FNCE 30001 Week 12 Portfolio Performance Evaluation

FNCE 30001 Investments 12.
0
FNCE 30001 Investments
Semester 2, 2011
26 & 28 October 2009
Week 12: Portfolio Performance
Evaluation
Professor Rob Brown
FNCE 30001 Investments 12.1
Lecture 11: Portfolio Performance Evaluation
Overview of Lecture
1. Steps in performance evaluation
2. Performance measurement
3. Performance appraisal
4. Performance attribution
Reading: Bodie et al, Chapter 24.
Performance Measurement (pdf available on the LMS).
1. Steps in Performance Evaluation
Steps in Performance Evaluation
1. Performance measurement
Calculating the return that a portfolio achieved over a
period of time.
2. Performance appraisal
Evaluating the overall performance of a portfolio.
3. Performance attribution
Determining what portion of this overall performance was
due to the managers skill in selecting securities.
Steps in Performance Evaluation
2. Performance Measurement
Measuring past returns may be harder than you think.
Some issues are:
Cash flows (eg quarterly) may not match the desired
frequency of return measurement (eg annual).
There may be multiple cash inflows and /or outflows due
to (eg):
dividends
distributions to fund members
new funds invested
funds withdrawn
management fees
Performance Measurement
Choice of measurement methodology:
Time-weighted
geometric (discrete time) or
logarithmic (continuous time)
Dollar-weighted
aka internal rate of return
Over short periods of time there is often little difference
between the methods.
Over long periods of time, there may be larger differences.
We will tackle all these complications using examples.
We will start with the simplest case and work up to more
complex cases.
Example 1: One stock held for one period; no dividend.
Purchase price (P
0
) is $35.50.
Sale price (P
1
) is $38.34. Sale occurs 6 months after purchase.
What is the rate of return per half-year (discrete time)?
1 0
0
Rate of return per half-year
$38.34 $35.50
$35.50
$2.84
$35.50
8.00% per half-year
P P
P
=
=
=
Same as Example 1, except we require an annual rate of return.
The annual rate of return (discrete time) is given by:
This is just the familiar idea of the effective interest rate
applied in a slightly different context.
( )
=
=
2
Rate of return pa 1.0800 1
16.64% pa
Example 2 (contd.)
More formally, in discrete time we assume that:
( )
= +
| |
=
|
\ .
| |
=
|
\ .
=
1 0
1
1
0
1 0.5
1 , which implies:
1
Here, is 6 months (half a year); so is 0.5.
$38.34
1
$35.50
16.64% pa
n
n
P P r
P
r
P
n n
r
Same as Example 2, except in continuous time.
In continuous time, we assume that:
=
| |
=
|
\ .
| |
=
|
\ .
=
=
1 0
1
0
, which implies:
1
n
Here, is 6 months (half a year); so is 0.5. Hence,
1 $38.34
n
0.5 $35.50
2 0.076961041
15.392% pa
r n
P P e
P
r
n P
n n
r
Example 4: One stock held for one period; with dividend
Purchase price (P
0
) is $35.50; Sale price (P
1
) is $38.34 (ex-div).
A dividend of 71 cents is paid after 6 months.
What is the rate of return (discrete time) per year?
( )
1 0 1
0
2
Rate of return per half-year
$3.55
$35.50
10.00% per half-year
Rate of return pa 1.1000 1
21.00% pa
P P D
P
+
=
=
=
=
=
Example 5: One stock held for many periods; no dividends
Purchase 200 shares at $10.20 each and hold for 8 quarters.
Outlay = 200 x$10.20 = $2040. Prices move as shown below.
Quarter (end) Price per share Portfolio value
0 $10.20 $2040
1 $9.80 $1960
2 $10.96 $2192
3 $11.25 $2250
4 $11.61 $2322
5 $11.75 $2350
6 $11.05 $2210
7 $11.85 $2370
8 $14.58 $2916
Example 5 (contd.)
Calculate:
(a) Arithmetic and logarithmic rates of return for each quarter.
(b) The total rate of return over the 8 quarters.
(c) The mean rate of return per quarter and per annum.
=
| |
=
|
\ .
1
1
1
Arithmetic RoR in quarter
Logarithmic RoR in quarter n
t t
t
t
t
P P
t
P
P
t
P
Example 5 (contd.)
