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Portfolio Management
3-228-07
Albert Lee Chun
Lecture 11
Evaluation of Portfolio
Performance
2 Dec 2008
Albert Lee Chun Portfolio Management
Introduction
As portfolio managers, how can we evaluate the
performance of our portfolio?
We know that there are 2 major requirements of
a portfolio managers performance:
1. The ability to derive above-average returns
conditioned on risk taken, either through
superior market timing or superior security
selection.
2. The ability to diversify the portfolio and
eliminate non-systematic risk, relative to a
benchmark portfolio.
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Today
Performance Measurement
Risk Adjusted Performance Measures
Measures of Sharpe, Treynor and Jensen
Measures of Skill and Timing
Attribution de performance
Concept de mesures ajustes pour le risque
Mesures de Sharpe, Treynor et Jensen
Mesure des habilits de timing
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Averaging Returns
Arithmetic Mean:
=
=
n
t
t
n
r
r
1
Geometric Mean:
1 ) 1 (
/ 1
1
(
+ =
[
=
n
n
t
t
r r
Example:
(.10 + .0566) / 2 = 7.83%
[ (1.1) (1.0566) ]
1/2
- 1
= 7.808%
Example:
17-3
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Geometric Average
The arithmetic average provides unbiased estimates of the
expected return of the stock. Use this to forecast returns in the
next period.
The fixed rate of return over the sample period that would yield
the terminal value is know as the geometric average.
The geometric average is less than the arithmetic average and this
difference increases with the volatility of returns.
The geometric average is also called the time-weighted average (as
opposed to the dollar weighted average), because it puts equal
weights on each return.
17-4
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Dollar- and Time-Weighted Returns
Dollar-weighted returns
Internal rate of return.
Returns are weighted by the amount invested in each
stock.
Time-weighted returns
Not weighted by investment amount.
Equal weighting
Geometric average
17-5
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Example: Multiperiod Returns
Period Action
0 Purchase 1 share of Eggberts Egg Co. at $50
1 Purchase 1 share of Eggberts Egg Co. at $53
Eggbert pays a dividend of $2 per share
2 Eggbert pays a dividend of $2 per share
Sell both shares for $108
17-6
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Period Cash Flow
0 -50 share purchase
1 +2 dividend -53 share purchase
2 +4 dividend + 108 shares sold
% 117 . 7
) 1 (
112
) 1 (
51
50
2 1
=
+
+
+
=
r
r r
Internal Rate of Return:
Dollar-Weighted Return
Dollar Weighted: The stocks performance in the second year,
when we own 2 shares, has a greater influence on the overall return.
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Time-Weighted Return
% 66 . 5
53
2 53 54
% 10
50
2 50 53
2
1
=
+
=
=
+
=
r
r
[ (1.1) (1.0566) ]
1/2
- 1
= 7.808%
17-8
Time Weighted: Each return has equal weight in the geometric
average.
Geometric Mean:
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Performance Measurement
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Early Performance Measure Techniques
Portfolio evaluation before 1960
Once upon a time, investors evaluated a portfolios
performance based purely on the basis of the rate of
return.
Research in the 1960s showed investors how to
quantify and measure risk.
Grouped portfolios into similar risk classes and
compared rates of return within risk classes.
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Peer Group Comparisons
This is the most common manner of evaluating
portfolio managers.
Collects returns of a representative universe of
investors over a period of time and displays them
in a box plot format.
Example: US Equity with Cash relative to peer
universe of US domestic equity managers.
Issue: There is no explicit adjustment for risk. Risk
is only considered implicitly.
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Treynor Portfolio Performance
Measure
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Treynor (1965)
Treynor (1965) developed the first composite measure of
portfolio performance that included risk.
He introduced the portfolio characteristic line, which
defines a relation between the rate of return on a specific
portfolio and the rate of return on the market portfolio.
The beta is the slope that measures the volatility of the
portfolios returns relative to the market.
Alpha represents unique returns for the portfolio.
As the portfolio becomes diversified, unique risk
diminishes.
( )
t p p p , t M, t p,
R R c | o + + =
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A risk-adjusted measure of return that divides a portfolio's
excess return by its beta.
The Treynor Measure is given by
Treynor Measure
p
f p
p
r R
= T
|
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Sharpe Measure
It adjusts returns for total portfolio risk, as opposed to only
systematic risk as in the Treynor Measure.
Thus, an implicit assumption of the Sharpe ratio is that the
portfolio is not fully diversified, nor will it be combined with
other diversified portfolios.
It is relevant for performance evaluation when comparing
mutually exclusive portfolios.
Sharpe originally called it the "reward-to-variability" ratio, before
others started calling it the Sharpe Ratio.
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SML vs. CML
Treynors measure uses Beta and hence examines portfolio
return performance in relation to the SML.
Sharpes measure uses total risk and hence examines portfolio
return performance in relation to the CML.
For a totally diversified portfolio, both measures give equal
rankings.
