Chapter 18

18.1 Risk-Adjusted Returns

Portfolio
Performance
Evaluation

McGraw-Hill/Irwin

18-2

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Types of management revisited

Performance evaluation

Passive management
1. Capital allocation between cash and the risky portfolio
2. Asset allocation within the risky portfolio.
How passive the management actually is varies

Purpose:
Are the returns worth the risk and the fees?

Measures
Average return by itself is an insufficient measure. Why?
Average return may not = expected return
Risk return relationship
Major component of returns is the market
performance
Need a measure of abnormal performance

Change allocations in 1 or 2 according to perceptions

of risk to keep current with portfolio goals.
Active management
Forecasting future rates of return on either/both asset
classes and individual securities

18-3

18-4

Factors That Lead to Abnormal

Performance

Abnormal Performance

How is abnormal performance measured?

Successful across asset allocations

Comparisons to peer groups

Rank fund performance within a given category
Benchmark portfolio such as an index
Really need measures that consider risk:
Calculate reward to risk measures such as the alpha,
Sharpe Measure (or variations)

Superior allocation within each asset class

Sectors or industries

Overweight better performing sectors, underweight

poorer performers

Individual security selection

18-5

Risk Adjusted Performance

To measure abnormal performance, must measure
normal performance:
The single index model can be used:

RPt

RMt

E(RMt )

Risk Adjusted Performance:

Jensen
P

ept

RP

From this the expected return [E(RP)] can be

found:

E(RP )

Pick the right stocks, those with performance

better than expected

RM

P
18-7

RP -

Portfolio alpha

18-6

RM

Average excess return on the portfolio

Portfolio beta
Average excess return on the market

18-8

Risk Adjusted Performance:

Jensen (cont.)
P

RP -

Measuring Risk Adjusted

Performance: Sharpe Ratios
1) Historical Sharpe Ratios

P RM

Measure of abnormal return

Must establish statistical significance via regression
Possible conceptual problem:
Greater abnormal return may be due to greater risk
Unless you can hedge out the risk with short sales one
should rank portfolio performance by the adjusted
alpha which is p / p

Risk Adjusted Performance:

Treynor

18-9

2) Historical Treynor Ratios

Treynor Ratios
rp
rf

rp r f
p

Average return on the portfolio

Average risk free rate

Portfolio beta

Sharpe Ratios
rp
rf

rp

rf

Average return on the portfolio

Average risk free rate

p Portfolio standard deviation

M2 Measure

Use:
When choosing
among competing
portfolios that will not
be mixed.
In practice:
Used when one
manager handles the
(entire) portfolio.
18-10

Sharpe Ratios

rp

rf

Variation of the Sharpe Ratio that is easier to interpret.

Concept of the Sharpe is easy to interpret but the
Sharpe number is not.
Developed by Modigliani and Modigliani; hence M2
Use M2 to compare performance of a managed
portfolio (MP) with a market index.
The M2 measure creates a hypothetical complete
portfolio that is composed of T-bills and the managed
portfolio that has the same standard deviation as the
market index.

Use:
Evaluate a portfolio
when portfolio is a
piece of a larger
portfolio that has
different managers.

18-11

18-12

Information Ratio

M2 Measure: Example

Return

Managed Portfolio
32%

Stan. Dev

Market

TT-bill

25%

0%

18%

40%

When evaluating a portfolio to be mixed with a

position in the passive benchmark portfolio we
must draw on insights of the Treynor-Black
Model (See Chapter 6)
Choose the portfolio, which when combined with
the passive benchmark, generates an efficient
frontier with the best return per unit of risk as
measured by the standard deviation.
This is found by combining the Sharpe ratio of the
benchmark M with the information ratio of
2
portfolio P:
2
P
S Optimal sqrt S M

6%

Purpose: Create a complete portfolio w/ same risk as the market

Market

= WMP

MP

+ (1

25% = WMP40% + (1

WMP)

T-bill

WMP)0;

WMP = 25% / 40% = 62.5%

&

WT-bills = 37.5%

E(rPComplete) = (0.625)(0.32) + (0.375)(0.06) = 22.25%

Since this return is more than the market the managed portfolio
outperformed the market on a risk adjusted basis by 4.25%.