Answer to (a):
Quarter
(end)
Price per
share
Portfolio
value
Arithmetic
RoR
Logarithmic
RoR
0 $10.20 $2040
1 $9.80 $1960 3.9216% 0.040005
2 $10.96 $2192 11.8367% 0.111870
3 $11.25 $2250 2.6460% 0.026116
4 $11.61 $2322 3.2000% 0.031499
5 $11.75 $2350 1.2059% 0.011986
6 $11.05 $2210 5.9574% 0.061423
7 $11.85 $2370 7.2398% 0.069897
8 $14.58 $2916 23.0380% 0.207323
Example 5 (contd.)
Answer to (b):
Total rates of return
Using arithmetic rates of return each quarter, we need the geometric rate of
return over the 8 quarters:
Using logarithmic rates of return each quarter, we sum the quarterly returns:
=
=
Total Geometric RoR 0 960784 1 118367 1 230380 1
0 429412 (over 8 quarters)
. . ... .
.
= + + +
=
Total Logarithmic RoR 0 040005 0 111870 0 207323
0 3572630 (over 8 quarters)
. . ... .
.
Example 5 (contd.)
Answer to (c):
Mean rates of return
( )
( )
=
=
=
=
1 8
4
Mean Geometric RoR (pq) 1 429412 1
4 567007% pq
Mean Geometric RoR (pa) 1 04567007 1
19 558% pa
.
.
.
.
= = =
=
=
0 3572630
Mean Logarithmic RoR (pq) 0 0446579 4 466% pa
8
Mean Logarithmic RoR (pa) 0 0446579 4
17 863% pa
.
. .
.
.
Example 5 (contd.)
Three further observations on Example 5:
Observation 1
Of course, geometric and logarithmic rates of return are just different ways of
telling the same story:
Observation 2
Because there are no dividends, we can use just the start and end portfolio
values and ignore the intermediate quarters.
=
=
0 3572630
0 0446579
Total Returns:
1 0 429412 (over 8 quarters)
Mean Returns:
1 0 045670 pq
.
.
e .
e .
But, as well see in Example 6, things can get more complex when there are
dividends.
( )
| |
=
|
\ .
=
=
| |
=
|
\ .
=
=
1 2
1 2
$2916
Mean Geometric RoR 1
$2040
1.429411765 1
19.558% pa
1 $2916
Mean Logarithmic RoR n
2 $2040
1
0.357263006
2
17.863% pa
Example 5 (contd.)
Observation 3
The geometric rate of return is also known as the time-
weighted rate of return.
because every quarter (or other period) is given equal
weight in calculating the total and mean rates of return.
In many practical situations (like a mutual fund or a
superannuation fund) the size of the fund varies from time to
time.
dollar-weighted rate of return
Example 5 (contd.)
Example 6: One stock held for many periods; with dividends
As in Example 5, except that we assume that dividends are paid and are
reinvested in the same stock. The history of the stock unfolds as follows:
Quarter
(end)
Price per share
(ex-div)
Dividend
per share
0 $10.20
1 $9.80 $0.08
2 $10.96
3 $11.25 $0.10
4 $11.61
5 $11.75 $0.15
6 $11.05
7 $11.85 $0.16
8 $14.58
Example 6 (contd.)
Qtr
(end)
Price ps
(ex-div)
Div ps Dividend
received
No. of shares
bought
Holding Portfolio
value
0 $10.20 200.000 $2040.00
1 $9.80 $0.08 x200.000 = $16.00 / $9.80 = 1.633 201.633 $1976.00
2 $10.96 201.633 $2209.89
3 $11.25 $0.10 x201.633 = $20.16 / $11.25 = 1.792 203.425 $2288.53
4 $11.61 203.425 $2361.76
5 $11.75 $0.15 x203.425 = $30.51 / $11.75 = 2.597 206.022 $2420.76
6 $11.05 206.022 $2276.54
7 $11.85 $0.16 x206.022 = $32.96 / $11.85 = 2.782 208.804 $2474.32
8 $14.58 208.804 $3044.36
Example 6 (contd.)
We then calculate returns as usual using the portfolio values.
Example 6 (contd.)
Quarter
(end)
Portfolio
value
Arithmetic
RoR
Logarithmic
RoR
0 $2040.00
1 $1976.00 3.1373% 0.031875
2 $2209.89 11.8367% 0.111870
3 $2288.53 3.5584% 0.034965
4 $2361.76 3.2000% 0.031499
5 $2420.76 2.4978% 0.024672
6 $2276.54 5.9574% 0.061423
7 $2474.32 8.6878% 0.083309
8 $3044.36 23.0380% 0.207323
Example 6 (contd.)
