Investment Analysis and

Portfolio Management
by Frank K. Reilly & Keith C. Brown

Evaluation of Portfolio Performance

– Early Performance Measurement Techniques
– Composite Portfolio Performance Measures
Chapter 25

– Application of Portfolio Performance Measures

– Portfolio Performance Evaluation: Extensions
– Factors Affecting Use of Performance Measures
– Evaluation of Bond Portfolio Performance
– Reporting Investment Performance
What is Required of a Portfolio Manager?

• Two Desirable Attributes

– 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
– 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
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
Composite Portfolio Performance Measures

• Treynor Portfolio Performance Measure

– Treynor portfolio performance measure
• market risk
• individual security risk
• introduced characteristic line
– Treynor recognized two components of risk
• Risk from general market fluctuations
• 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
Composite Portfolio Performance Measures

– The Formula

• The numerator is the risk premium

• The denominator is a measure of risk
• The expression is the risk premium return per unit of risk
• Risk averse investors prefer to maximize this value
• This assumes a completely diversified portfolio leaving
systematic risk as the relevant risk
Composite Portfolio Performance Measures

– 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?

– The T Values
TM = (14%-8%) / 1 =6%
TW = (12%-8%) / 0.9 =4.4%
TX = (16%-8%) / 1.05 =7.6%
TY = (18%-8%) / 1.20 =8.3%
– See Exhibit 25.2
Exhibit 25.2
Composite Portfolio Performance Measures

• 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 =
σi
where:
σi = the standard deviation of the rate of return for Portfolio i
Composite Portfolio Performance Measures

– 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?

– The Sharpe Measures

SM = (14%-8%) / 20% =0.300
SD = (13%-8%) / 18% =0.273
SE = (17%-8%) / 22% =0.409
SF = (16%-8%) / 23% =0.348
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
Composite Portfolio Performance Measures

• 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 25.3
Exhibit 25.3
Composite Portfolio Performance Measures

– 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:
Composite Portfolio Performance Measures

• The Information Ratio Performance Measure

– The Formula
R j − Rb E j
I j= =
σE R
σE
where:
R
R R
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
Application of Portfolio Performance
Measures
• Total Rate of Return on A Mutual Fund

EPi + Divi + Cap.Dist.i − BPi

Ri = t t t t
t BPi
t
where
Rit = the total rate of return on Fund i during month t
EPit = the ending price for Fund i during month t
Divit = the dividend payments made by Fund i during month t
Cap.Dist.it = the capital gain distributions made by Fund i
during month t
BPit = the beginning price for Fund i during month t
Application of Portfolio Performance
Measures
• Total Sample Results
– Selected 30 open-end mutual funds from the nine
investment style classes and used monthly data for
the five-year period from April 2002 to March 2007
– Active fund managers performed much better than
earlier performance studies
– A primary factor for this outcome was the abnormally
poor performance of the index during the first part of
the sample period
– The various performance measures ranked the
performance of individual funds consistently
Application of Portfolio Performance
Measures
• Potential Bias of One-Parameter Measures
– Composite measures of performance should be
independent of alternative measures of risk because
they are risk-adjusted measures
– Positive relationship between the composite
performance measures and the risk involved
– The alpha measure can be biased downward for
those portfolios designed to limit downside risk
Application of Portfolio Performance
Measures
• Measuring Performance with Multiple Risk
Factors
– Form of the Estimation Equation

– Jensen’s alphas are computed relative to:

• A three-factor model including the market (Rm - RFR),
firm size (SMB), and relative valuation (HML) variables
• A four-factor model that also includes the return
momentum (MOM) variable
– The one-factor and multifactor Jensen measures
produce similar but distinct performance rankings
Application of Portfolio Performance
Measures
• Relationship among Performance Measures
– Exhibit 25.10 contains the matrix of rank correlation
coefficients among different performance measures
– Implications of High Positive Correlations
• 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
Exhibit 25.10
 Portfolio Performance Evaluation:
Some Extensions
• Components of Investment Performance
– Fama suggested overall performance, in excess of
the risk-free rate, consists of two components:
Overall Performance =Excess return
=Portfolio Risk + Selectivity
– The selectivity component represents the portion of
the portfolio’s actual return beyond that available to
an unmanaged portfolio with identical systematic
risk and is used to assess the manager’s
investment prowess
Portfolio Performance Evaluation:
Some Extensions
– Evaluating Selectivity: One can measure the return
due to selectivity as follows:

Selectivit = Ra − R x (β a )
where:
y
Ra = the actual return on the portfolio being evaluated
Rx(βa) = the return on the combination of the riskless asset
and the market portfolio that has risk βx equal to βa
⎡ Rm − RF ⎤
R x = RF + ⎢ ⎥ βx
⎣ σ (RRm ) ⎦
R

– See Exhibit 25.11

Exhibit 25.11
Portfolio Performance Evaluation:
Some Extensions
– Evaluating Diversification
• The gross selectivity component can be broken
into two parts
– Net selectivity
– Diversification

Selectivit Diversificatio
yR − R (β )= Net Selectivit + [R (nσ (R )) − R (β )]
a x a x a x a
where: y
Rx(σ (Ra)) = the return on the combination of the riskless
asset and the market portfolio that has return
volatility equivalent to that of the portfolio being
evaluated
 Portfolio Performance Evaluation:
Some Extensions
• Performance Measurement with Downside Risk
– The Sortino measure is a risk-adjusted measure that
differs from the Sharpe ratio in two ways
• It measures the portfolio’s average return in excess of
a user-selected minimum acceptable return threshold
• It captures just the downside risk (DR) in the portfolio
rather than the total risk as in Sharpe measure
– The Formula
R i −τ
STi =
D i
where: τ = the minimum
R acceptable return threshold
DRi = the downside risk coefficient for Portfolio i
 Portfolio Performance Evaluation:
Some Extensions
• Holding Based Performance Measurement
– There are two distinct advantages to assessing
performance based on investment returns
• Return are usually easy for the investor to observe on
a frequent basis
• Represent the bottom line that the investor actually
takes away from the portfolio manager’s investing
prowess
• Returns-based measures of performance are indirect
indications of the decision-making ability of a manager
• Holdings-based approach can provide additional
insight about the quality of the portfolio manager
 Portfolio Performance Evaluation:
Some Extensions
• Holding Based Performance Measurement
– Grinblatt -Titman (GT) Performance Measure
• Assess the quality of the services provided by money
managers by looking at adjustments they made to the
contents of their portfolios
• The Formula
GTi = Σj (wjt – wjt-1) Rjt
Average GT = Σt GTt / T
where:
(wjt, wjt–1) = the portfolio weights for the jth security at the
beginning of Period t and Period t - 1, respectively,
Rjt = the return to the jth security during Period t, which
begins on Date t - 1 and ends on Date t
Portfolio Performance Evaluation:
Some Extensions
– Characteristic Selectivity (CS) Performance
Measure
• The measure compares the returns of each stock
held in an actively managed portfolio to the return of a
benchmark portfolio that has the same aggregate
investment characteristics as the security in question
• The Formula
CSt = Σj wjt (Rjt – RBjt)
Average CS = Σt CSt / T
where: RBjt = the Period t return to a passive portfolio whose
investment characteristics are matched at the
beginning of Period t with those of Stock j
– See Exhibit 25.13
Exhibit 25.13
 Portfolio Performance Evaluation:
Some Extensions
• Performance Attribution Analysis
– It attempts to distinguish the source of the portfolio’s
overall performance (See Exhibit 25.14)
• Selecting superior securities
• Demonstrating superior timing skills
– The Formula
[
Allocation Effect = Σ i (W ai −W pi )× (R pi − R p ) ]
[ (
Selection Effect = Σ i (Wai )× Rai − R pi )]
where:
wai, wpi = the investment proportions of the ith market segment
the manager’s portfolio and the policy portfolio, respectively
Rai, Rpi = the investment return to the ith market segment in the
manager’s portfolio and the policy portfolio, respectively
Exhibit 25.14
Portfolio Performance Evaluation:
Some Extensions
– Performance Attribution Extensions
• Attribution methodology can be used to distinguish
security selection skills from any of several other
decisions that investor might make
• See Exhibit 25.15
– Measuring Market Timing Skills
• Tactical asset allocation (TAA)
• Attribution analysis is inappropriate
– Indexes make selection effect not relevant
– Multiple changes to asset class weightings during an
investment period
• Regression-based measurement
Exhibit 25.15
Factors That Affect Use of Performance