M2 = 22.25% - 18% = 4.25%

18-13

Summary of measures and usage

Performance Definition
Measure
Sharpe
Treynor
Information
ratio

Rp /

More on Alpha

Application

Alpha and the Sharpe measure

When choosing
among portfolios
competing as the
optimal risky portfolio

SP

SM

SM (

1)

P
P

= Correlation between RP.RM

Positive alpha does not guarantee a higher Sharpe than

the benchmark because SM( -1) < 0.
Necessary but not a sufficient condition for net
performance improvement
The alpha must be large enough to offset increase in
residual risk from moving away from the diversified
optimum.

When ranking many

portfolios that will be
mixed to form the
optimal risky portfolio

Rp /

18-14

When evaluating a
portfolio to be mixed
with a position in the
passive benchmark
portfolio

18-15

18-16

More on Alpha

More on Alpha

Alpha and the Treynor measure

TP

TM

Alpha and the Information Ratio:

Informatio n Ratio

Positive alpha does not guarantee a

higher Treynor ranking because you have
to know the Beta as well.

eP

Positive alpha does not guarantee a

higher square of the information ratio
because higher alpha may come with
higher residual risk.
18-17

18-18

Performance measures for P, Q, M

& cash

Alpha Capture & Transport

If an analyst finds an undervalued security and
invests in it, market moves may wipe out any
gains.

Can hedge out market risk via shorting stock index or

stock index futures to establish a market neutral
position.
Process is called alpha capture or alpha transport.
When short positions and leverage are allowed a
significant non-zero alpha is a sufficient condition for
an improvement in the Sharpe and information ratio.
18-19

18-20

Evaluation with a multi-index

model

T2 (Treynor Square) Measure

Used to convert the Treynor Measure into
percentage return basis
Makes it easier to interpret and compare
Equates the beta of the managed portfolio with

Evidence indicates we should use a multiindex model such as the Fama-French

model to establish the expected return:
RPt
ept
PRMt
SMB rSMBt
HML rHMLt
P
RPt
P RMt
SMB r SMBt
HML r HMLt
This allows an estimation of alpha:

portfolio made up of T-bills and the managed

portfolio
If the beta is lower than one, leverage is used
and the hypothetical portfolio is compared to the
market

18-21

T2 Example

Port. P.

Market

Beta

0.80

1.0

Treynor Measure

16.25

Risk Prem. (r-rf)

Alpha

Weight to match Market w =

13%
5%

M/ P

10%

18-22

18.2 Style Analysis

0%

10

= 1.0 / 0.8

Adjusted Return RP* = w (RP) = 16.25%

T2P = RP* - RM = 16.25% - 10% = 6.25%

18-23

18-24

Style Analysis

Style Analysis

Complex method of performance

evaluation introduced by William Sharpe

Explaining percentage returns by

allocation to style

Recent studies of mutual fund

performance show that > 90% of variation

Style Analysis has become popular with

the industry

allocations to bills, bonds and stocks.

18-25

18-26

the Magellan Fund

Risk-Adjusted Ratings

97.5%
variability is explained by
asset allocation among
these 7 factors, & actually
only three
_____ variables explain
2.5% is due
The remaining _____
to security selection.

18-27

18-28

Category RARs and Excess Return

Sharpe Ratios

Rating

Companies are put into peer groups based on Morningstar style

definitions
Risk adjusted fund performance is ranked and then Stars are assigned
according to the following table (5 stars is the highest rating)
Percentile

Stars

10-32.5

0-10

32.5-67.5

90-100

67.5-90

Star ratings are highly correlated to Sharpe measure

rankings
18-29

18.4 Risk Adjustment With

Changing Portfolio
Composition

Problems with performance

measures

18-30

Measures assume a fund maintains a constant

level of risk
Particularly problematic for funds that engage in
active asset allocation
Sharpe M = 0.4
First 4 qtrs Sharpe = 0.5
2nd 4 qtrs Sharpe = 0.5
Overall Sharpe = 0.37
What happened?

18-31

18-32

Problems with performance

measures

In a large universe of funds, some funds

will have abnormal performance in every
period just by chance.

18.5 Performance
Attribution Procedures

Requires statistical work

Volatility is quite high and creates large errors in

estimation

18-33

Performance Attribution

Decomposing overall performance into

components
Performance is determined by specific
portfolio choices,
Major performance determinants:
Broad asset allocation among types of
securities,
Industry weighting in equity portfolio,
Security choice,
Timing of purchases and sales.