Time-weighted Rates of Return
Geometric Rates of Return
Logarithmic Rates of Return
( )
=
=
=
=
1 2
Total RoR 0.968627 1.118367 ... 1.230380 1
0.4923315 (over 8 quarters)
Mean RoR (pa) 1.4923315 1 pa
22.161% pa
= + + +
=
=
=
Total RoR 0.031875 0.111870 ... 0.207323
0.4003397
1
Mean RoR (pa) 0.4003397
2
20.017% pa
Example 6 (contd.)
Again, using just the opening and closing portfolio values also works:
But we know the final portfolio value ($3044.36) only if we work through the
reinvestment of dividends.
( )
| |
=
|
\ .
=
=
| |
=
|
\ .
=
=
1 2
1 2
$3044.36
Mean Geometric RoR 1
$2040.00
1.42933333 1
22.161% pa
1 $3044.36
Mean Logarithmic RoR n
2 $2040.00
1
0.4003409
2
20.017% pa
Example 7: Many stocks, many periods, with dividends,
distributions, redemptions and new fund inflows
In this example we consider the Melbourne Fund, which is an
open-ended fund (eg a mutual fund or a superannuation fund)
that invests in many stocks over many periods. Many of the
stocks pay dividends. The Fund charges management fees.
We assume that:
all cash flows occur at end-of-quarter (not during a quarter);
all cash flows are immediately reflected in the amount of
funds under management (FUM);
FUM is always measured at current market prices.
Fund
Assets
Fund
Manager
FUM
Fund
Members
Management fees
Dividends &
interest
Capital gains &
losses
Distributions
Redemptions
New inflows
Example 7 (contd.)
Objective
We wish to measure and report the mean rate of return pa (in
discrete time) achieved by Fund members over the past 8
quarters.
We will measure and report on:
the time-weighted rate of return (TWR) and
the dollar-weighted rate of return (DWR).
Example 7 (contd.)
Effect of investing in many stocks
In principle, having many stocks instead of just one makes
little difference.
We simply sum the market values of all stocks held and all
dividends received.
But the practical record-keeping issues can be considerable.
Distributions
Are like dividends paid from the Fund to fund members.
For tax reasons, distributions are often pass-throughs of
dividends received by the Fund.
Example 7 (contd.)
Redemptions and new fund inflows
When fund members exit (redemptions) they are paid out
at a price that reflects the current market value of the Funds
investments.
Similarly, when new members join the Fund, or existing
members increase their contributions, they do so at a price
that reflects the current market value of the Funds
investments.
Management fees
The Fund charges about 2.5% pa in management fees,
payable quarterly in arrears.
Example 7 (contd.)
Cash Flows of the Fund
Qtr
(end)
Portfolio
Value
(FUM) $m
Dividends
received
$m
Capital
gains
$m
Distrib-
utions
$m
Redemp
-tions
$m
Manage-
ment fees
$m
New
inflows
$m
0 427.8
1 409.3 1.9 4.7 1.5 31.0 2.7 10.1
2 455.0 2.4 30.4 2.0 22.1 2.6 39.6
3 446.9 1.1 4.2 1.0 18.7 2.8 9.1
4 430.4 2.8 19.7 3.1 6.6 2.8 12.9
5 448.6 2.0 13.2 1.9 19.9 2.7 27.5
6 480.6 2.6 17.7 2.5 8.8 2.8 25.8
7 500.4 1.1 17.9 1.0 14.2 3.0 19.0
8 498.8 3.0 28.7 3.3 42.8 3.1 15.9
Example 7 (contd.)
Note the identity here (using Quarters 0 and 1 as an example):
Funds under management at end Qtr 0 $427.8 m
Plus Dividends received at end Qtr 1 + $1.9 m
Plus Capital gains at end Qtr 1 + $4.7 m
Less Distributions at end Qtr 1 $1.5 m
Less Redemptions at end Qtr 1 $31.0 m
Less Management fees at end Qtr 1 $2.7 m
Plus New inflows at end Qtr 1 + $10.1 m
Equals Funds under management at end Qtr 1 $409.3 m
Example 7 (contd.)
