FINC3017 Investments and Portfolio Management

Tutorial 10 Solutions
Performance Evaluation


1. The spreadsheet contains the monthly raw returns for a sample of U.S. mutual
funds from January 2000 to March 2012. The returns are presented in
percentages, not decimals, on a monthly basis. The spreadsheet also details the
investment style of each mutual fund, the return of the U.S. equity market
portfolio (a market capitalisation weighted return of all U.S. equity securities),
the risk-free rate, as well as the size (SMB), value (HML) and momentum
(PR1YR) risk factors.

a. Compare performance measures among the different mutual funds by
estimating each funds raw return, Sharpe ratio, Jensens alpha, and the
alpha from the Carhart (1997) 4-factor model over the entire sample.
b. Are any of the mutual funds able to time the market?
c. Which mutual fund you believe exhibits the most skill?


2. Persistence in the performance of funds has been documented.
a. Explain what is meant by performance persistence?
b. What are the implications of performance persistence for poorly
performed funds?
c. Performance persistence implies some predictability of future
performance. How does this evidence sit with the notion of an efficient
market?

a Performance persistence is the degree to which funds are able to maintain consistent
performance across time. This can be assessed by examining the correlation of fund returns
over time.

b A degree of persistence in performance suggests that past returns and rankings are useful in
predicting future returns and rankings. If this is the case then poorly performed funds will
continue to be poor performers. Moreover, if this information becomes known and accepted
them the predicted returns will reveal a poor outlook for these funds. Consequently, investors
will shy away from the funds resulting in an outflow of invested funds and a downsizing of
the fund, such that it may struggle to survive.

c There is anecdotal evidence that funds exhibit performance persistence. Research has
supported this claim and the results from the USA indicate a degree of persistence in
performance in the US funds market. The results suggest that past returns and rankings are
useful in predicting future returns and rankings. Specifically, some evidence shows that
winners repeat, particularly extremely good performers. Performance persistence is also
documented among poorly performed funds. However the evidence is inconsistent and
research in the Australian and New Zealand equity funds market has not yet revealed any
evidence of performance persistence. If performance persistence exists then it implies that
future fund returns are in some sense predictable. If this is the case, then past information can
be used to make profitable forecasts which tend to be perceived as inconsistent with a truly
efficient market. However, the problem for investors is that by chasing the best performed
funds they hold diversifiable risk because the positive correlation among the winning funds
means that an investment in them is not well diversified across the market. Hence we may
argue that expected return is higher but must also note that (diversifiable) risk is higher. In
this sense, there is still consistency with the notion of an efficient market as higher expected
returns come at a cost of higher risk (although this is dependent upon the view taken of the
appropriate risk measure).


3. Consider the following table:

Avg return (% p.a.) Std Dev (% p.a.) Beta
Market index 10.7 19.0 1.00
Fund I 19.4 44.2 1.34
Fund II 13.5 21.8 1.12
Fund III 12.9 17.6 1.30
Fund IV 9.3 5.6 0.71

a. If the risk-free rate is 5.6% p.a., calculate the following performance
measures for each of the funds in the table and the market index.
i. Jensens alpha
ii. Sharpe index
iii. Treynor index
b. Compare and comment on your answers from part a)
c. Which fund has exhibited the best performance?



a Jensens alpha:
p
= R
p
-R
f
|
p
(R
m
-R
f
)
Sharpe Index: SI
p
= (R
p
-R
f
)/
p

Treynor Index: TI
p
= (R
p
-R
f
)/ |
p


b From part a, the performance measures provide different rankings. Under Jensens alpha,
Fund I is clearly preferred and the ranking is Funds I, II, III and IV. Under the Sharpe index,
all funds perform better than the market benchmark and the ranking offunds is reversed, i.e.
Funds IV, III, II and I. Under the Treynor index, the ranking is yet again reversed with Fund I
now the highest ranked, i.e. Funds I, II, III and IV. The results show that inconsistency in
rankings is possible under different performance measures.

c Given the inconsistency in rankings, it is difficult to claim one fund as superior. Fund I is
ranked best under Jensens alpha and the Treynor index while Fund IV is ranked best under
the Sharpe index. Both Jensens alpha and the Treynor index use beta as the risk measure
while the Sharpe index uses standard deviation as the risk measure. Hence, the ranking of
funds depends upon the investors assessment as to the appropriate risk measure (which may
include consideration of the level of diversification).

4. Application of the Treynor and Mazuy (1966) model to a fund returns and the
market benchmark results in the following estimates:
o
p
= 0.038, |
p
= 0.624, +p=-0.007
What does this imply about the managers performance and ability to time the
market?


The Treynor and Treynor and Mazuy (1966) model suggest that a positive value of alpha is
indicative of superior stock selection performance, while a positive value for gamma
indicates superior market timing ability. In this example, an alpha value of 0.038 indicates
some evidence of superior stock selection ability and a gamma value of -0.007 indicate a
slight inability to time the market.


5. If you believe that the market is efficient would you invest in a fund manager
that has an active approach to investing?

Try and get a discussion going here about what the implications of the EMH are. If
markets are efficient then active management does not make any sense as you cannot
beat the market. If markets are efficient then passive management is the optimal
choice. This is especially so when one considers the higher fees that active fund
managers charge compared to the fees of passive managers.


6. Discuss how investment styles are related to market anomalies. Why would an
investor invest in a growth fund?

High book-to-market stocks beat low book-to-market stocks, on average. That is,
value stocks beat growth stocks. Small cap stocks outperform large cap stocks, on
average. Fund will specialise in a given value/growth dimension (value, core, growth)
and/or a given size dimension (large, mid, small).

It is important to bear in mind that value beats growth, on average, but not at every
point in time. There will be periods when growth will beat value. If an investor can
identify a growth manager that has skill they can still make abnormal returns.


7. Comment on the deficiencies of using i) the market index and ii) the median of
the manager universe as benchmarks for performance evaluation.

Each of these benchmarks has several deficiencies, as described below.

Market index:
- A market index may exhibit survivorship bias. Firms that have gone out of
business are removed from the index, resulting in a performance measure that
overstates actual performance had the failed firms been included.
( ) ( )
p
2
f M f M f P
e r r r r r r + + + | + o =
- A market index may exhibit double counting that arises because of companies
owning other companies and both being represented in the index.
- It is often difficult to exactly and continually replicate the holdings in the
market index without incurring substantial trading costs.
- The chosen index may not be an appropriate proxy for the management style
of the managers.
- The chosen index may not represent the entire universe of securities. For
example, the S&P 500 Index represents 65% to 70% of U.S. equity market
capitalization.
- The chosen index (e.g., the S&P 500) may have a large capitalization bias.
- The chosen index may not be investable. There may be securities in the index
that cannot be held in the portfolio.

Median of the manager universe:
- It can be difficult to identify a universe of managers appropriate for the
investment style of the plans managers.
- Selection of a manager universe for comparison involves some, perhaps much,
subjective judgement.
- Comparison with a manager universe does not take into account the risk taken
in the portfolio.
- The median of a manager universe does not represent an investable
portfolio; that is, a portfolio manager may not be able to invest in the median
manager portfolio.
- Such a benchmark may be ambiguous. The names and weights of the
securities constituting the benchmark are not clearly delineated.
- The benchmark is not constructed prior to the start of an evaluation period; it
is not specified in advance.
- A manager universe may exhibit survivorship bias; managers who have gone
out of business are removed from the universe, resulting in a performance
measure that overstates the actual performance had those managers been
included.