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Evaluation of Portfolio Performance

INVESTMENT

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ROSLE AWANG BIN MOHIDIN -
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24 views23 pages

Evaluation of Portfolio Performance

INVESTMENT

Uploaded by

ROSLE AWANG BIN MOHIDIN -
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Evaluating Investing

Performance
Composite Portfolio
Performance Measures
• Portfolio evaluation before 1960
– rate of return within risk classes
• Peer group comparisons
– no explicit adjustment for risk
– difficult to form comparable peer group
• Treynor portfolio performance measure
– market risk
– individual security risk
– introduced characteristic line
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Treynor Portfolio
Performance Measure
• 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

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Treynor Portfolio
Performance Measure
T
R i  RFR 
i
• 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

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Treynor Portfolio
Performance Measure
• Comparing a portfolio’s T value to a similar measure for
the market portfolio indicates whether the portfolio would
plot above the SML
• Calculate the T value for the aggregate market as follows:

Tm 
R m  RFR 
m

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Treynor Portfolio
Performance Measure

• Comparison to see whether actual return of


portfolio G was above or below expectations
can be made using:

ER G   RFR   i R m  RFR 

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Sharpe Portfolio
Performance Measure

• Risk premium earned per unit of risk

R i  RFR
Si 
i
Copyright © 2000 by Harcourt, Inc. All rights reserved.
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
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

ER j   RFR   j ER m   RFR 

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Jensen Portfolio
Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

ER j   RFR   j ER m   RFR 


Where: E(Rj) = the expected return on security
RFR = the one-period risk-free interest rate
j= the systematic risk for security or portfolio j
E(Rm) = the expected return on the market portfolio of
risky assets

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Jensen Portfolio
Performance Measure
• Jensen’s alpha is:

ER j   RFR   j ER m   RFR 


 j  R j  ER j 
 j  R j  RFR   j ER m   RFR 
• E(Rj) could also be determined by APT instead of
CAPM, and alpha can be estimated through
regression.
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Traditional Performance Measures

 The Sharpe measure relates return to total


risk. It can be used effectively with a portfolio
where unsystematic risk has been diversified
away.

Ri  Rf
Sharpe measure 
i
where R i = arithmetic mean return of security i
Rf = risk free rate
 i = standard deviation of returns on security i

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Traditional Performance Measures

 The Treynor measure relates return to


systematic risk, as measured by the
security (or portfolio) beta. It is an
appropriate measure for both single
securities as well as for portfolios.

Ri  R f
Treynor measure 
i

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Traditional Performance Measures
 The Jensen measure stems directly from the
implications of the capital asset pricing
model as estimated by the market model.

Ri  Rf   i   i Rmarket  Rf 
or  i  Ri  Rf    i R market  Rf 

 According to finance theory, i should be


zero. So, a positive alpha that is statistically
different from zero indicates an above-
average performance, and vice versa.

Copyright © 2000 by Harcourt, Inc. All rights reserved.


mean return Traditional Performance Measures
 The Sharpe performance
measure can be interpreted as
the slope of a line relating the
security’s return with its risk.
standard deviation

 The line extending from the risk-free rate


through the market portfolio on the efficient
frontier is the capital market line.
 Securities plotted above the capital market
line show better-than-expected performance,
and vice versa.

Copyright © 2000 by Harcourt, Inc. All rights reserved.


mean return Traditional Performance Measures

It is also possible to plot the



returns of securities against
their levels of systematic risk,
or beta, cf. both Treynor and
beta
Jensen.
 The standard of comparison in this case is
the security market line. This line extends
from the risk-free rate through the point
corresponding to the return associated with a
beta of 1.0.

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Components of Investment
Performance
• Fama suggested overall performance, which
is its return in excess of the risk-free rate
Portfolio Risk + Selectivity
• Further, if there is a difference between the
risk level specified by the investor and the
actual risk level adopted by the portfolio
manager, this can be further refined
Investor’s Risk + Manager’s Risk + Selectivity

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Components of Investment
Performance
• The selectivity measure is used to assess the
manager’s investment prowess
• The relationship between expected return
and risk for the portfolio is:

 
 E m Rˆ  RFR  Cov R̂ j , R̂ m
E Rˆ  RFR  
 

  Rm    Rm 

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Components of Investment
Performance
• The market line then becomes a benchmark
for the manager’s performance
 Rm  RFR 
Rx  RFR    x
   Rm  

Selectivit y  Ra  Rx  a 

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Components of Investment
Performance
• The selectivity component can be broken
into two parts
– gross selectivity is made up of net selectivity
plus diversification

Selectivit y Diversification
Ra  Rx  a   Net Selectivit y  Rx  Ra   Rx  a 

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Components of Investment
Performance
• Assuming the investor has a target level of
risk for the portfolio equal to T, the portion
of overall performance due to risk can be
assessed as follows:
Risk  Manager' s Risk  Investor's Risk
Rx  a   RFR   Rx  a   Rx  T   Rx  T   RFR 

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Characteristics of Benchmarks
• Unambiguous
• Investable
• Measurable
• Appropriate
• Reflective of current investment opinions
• Specified in advance

Copyright © 2000 by Harcourt, Inc. All rights reserved.


Exercise

Copyright © 2000 by Harcourt, Inc. All rights reserved.

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