Time-weighted Rate of Return (TWR)
The after-fee dollar return to Fund members each quarter is
given by:
Dollar return = Dividends + Capital gains Fees
The rate of return each quarter is the dollar return divided by the
funds under management at the end of the previous quarter.
This is shown in the table on the next slide.
These quarterly rates of return must then be accumulated over
the 8 quarters and averaged.
Example 7 (contd.)
Qtr
(end)
Portfolio
Value (FUM)
$m
After-fee dollar return to Fund members
= dividends + capital gains fees
$m
Quarterly
RoR
% pq
0 427.8
1 409.3
1.9 + 4.7 2.7 = 3.9
0.9116%
2 455.0
2.4 + 30.4 2.6 = 30.2
7.3785%
3 446.9
1.1 + 4.2 2.8 = 2.5
0.5495%
4 430.4
2.8 19.7 2.8 = 19.7
4.4081%
5 448.6
2.0 + 13.2 2.7 = 12.5
2.9043%
6 480.6
2.6 + 17.7 2.8 = 17.5
3.9010%
7 500.4
1.1 + 17.9 3.0 = 16.0
3.3329%
8 498.8
3.0 +28.7 3.1 = 28.6
5.7154%
Example 7 (contd.)
We then accumulate and average these quarterly returns in the usual way to
get the time-weighted rate of return pa (TWR):
Hence, TWR = 10.290% pa.
( )
=
=
=
=
1 2
Total RoR 1.009116 1.073785 ... 1.057154 1
0.21639203 (over 8 quarters)
Mean RoR (pa) 1.21639203 1 pa
10.290% pa
Example 7 (contd.)
Dollar-weighted Rate of Return (DWR)
To calculate the DWR we need to identify the amount and
timing of every cash flow that the Fund members experience.
These are:
At t = 1, 2, , 8: Inflows are distributions and redemptions
At t = 1, 2, , 8: Outflows are the new inflows to the fund
At t = 8: Inflow of $498.8m (notional sale of shares)
At t = 0: Outflow of $427.8m (notional purchase of shares)
Example 7 (contd.)
Qtr
(end)
Inflows
(Distri-
butions)
$m
Inflows
(Redemp-
tions)
$m
Outflows
(Inflows to
the Fund)
$m
Inflow
(notional
sale)
$m
Outflow
(notional
purchase)
$m
Net cash
flows of Fund
members
$m
0 427.8 427.8
1 1.5 31.0 10.1 22.4
2 2.0 22.1 39.6 15.5
3 1.0 18.7 9.1 10.6
4 3.1 6.6 12.9 3.2
5 1.9 19.9 27.5 5.7
6 2.5 8.8 25.8 14.5
7 1.0 14.2 19.0 3.8
8 3.3 42.8 15.9 498.8 529.0
Example 7 (contd.)
Therefore we need to solve for i:
( ) ( ) ( ) ( )
( ) ( ) ( )
2 3 4 5
6 7 8
$22.4 $15.5 $10.6 $3.2 $5.7
1
1 1 1 1
$14.5 $3.8 $529
$427.8 0.
1 1 1
The solution(found using Excel's IRR function) is 2.4902912% pq.
The dollar-weighted rate of return pa is given by:
i
i i i i
i i i
i
+
+
+ + + +
+ =
+ + +
=
( )
4
1.024902912 1 10.339% pa. DWR = =
Example 7 (contd.)
In this example there is little difference between time-weighted
and dollar-weighted rates of return:
TWR = 10.290% pa
DWR = 10.339% pa
When intermediate cash flows are small, the two will be very
close.
When intermediate cash flows are large or when subperiod
return is very volatile, then there can large differences.
If large amounts are contributed just before a period of
strong performance, then DWR will be greater than TWR.
If large amounts are withdrawn just before a period of
strong performance, then DWR will be less than TWR.
Example 7 (contd.)
This example is our most realistic.
But there are still further complications of reality that we wont
tackle, including:
Share capitalisation changes (eg bonus issues, rights issues,
reconstructions);
Cash flows that occur within subperiods (eg monthly cash
flows in a quarterly calculation);
Tax effects: eg What about imputation credits? What about
capital gains taxes?;
Out of date or even unobservable share prices.
Example 8
As in Example 7, except there is now a large new inflow at the
end of Quarter 1 followed by a large redemption at the end of
Quarter 2. There are also some consequential changes to
component cash flows (eg capital gains) these are shown in red
in the table on the next slide.
