Topic 1:

PORTFOLIO PERFORMANCE
EVALUATION
• Till now…
• The focus was on Asset Allocation and Asset Selection Decisions.
• How good/ bad were the decisions?
• Did we succeed at identifying profitable investment opportunities or
do we need to change?
• The portfolio did perform well..
• Was it our skill?
• Or, sheer luck?
• Thus Portfolio Performance Evaluation is one of the most important
parts of Investment process!
Criteria of Evaluation: Returns
• If the fund/ portfolio doesn't have any new inflows or outflows during
the period: HOLDING PERIOD RETURN is used to measure
performance
• Example:
• Fund’s value on April 1, 2016: $200 million
• Fund’s value on June 30, 2016: $220 million
• Holding Period Return = End Value – Beginning Value = 220 – 200 = 10%
Beginning Value 200

THIS RETURN CALCULATION DOES NOT ACCOUNT FOR ANY FUND INFLOWS OR
OUTFLOWS DURING THE QUARTER!
Inflow during the Period
Fund Value = $200 mn Inflow = $40 mn Fund Value = $220 mn

April 1, 2016 May 15, 2016 June 30, 2016

• How do we now assess fund’s performance?

• Part of increase in fund value over quarter can be because of the
inflow.
• Holding Period Return is not suitable in this case.
 Dollar-Weighted Returns/ Currency-weighted Returns
• Let half a quarter = 1 period
• Let rc be the currency-weighted return per period
Fund Value = $200 mn Inflow = $40 mn Fund Value = $220 mn

April 1, 2016 May 15, 2016 June 30, 2016

Discounted for 1 period
Discounted for 2 periods

• $200 mn is the present value of future cash flows:

$200 mn = -$40 mn + $220 mn
(1+rc) (1+rc)2
Solving, rc = -4.64% Currency-Weighted Return for One Period (Half a quarter)
Return over one quarter = -4.64%* 2 = -9.28%
Time-Weighted Returns
• Information Required: Fund’s value at different time points just before the
inflows/ outflows
• Fund performance measured based on these fund values at different points
of time.
Fund Value = $200 mn Inflow = $40 mn Fund Value = $220 mn

April 1, 2016 May 15, 2016 June 30, 2016

B E
$170 mn
M1
$210 mn
M2
• Return for period B to M1 = End Value – Beginning Value
Beginning Value
= 170-200 = -15%
200
• Return for Period M2 to E = 220-210 = 4.76%
210
• Time-Weighed Return for the Quarter (B to E) = (1+ rt1)(1+rt2) – 1
= (1- 0.15)(1 + 0.0476) - 1 = -10.95%
Preferred Measure
• Holding Period Return does not take care of inflows and outflows
during the holding period. It considers only beginning and end value
of the flow.
• Dollar-weighted returns are usually influenced by the timing as
well as the size of cash flows, whereas this is not the case for time-
weighted returns.
• Hence, Time-Weighted returns is generally preferred over dollar-
weighted return.
Is the Return Good or Bad?
• Time-Weighed Return for the Quarter (B to E) = -10.95%
• Is it good or bad?
• It is negative, thus, must be bad?
• Not necessarily!!
• The rest of the market may have actually performed worse than this.
• So, we cannot comment on any fund’s performance in isolation.
• The fund’s performance has to be evaluated in comparison to some
benchmark.
Identifying the Benchmark
• Investment’s Performance must always be evaluated on a relative
basis, and not on an absolute basis.
• Relative to a benchmark.
• For a fair comparison, benchmark must have identical risk as the portfolio
being assessed
• However, it may be difficult to identify portfolios with identical risk. And so,
it is better to use a risk-adjusted measures of performance.
• Measures of Risk:
• Total Risk on portfolio (σ)
• Systematic Risk (β)
• Unsystematic (Diversifiable) Risk (σe)
The Risk-Adjusted Performance Measures
• Sharpe Ratio
• Treynor Ratio
• Jensen’s Alpha
• Appraisal Ratio (Information Ratio)
Sharpe Measure
• The Sharpe ratio measures excess return per unit of total risk.
(rP − rf )
P
• rp = Average return on the portfolio
• rf = Average risk free rate
• σp = Standard deviation of portfolio return (Total risk on Portfolio)

➢It measure the return to total variability trade off.

➢Sharpe Ratio is the slope of Capital Allocation Line (CAL)
Treynor’s Measure
• The Treynor ratio measures excess return per unit of systematic risk.
(rP − rf )
P
• rp = Average return on the portfolio
• rf = Average risk free rate
• βp = CAPM Beta for the portfolio (Systematic Risk)

•
Sharpe’s and Treynor’s Drawback
• They don't quantify how much additional value the portfolio manager
is adding.
• All they say is how much excess returns the portfolio has earned
for each unit of risk.
• Hence, they can largely be used as a ranking criteria only.
• A measure that addresses this drawback is the Jensen measure, or
portfolio alpha.
Jensen’s Measure
• Quantifies portfolio’s average return in excess of that predicted by CAPM.