If it is not a diversified portfolio, the Sharpe measure could
give lower rankings than the Treynor measure.
Thus, the Sharpe measure evaluates the portfolio manager in
terms of both return performance and diversification.
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Price of Risk
Both the Treynor and Sharp measures, indicate the risk
premium per unit of risk, either systematic risk (Treynor) or
total risk (Sharpe).
They measure the price of risk in units of excess returns per
each unit of risk (measured either by beta or the standard
deviation of the portfolio).
T = r R
p p f p
|
p p f p
S r R o =
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Jensen Portfolio Performance Measure
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Alpha is a risk-adjusted measure of superior performance
This measure adjusts for the systematic risk of the portfolio.
Positive alpha signals superior risk-adjusted returns, and that
the manager is good at selecting stocks or predicting market
turning points.
Unlike the Sharpe Ratio, Jensens method does not consider the
ability of the manager to diversify, as it is only accounts for
systematic risk.
Jensens Alpha
( )
t p t f p p
r
, , t M, t f, t p,
R r R c | o + + =
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Multifactor Jensens Measure
Measure can be extended to a multi-factor setting, for example:
( )
t p
p p
t f
p
p
HML SML r
,
3 2
, t M,
1
t f, t p,
R r R c | | | o + + + + =
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Information Ratio
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Information Ratio 1
Using a historical regression, the IR takes on the form
where the numerator is Jensens alpha and the denominator is
the standard error of the regression. Recalling that
c
o o
p p
IR =
( )
t p t f p p
r
, , t M, t f, t p,
R r R c | o + + =
Note that the risk here is nonsystematic risk, that could, in theory,
be eliminated by diversification.
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Information Ratio 2
ER
b
p
p
R R
= IR
o
=
=
T
t
t
ER
T
ER
1
1
( )
2
1
2
1
1
=
T
t
t ER
ER ER
T
o
2
ER ER
o o =
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Information Ratio
Excess return represents managers ability to use information
and talent to generate excess returns.
Fluctuations in excess returns represent random noise that is
interpreted as unsystematic risk.
Information to noise ratio.
Annualized IR
p p
IR T = IR
ER
b
p
p
R R
= IR
o
= =
= =
=
= =
= =
Where B is the bogey portfolio and p is the managed portfolio.
Formula for Attribution
17-58
Set up a Benchmark or Bogey portfolio
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Allocation Effect
Asset Allocation Effect
Captures the managers decision to over or
underweight a particular market segment i.
Overweighting a segment i when the
benchmark yield is high is rewarded.
( ) ( ) | |
Bi Bi Pi i
r w w E =
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Selection Effect
Security Selection Effect
Captures the stock picking ability of the manager,
and rewards the ability to form specific market
segment portfolios. Rewards the manger for
placing larger weights on those segments where
his portfolio outperforms the benchmark
portfolio in that particular segment.
( ) ( ) | |
Bi Pi Pi i
r r w E =
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Performance of the Managed
Portfolio
17-61
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Performance Attribution
17-62
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Sector Selection within the Equity Market
17-63
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Portfolio Attribution: Summary
17-64
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Global Benchmark Problem
(Optional)
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Benchmark Error
Market portfolio is difficult to approximate
Benchmark error
can effect slope of SML
can effect calculation of Beta
greater concern with global investing
problem is one of measurement
Note: Sharpe measure not as dependent on
market portfolio as the Treynor measure and
others relying on Beta.
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Differences in Betas
Two major differences in the various beta
statistics:
For any particular stock, the beta estimates
change a great deal over time.
There are substantial differences in betas
estimated for the same stock over the same time
period when two different definitions of the
benchmark portfolio are employed.
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Global Benchmark Problem - SML
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Global Benchmark Problem - SML
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Global Benchmark Problem - SML
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Bond Portfolio Performance
Measures
(Optional)
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Bond Portfolio Measures
Returns-Based Bond Performance Measurement
Early attempts to analyze fixed-income performance
involved peer group comparisons
Peer group comparisons are potentially flawed because
they do not account for investment risk directly.
How did the performance levels of portfolio managers
compare to the overall bond market?
What factors lead to superior or inferior bond-portfolio
performance?
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Fama-French Measure
Fama and French extended their 3-factor equity pricing
model with 2 additional factors to account for the return
characteristics of bonds
TERM captures the term premium in the slope of the yield
curve.
DEF captures the default premium in the credit spread
between corporate bonds and treasuries.
These two bond factors are the dominate drivers of bond
portfolio returns.
( )
jt t j j1 mt t j2 t j3 t j4 t j4 t jt
R - RFR = + b R - RFR + b SMB + b HML + b TERM + b DEF + e ( (
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Seven Bond Portfolios
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Bond Performance Attribution
A Bond Market Line
Need a measure of risk such as beta coefficient for
equities
Difficult to achieve due to bond maturity and
coupon effect on volatility of prices
Composite risk measure is the bonds duration
Duration replaces beta as risk measure in a bond
market line
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Bond Market Line
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Thats all for today!
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