Because Quarter 2 has a high rate of return we should see a large
increase in the dollar-weighted rate of return and little change in
the time-weighted rate of return.
Example 8 (contd.)
Cash Flows of the Fund
Qtr
(end)
Portfolio
Value
(FUM) $m
Dividends
received
$m
Capital
gains
$m
Distrib-
utions
$m
Redemp-
tions
$m
Manage-
ment fees
$m
New
inflows
$m
0 427.8
1 609.3 1.9 4.7 1.5 31.0 2.7 210.1
2 455.0 3.6 45.3 3.0 235.9 3.9 39.6
3 446.9 1.1 4.2 1.0 18.7 2.8 9.1
4 430.4 2.8 19.7 3.1 6.6 2.8 12.9
5 448.6 2.0 13.2 1.9 19.9 2.7 27.5
6 480.6 2.6 17.7 2.5 8.8 2.8 25.8
7 500.4 1.1 17.9 1.0 14.2 3.0 19.0
8 498.8 3.0 28.7 3.3 42.8 3.1 15.9
Example 8 (contd.)
When we do the calculations, we find:
TWR = 10.294% pa (vs 10.290% pa in Example 7) and
DWR = 11.511% pa (vs 10.339% pa in Example 7).
That is, we find the expected result.
3. Performance Appraisal
The Fundamental Issue in Performance Appraisal
My portfolio has achieved a return of x%. Is this good or bad?
The fundamental issue is: good or bad compared to what?
Answer: compared to the performance that might otherwise
have been achieved.
That is: an opportunity cost argument (alternative forgone).
But the alternative forgone must be in some sense comparable to
the investment actually made (comparing apples with apples).
Typically, this requirement is taken to mean having the same risk.
Therefore, performance appraisal requires us to use some kind of
asset pricing model, either explicitly or implicitly.
Performance Appraisal
We need an asset pricing model to decide what is a normal (or
expected) return.
Any significant difference between actual performance and
normal performance is abnormal performance.
If greater, then abnormally good:
superior performance or out-performance.
If less, then abnormally bad:
inferior performance or under-performance.
Why significant difference?
Because actual performance may differ from normal
performance randomly.
What causes abnormal performance?
1. Asset allocation
How much in stocks and how much in bonds?
2. Market timing: buying and/or selling assets at a good time.
Switching between asset classes
eg out of stocks into property.
Switching between industry sectors
eg out of manufacturing into financial services.
3. Security selection
Identifying individual securities that are underpriced or
overpriced, then buying or selling accordingly.
What causes abnormal performance? (contd.)
4. Random influences (luck)
Investment is an uncertain business, so it is always
possible to get a good outcome (ex post) from a bad
decision (ex ante)
and, of course, vice versa.
We tend to label such outcomes as good luck and bad
luck respectively.
The effects of luck will on average wash out over time.
Nevertheless, in any given case, a significance test may
give a false positive or a false negative.
There is no universally accepted measure for performance
appraisal.
We will consider 7 approaches:
1. Simple Benchmark Index
2. The Sharpe Ratio
3. The Treynor Ratio
4. Jensens Alpha
5. The Information Ratio
6. The M
2
Measure
7. Style Analysis
1. Simple Benchmark Index
This is probably the most common approach.
We specify a benchmark index that has (or is assumed to
have) the same risk as the portfolio.
A benchmark index should also be:
Viable; that is, could have been invested in.
Low transaction cost.
Identifiable before the fact.
eg a portfolio comprising mainly large listed Australian stocks
might be benchmarked against the ASXs All Ordinaries
Accumulation Index.
If the portfolio achieves a higher return than the index (it
beats the index) then it has superior performance.
Clearly, the bigger the difference the better the performance.
Good news:
Cheap to implement.
Easy to understand.
Doesnt rely on any explicit asset pricing model
which could also be bad news.
Bad news:
No significance test.
How do we know the benchmark index (portfolio) has the
same risk as the portfolio?
2. The Sharpe Ratio
Named after William Sharpe.
Fund (portfolio) risk is defined as the total risk of the portfolio:
ie the standard deviation of portfolio returns.
The measure of return is the excess return, which is the
return above the risk-free rate.
It provides a measure of excess return per unit of total risk.
Also known as the reward-to-variability ratio.
There is a significance test due to Jobson and Korkie.