Process of Attributing
Performance to Components

18-34

Use indexes for each component in the

bogey
Use target weight structure in the bogey

18-35

18-36

Process of Attributing
Performance to Components

Performance Attribution
Example

Managed portfolio with monthly return of

5.34%.

the managed portfolio

Component

Explain the difference in return based on

component weights or selection

Weight

Monthly
Return

Equity

70%

7.28%

Bonds

7%

1.89%

Cash

23%

0.4857%

Total

5.34%

The portfolio was comprised of

Summarize the performance differences

into appropriate categories
18-37

Performance of the Managed Portfolio

Component
Bonds (Shearson-Lehman Index)
Equity (S&P500 Index)
Cash (Money Market)

Bogey Return

(0.30)(1.4 5%)

Bogey Performance
and Extra Return
Benchmark Index Return
Weight
during Month
0.3
1.45%
0.6
5.81%
0.1
0.48%

(0.60)(5.8 1%)

(0.10)(0.4 8%)

Return of the Managed Portfolio

5.34%

Extra Return of the Managed

Portfolio

1.37%

- Return of the Bogey Portfolio

18-38

Performance of the Managed Portfolio

3.97%

3.97%

indices with the given weights.

component indices with the given weights.

The Bogey return represents the return on an unmanaged

portfolio

The Bogey weights are representative of a standard portfolio for

the typical risk tolerance of the given type of client or for the
typical fund in this category

18-39

The Bogey return represents the return on an

unmanaged portfolio.

The Bogey weights are representative of a standard

portfolio for the typical risk tolerance of the given type of
client or for the typical fund in this category.

18-40

Performance Attribution Example

A. Contribution of Asset Allocation to Performance

Actual Weight

Market

Benchmark Weight

Bonds

0.07

0.30

Cash

0.23

0.10

Stock

0.70

Excess Weight

Index Return
Minus Bogey

x
1.45-3.97 = -2.52%
=
x
5.81-3.97 = 1.84%
=
0.13
0.48-3.97 = -3.49%
x
=
Contribution of asset allocation:

-0.23

0.60

0.10

Performance Attribution

Contribution
0.5796%
0.1840%

-0.4537%
0.3099%

Contribution to performance from broad asset allocation decision

Note this uses the index return, not the actual managed portfolio return
Superior performance is generated by overweighting investments in
classes that perform better than the bogey.

Contribution to performance from broad asset allocation decision

Note that Column 4 is the INDEX return, not the actual managed
portfolio return.

Superior performance is generated by overweighting investments in

classes that perform better than the bogey.
18-41

Performance Attribution

B. Contribution of Selection to Total Performance

Market
Bonds
Stock
Cash

Portfolio
Return

0.0189
0.0728

0.004857

Index
Return

0.0145
0.0581
0.0048

Extra
Return

0.0044
0.0147

Portfolio
Weight

x
x

0.000057 x

Contribution of Selection

0.07
0.70
0.23

18-42

Performance Attribution

Contribution to
Performance
0.0308%
1.0290%

0.000013%
1.0611%

Material superior performance in both Bond and Stock

Sectors
Table B delineates contribution to performance of both
sector and security selection

18-43

18-44

Performance Attribution

Sector Selection within the Equity Market

C. Contribution of Equity Sector Allocation to Total Performance
Weights
Sector

Basic Materials

Business Services
Capital Goods

Consumer Cyclicals

Consumer Noncyclicals
Credit Sensitive
Energy

Technology

Sector Selection within the

Equity Market

18-45

Portfolio
0.0196
0.0784
0.0187
0.0847
0.4037
0.2401
0.1353
0.0195

S&P 500

0.083
0.041
0.078
0.125
0.204
0.218
0.142

Excess
Weight

Sector
Return

Contribution of
Sector Allocation

-0.0634 x

6.90%

-0.0593 x

4.10%

-0.243%

0.1997 x 10.00%

1.997%

0.0374 x

-0.0403 x

0.262%

8.80%

0.0221 x

5.00%

-0.0895 x

0.30%

-0.0067 x

-0.437%

7.00%

-0.355%
0.111%

2.60%

-0.017%

Contribution of Sector Allocation

1.290%

0.109

-0.027%

Portfolio Attribution: Summary

D. Portfolio Attribution Summary

0.3099%

1. Asset Allocation
2. Selection

18-46

a. Equity Extra Return

i. Sector Allocation

1.290%

ii. Security Selection

0.180%
1.470%

Weights

b. Bonds Extra Return

0.4400%

c. Cash Extra Return

0.0057%

70.00%
7.00%
23.00%

Total Extra Return on the portfolio

1.029%
0.031%

= 0.0013%

See Table B
Table B

1.3710%

The Security Selection component is inferred as follows:

