − 𝑅"
THE INFORMATION RATIO PERFORMANCE MEASURE

3 steps process to calculate the information ratio

• Step 2: Determine portfolio tracking error
• Tracking error measures the relative risk of a portfolio, as
measured by standard deviation against the portfolio’s
benchmark.

∑ 𝑅# − 𝑅" $
𝜎 𝑇𝐸 =
𝑛
Where
N = number of observation
𝑅& = portfolio return
𝑅' = benchmark portfolio return
THE INFORMATION RATIO PERFORMANCE MEASURE

3 steps process to calculate the information ratio

• Step 3: Determine information ratio

𝑅! − 𝑅"
𝐼𝑅 =
∑ 𝑅! − 𝑅" #
𝑛
 THE INFORMATION RATIO PERFORMANCE MEASURE
Period Portfolio Bench- Difference Difference Portfolio Benchmark
mark square Index Index
0
1 51% 46%
2 21% 18%
3 -7% -26%
4 2% 1%
5 -11% -8%
6 13% 15%
7 41% 36%

a. Calculate the annualised return of the portfolio and the benchmark in percentage
terms to 2 decimal places.
b. Calculate the portfolio alpha in percentage terms to 2 decimal places.
c. Calculate the tracking error of the portfolio in percentage terms to 2 decimal places.
d. Calculate the information ratio of the portfolio to 2 decimal places.
Portfolio performance evaluation
The risk free rate is 3.75% and a portfolio has a sensitivity to the risk
factors outlined in the table below.
Factor Equity Risk SmB HmL
Premium
Sensitivity s = -0.29 h = 0.38
Risk premium 18.11% 4.86% 6.34%
a. A portfolio delivered a return of 22.74%pa over a three year period. An asset
consultant uses the Capital Asset Pricing Model to assess manager performance,
while the investment manager assesses its performance using the Fama–French
model

i. According to the investment manager, how much Carhart alpha did the portfolio
generate over the period?
ii. If the asset consultant assessed that the investment manger generated 2.99%pa of
Jensen’s alpha over the period, what value of beta is the consultant using for the
portfolio?
iii. If, over the period, the market had a variance of 0.0351 whilst the portfolio had a
variance of 0.0491, and using the consultant’s value for beta, what must be the
correlation of the portfolio with the market?
 COMPARING THE COMPOSITE
PERFORMANCE MEASURES
• Each portfolio performance statistic is widely used
in practice and has its own strengths and
weaknesses
§ Although the measures provide a generally consistent
assessment of portfolio performance when taken as a
whole, they remain distinct at an individual level
§ Therefore it is best to consider these composites
collectively
§ The user must understand what each means
• The primary advantages and disadvantages of the
measures are listed in Exhibit 7.5
EXHIBIT 7.5