The formula is:
If the Sharpe ratio of the portfolio exceeds the Sharpe ratio of
the market portfolio then there is superior performance:
in that case, the portfolio plots above the capital market line.
o
o
= ,
where
is the average return achieved on the portfolio over the time period
is the average risk-free rate over the time period
is the standard deviation of the return on the portfolio o
P f
P
P
f
P
r r
S
r
r
ver the time period
Note that in this example the Funds return is less than the
return on the market portfolio
BUT so is its risk (standard deviation).
According to the Sharpe ratio, in this particular case the (much)
lower risk more than compensates for the (slightly) lower return.
Because the Sharpe ratio uses total risk, it is best suited to
evaluating the performance of whole portfolios;
that is, when the portfolio to be evaluated is the total holding
of the investor.
3. The Treynor ratio
Named after Jack Treynor.
Fund (portfolio) risk is defined as the non-diversifiable risk of
the portfolio:
ie the beta of portfolio returns.
Therefore, the Treynor ratio can be used to evaluate
undiversified portfolios and even single securities, if they are
held as part of a diversified portfolio.
As in the Sharpe ratio, the measure of return is the excess
return, which is the return above the risk-free rate.
It provides a measure of excess return per unit of non-
diversifiable risk.
Also known as the reward-to-volatility ratio.
The formula is:
|
|
= ,
where
is the average return achieved on the portfolio over the time period
is the average risk-free rate over the time period
is the beta of the portfolio over the time period
P f
P
P
f
P
r r
T
r
r
If the actual return on the portfolio exceeds the expected return
on the portfolio (where expected means according to the
CAPM) then there is evidence of superior performance.
So the critical question is whether the Treynor ratio exceeds the
market risk premium.
( )
( )
( )
( )
|
|
|
>
= +
> +
>
This means that E .
But E .
That is: .
which implies .
That is: Treynor ratio > the market risk premium.
P P
P f P M f
P f P M f
P f
M f
P
r r
r r r r
r r r r
r r
r r
4. Jensens alpha
Named after Michael Jensen.
Explicitly based on the CAPM.
( ) ( )
Recall CAPM: E E
This is an single-period model.
P f P M f
r r r r
ex ante
|
(
= +

( )
, , , ,
Hence:
This is an multiperiod model.
P t f t P M t f t t
r r r r e
ex post
| = + +
( )
, , , ,
Therefore:
P t f t P M t f t t
r r r r e | = +
Note : No constant
So, if we insert a constant,
P
, we expect its estimated
value to be zero.
But suppose we run this regression and find that
P
is
significantly positive.
Then, if the model is true, there is evidence of superior
performance by the fund manager who chose portfolio P.
Of course, if
P
is significantly negative, this is evidence of
inferior performance by the fund manager.
And if
P
is not significantly different from zero, there is no
statistical evidence of abnormal performance by the fund
manager.
( )
, , , , P t f t P P M t f t t
r r r r e o | = + +
Note: By definition, we can calculate Jensens alpha as follows:
But where does the
P
come from?
From the regression!
And, having done the regression, we also get the prob value
(significance level) for the hypothesis that
P
equals zero.
So the bottom line is: do the regression!
( )
( )
, , , ,
, , , ,
P P t f t P M t f t
P t f t P M t f t
r r r r
r r r r
o |
|
=
(
= +

5. The Information Ratio
Also known as active return-to-risk ratio:
Numerator is Active Return.
Denominator is Active Risk.
The information ratio divides the alpha of the portfolio by the
diversifiable risk.
The information ratio measures abnormal return per unit of risk
that in principle could have been eliminated by holding the
market portfolio.
Information Ratio / ( )
P P
e o o =
6. The M
2
Measure
Popularised by Franco Modigliani and his granddaughter Leah
Modigliani.
A selected portfolio, P, will nearly always have a return and
standard deviation that differ from the return and standard
deviation of the market portfolio, M.
But we can combine P and the risk-free asset to make a new
portfolio, P*, that has the same standard deviation (but different
return) as the market portfolio, M.
Since both P* and M have the same risk (standard deviation), we
can validly compare their returns.
The difference between these returns is the M
2
measure.
If the return on P* exceeds the return on M, then P has superior
performance.
Example
= o = = o = =
o = o
o = o =
o o
= = = =
o o
= =
*
*
*
Suppose 6%, 10%, 15%, 45% and 3%.
Recall that for a two-asset portfolio, where one of the assets is risk-free:
.
We require 45%.