_________________________________
The
total equity extra return = 1.47%
1.29% of the total so Security
Sector allocation accounted for ______
Selection must have resulted in 1.47%
_____________________.
- 1.29% or 0.18%
18-47

18-48

Portfolio Attribution: Summary

18.6 Market Timing

18-49

Market Timing

Adjust the asset allocation for movements

in the market

Figure 18.8 Rate of Return of a

Perfect Market Timer

18-50

Shift between stocks and money market

instruments or bonds

With perfect ability to forecast behaves like an

option
Little evidence of market timing ability
18-51

18-52

With Imperfect Ability to

Forecast

Value of Market Timing

Invest $1 on December 1, 1926
Strategy

Money Markets
Stocks

Perfect Timing*

Value in 2008

$20

Takes a long time horizon to judge the

ability

Geom Avg.
Return

$1,626

$36,699,302,473

Judge proportions of correct calls

3.71%
9.44%

Bull markets and bear market calls

34.54%

*Perfect Timing: Every month 100% of the funds are

placed in either stocks or cash based on which would
have the higher return.

Market Timing & Performance

Measurement

18-53

18-54

Characteristic Lines

Timer adjusts portfolio for up and down

movements in the market
Low Market Return - low eta
High Market Return - high eta

18-55

18-56

Problem 1

Selected Problems

Portfolio A
Portfolio B
Market index
Risk-free asset

E(r)
11%
14%
12%
6%

10%
31%
20%
0%

0.8
1.5
1.0
0.0

11%
14%

[6% + 0.8(12%
[6% + 1.5(12%

6%)] = 0.2%
6%)] = 1.0%

The alphas for the two portfolios are:

a.
A=
B =
Might add A if you believe the alpha is significant, might short
B if you believe its alpha is significant, should check Treynor.

18-57

18-58

Problem 1

Portfolio A
Portfolio B
Market index
Risk-free asset

b.

11% 6%
10%

0.5

E(r)
11%
14%
12%
6%

10%
31%
20%
0%

Problem 1

M2 Measure for A:
WA A + (1 WA) T-bill
20% = WA10% + (1 WA)0 ;
Market =
-1
20% / 10% = 2
(2)(0.11)&+WT-bills
(-1)(0.06)
WA =
= = 16%

0.8
1.5
1.0
0.0

14% 6%
31%

Portfolio A
Portfolio B
Market index
Risk-free asset

E(rPComplete) =

M2 measure for A =

0.26

If you hold only one of the two portfolios, then the Sharpe measure is the appropriate criterion:
SA =
SB =
Therefore, using the Sharpe criterion, Portfolio A is preferred.

18-59

E(r)
11%
14%
12%
6%

10%
31%
20%
0%

0.8
1.5
1.0
0.0

16% - 12% = + 4%

18-60

Problem 1

M2 Measure for B:
Market

WB

+ (1

WB)

Portfolio A
Portfolio B
Market index
Risk-free asset

E(r)
11%
14%
12%
6%

10%
31%
20%
0%

Problem 2

0.8
1.5
1.0
0.0

T-bill

20% = WB31% + (1
;

WB)0

WB = 20% / 31% = 0.645

& WT-bills = 0.355
E(rPComplete) = (0.645)(0.14) + (0.355)(0.06) = 11.16%
M2 measure for B =

a. Actual: (0.70)(2.0%) + (0.20)(1.0%) + (0.10)(0.5%) = 1.65%

Bogey: (0.60)(2.5%) + (0.30)(1.2%) + (0.10)(0.5%) = 1.91%
Relative performance = 1.65% 1.91% = -0.26%
(Underperformance)

11.16% - 12% = -0.84%

18-61

18-62

Problem 2

Problem 2

Asset Allocation

b.

Security Selection:
Market
Equity
Bonds
Cash

Portfolio
Performance
2.0%
1.0%
0.5%

Index
Performance
2.5%
1.2%
0.5%

Excess
Performance
-0.5%
-0.2%
0.0%

Portfolio Weight
0.70
0.20
0.10

Contribution of security selection:

c.

Contribution
-0.35%

Market

Actual Weight

0.00%

-0.39%

Excess Weight

Equity

0.70

0.60

0.10

Cash

0.10

0.10

0.00

Bonds

-0.04%

Benchmark Weight

0.20

0.30

-0.10

Index Return
Minus Bogey

Contribution

0.59%

0.059%

-1.41%

0.000%

-0.71%
Contribution of asset allocation:

0.071%
0.130%

Summary
Security selection

-0.39%

Excess performance

-0.26%

Asset allocation
18-63

0.13%

18-64