Measures
• Market Portfolio Is Difficult to Approximate
– Benchmark Portfolios
• Performance evaluation standard
• Usually a passive index or portfolio
• May need benchmark for entire portfolio and
separate benchmarks for segments to evaluate
individual managers
– Benchmark Error
• Can effect slope of SML
• Can effect calculation of beta
• Greater concern with global investing
• Problem is one of measurement
Factors That Affect Use of Performance
Measures
• Demonstration of the Global Benchmark
Problem
– 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 definition of the benchmark portfolio are
employed
Factors That Affect Use of Performance
Measures
• Implications of the Benchmark Problems
– Benchmark problems do not negate the value of
the CAPM as a normative model of equilibrium
pricing
– There is a need to find a better proxy for the market
portfolio or to adjust measured performance for
benchmark errors
– Multiple markets index (MMI) is major step toward
a truly comprehensive world market portfolio
Factors That Affect Use of Performance
Measures
• Required Characteristics of Benchmarks
– Unambiguous
– Investable
– Measurable
– Appropriate
– Reflective of current investment opinions
– Specified in advance
• Selecting a Benchmark
– A global level that contains the broadest mix of
risky asset available from around the world
– A fairly specific level consistent with the
management style of an individual money manager
 Evaluation of
Bond Portfolio Performance
• 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
– Fama and French Multifactor Model (Exhibit 25.17)
Rjt-RFRt=αj+[bj1(Rmt-RFRt)+bj2SMBt+bj3HMLt+[bj4TERMt+bj5DEFt] + ejt
TERM = the term premium built into the Treasury yield curve
DEF = the default premium and is calculatedby the credit spread
Exhibit 25.17
 Evaluation of
Bond Portfolio Performance
• Bond Performance Attribution
– The analysis tries to address the factors cause
superior or inferior bond-portfolio performance
– 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 bond’s duration
• Duration replaces beta as risk measure in a bond
market line
 Evaluation of
Bond Portfolio Performance
– This technique divides the portfolio return that
differs from the return on the Lehman Brothers
Index into four components
• Policy effect
– Difference in expected return due to portfolio duration
target
• Rate anticipation effect
– Differentiated returns from changing duration of the
portfolio
• Analysis effect
– Acquiring temporarily mispriced bonds
• Trading effect
– Short-run changes
Reporting Investment Performance
• Time-Weighted and Dollar-Weight Returns
– A better way to evaluate performance regardless of
the size or timing of the investment involved
– The dollar-weighted and time-weighted returns are
the same when there are no interim investment
contributions within the evaluation period
– Holding period yield computations
Ending Value of Investment
HPY = -1
Beginning Value of Investment
Ending Value of Investment – (1 – DW) (Contribution )
Adjusted HPY = −
Beginning Value of Investment + (DW ) ( Contribution) 1

where: DW = factor represents the portion of the period that

the contribution is actually held in the account
Reporting Investment Performance
• Performance Presentation Standards (PPS)
– CFA Institute introduced in 1987 and formally
adopted in 1993 the Performance Presentation
Standards
– The Goals of PPS
• Achieve greater uniformity and comparability among
performance presentation
• Improve the service offered to investment
management clients
• Enhance the professionalism of the industry
• Bolster the notion of self-regulation
Reporting Investment Performance
– Fundamental Principles of PPS
• Total return must be used
• Time-weighted rates of return must be used
• Portfolios must be valued at least monthly and
periodic returns must be geometrically linked
• Composite return performance (if presented) must
contain all actual fee-paying accounts
• Performance must be calculated after deduction of
trading expenses
• Taxes must be recognized when incurred
• Annual returns for all years must be presented
• Disclosure requirements must be met
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