45%
Therefore 4.5
10%
and 1 1 4
P P M M f
P P P
P M
M P
P
P P
f P
r r r
w
w
w w = .5 3.5.
This means that for every $1 of our own invested, we borrow $3.50 and
invest the whole amount ($4.50) in portfolio .
What is the return on portfolio * ?
And is this return greater than the retu
P
P
rn on portfolio ? M
Example (contd.)
= +
=
=
=
= = =
*
2
*
2
The return on portfolio * is given by
4.5 6% 3.5 3%
16.5%
Recall that 15%.
Therefore 16.5% 15% 1.5%.
Because is greater than zero, superior performance is indicated.
P P P f f
M
P M
P
r w r w r
r
M r r
M
7. Style Analysis
Introduced by William Sharpe (1992).
Can be considered a 7
th
type of performance appraisal.
But is a bit more than that.
Consider two-stage top down portfolio construction:
1. Allocation between major asset classes (styles):
eg stocks (equities) vs long-term debt (bonds) vs short-
term debt (bills)
2. Security selection:
Which securities to buy within each asset class.
The objective of style analysis is to measure
how much of a portfolios return is due to style choice (asset
allocation) vs
how much is due to other factors including selection.
Suppose we observe the monthly returns on a portfolio over a
period of, say, 5 years.
The managers of the portfolio are not permitted to short sell
or borrow.
They can invest in equities (E), long-term debt (L) and short-
term debt (S).
That is, there are 3 asset classes (E, L and S).
Then we specify the following regression equation:
, , , ,
where
is the return in month
means the portfolio
means an index of investments in equities
means an index of investments in long-term debt
means an index of inves
P t E E t L L t S S t t
t
r r r r e
r t
P
E
L
S
o | | | = + + + +
tments in short-term debt
But we also have the following restrictions:
0 1
0 1
0 1
1
So we incorporate these restrictions
into our regression estimation.
E
L
S
E L S
|
|
|
| | |
s s
s s
s s
+ + =
2
Suppose we find:
0.0021 0.86 0.11 0.03
and the regression is 0.92
and the constant (0.0021) is significantly
different from zero.
What do these findings mean?
P E L S
r r r r
R
= + + +
Observations:
1. The selected portfolio behaves like one (the tracking
portfolio) that consists largely (86%) of equities.
2. 92% of the variation in portfolio return is attributable to asset
allocation (style)
which leaves only 8% being attributable to timing and
security selection.
3. Nevertheless, abnormal performance is 0.21% per month
(about 2.5% pa) and is statistically significant.
4. Performance Attribution
Many fund managers specify a benchmark portfolio against
which their performance should be assessed.
eg the ASX 200 or the S&P 500.
The difference between the portfolio return and the benchmark
return is the measure of under- or out-performance.
Many fund managers also say they undertake a two-stage (top
down) analysis:
1. Asset allocation
2. Stock selection
The inevitable question: how much of the under- or out-
performance was due to asset allocation and how much was due
to stock selection?
This is performance attribution.
Performance Attribution
Suppose the benchmark is the ASX 200.
To keep this simple lets say the ASX 200 consists of 3 asset
classes:
Shares in mining and energy companies (M)
Shares in banks and financial companies (F)
Shares in industrial and other companies (I)
So the return on the benchmark is:
where ( ) is the return on the index of mining companies
and is the weight given to mining companies in the ASX 200.
M M F F I I
B B B B B B B
M
B
M
B
r w r w r w r
eg r
w
= + +
The return that the Funds portfolio (P) achieved is:
Lets compare these equations:
where ( ) is the return on
the mining companies chosen by the Fund
and is the weight given to mining companies
in the Fund's portfolio.
M M F F I I
P P P P P P P
M
P
M
P
r w r w r w r
eg r
w
= + +
M M F F I I
B B B B B B B
M M F F I I
P P P P P P P
r w r w r w r
r w r w r w r
= + +
= + +
M M F F I I
B B B B B B B
M M F F I I
P P P P P P P
r w r w r w r
r w r w r w r
= + +
= + +
The Funds asset
allocation decisions
affect these weights
and cause them to
differ from the
benchmark weights.
The Funds stock
selection decisions
affect these returns
and cause them to
differ from the
benchmark returns.
Lets look just at one of the asset classes (say, class I).
Note that, by definition, for a given asset class:
This equation is used for each asset class.
The result for the portfolio as a whole is found by then summing
across all asset classes.

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