 P = rP −  rf +  P (rM − rf ) 

Expected Return as per CAPM

• In CAPM, there is equilibrium and all portfolios lie on Security Market Line.
• Jensen’s Alpha:
• How far away the portfolio is from the Security Market Line (SML)
• It is a measure of abnormal returns (returns over and above the CAPM returns)
 Appraisal or Information Ratio
Information Ratio = αp
σep
• αp = Jensen’s Alpha
• σep = Diversifiable (Unsystematic) Risk of the Portfolio

• The ratio measures the abnormal return per unit of diversifiable risk
An Example

• Note: Q can be called the Market Portfolio.

• It has a beta of 1.00 and 0 diversifiable risk.
Measures of Portfolio Performance
• While Sharpe measure
shows P’s performance
worse than Q, other
measures say that it has
performed better than Q.
• So which measure should
we use to decide whether
portfolio P has performed
better or worse?
Rule of Thumb
Situation : Decide Portfolio manager's compensation
Measure: Jensen’s measure as it tells how much value the manager is actually
added.
Situation: Decide optimal portfolio choices when the portfolio represents your
entire investment.
Measure: Sharpe measure
Situation: Decide optimal portfolio choices when the portfolio is one of many
portfolios combined into a large fund.
Measure: Treynor’s measure
Situation: Portfolio is an actively-managed funds held in combination with
passively-managed portfolios.
Measure: Appraisal Ratio
Drawbacks
1. They rely on the validity of the CAPM.
2. They use a proxy for the true market portfolio, rather than the true
market portfolio itself.
3. They still cannot statistically distinguish skill from luck.
Alternative Performance Measures
• M2
• T2
 2
M by Modigliani and Modigliani
• Variation of Sharpe ratio: M2 focuses on total volatility as a measure of risk.
• But its risk adjusted measure has the easy interpretation of a differential
return relative to a benchmark index.
Four Steps:
• Step 1: Compute the average return and standard deviation of Market
Portfolio (Q) and the Portfolio P
• Step 2: Determine a combination of P and Risk-free asset (F) to form a
mimicking portfolio (P*) which has same total risk as a market portfolio (Q)
• Step 3: Compute the average return of the mimicking portfolio, P*. P*’s
standard deviation is same as Q by design
• Step 4: M2 = rp* - rQ
Our Example
STEP 1:

• Step 2: Find a combination of P and F to generate Portfolio P* such that

σP* = σQ = 30%
• We know that Portfolio P*’s variance: σp*2 = wP2σP2 + wF2σF2 + 2wPwF CovPF
• Also σF = 0; Cov (P, F) = 0
• So : σp*2 = wP2σP2 or σp*= wPσP
• Desired σp* = 30% , OR wPσP = 30%
Desired Combination of P and F
• Thus, 42%* wP = 30%. Or, wP = 0.71. Hence, wF = 0.29
P* = 0.71P + 0.29F
Our Example
• Step 3:
• P*’s standard deviation:
σP* = σQ = 30%
• P*’s return = 0.71*(Average Return of P) + 0.29*(risk free rate)
= 0.71*0.35 + 0.29*0.06 = 26.59%
• Step 4: M2 = rp* - rQ
• Return of Q = 28%
• M2 = 26.59% - 28% = -1.41%
T2

• Variation of the Treynor’s : T2 focuses on systematic risk it as a

measure of risk.
Four Steps:
• Step 1: Compute the average return and standard deviation of Market
Portfolio (Q) and the Portfolio P
• Step 2: Determine a combination of P and Risk-free asset (F) to form a
mimicking portfolio (P*) which has same β as a market portfolio (Q)
• Step 3: Compute the average return of the mimicking portfolio, P*.
• Step 4: T2 = rp* - rQ
Our Example
STEP 1:

• Step 2: Find a combination of P and F to generate Portfolio P* such that

βP* = βQ = 1
• Beta of a Portfolio is the weighted average of the individual Asset betas.
• So, Portfolio P*’s beta: βP* = wP βP + wF βF Also βF = 0
• So : βP* = wP βP
• Desired βP* = 1, OR wP βP = 1
Desired Combination of P and F
• Thus, 1.20* wP = 1. Or, wP = 0.83. Hence, wF = 0.17 P* = 0.83P + 0.17F
Our Example
• Step 3:
• P*’s Beta:
βP* = βQ = 1
• P*’s return = 0.83*(Average Return of P) + 0.17*(risk free rate)
= 0.83*0.35 + 0.17*0.06 = 30.07%
• Step 4: T2 = rp* - rQ
• Return of Q = 28%
• T2 = 30.07% - 28% = 2.07%
Performance Attribution Analysis
• Attribution Analysis seeks to find the factors to which portfolio
manager’s performance can be attributed to:
➢Selection Skills (Selecting Superior Securities)
➢Market Timing Skills (superior market timing skills by allocating
funds to different asset classes or market segments)
➢Sheer Good Luck!
Market Timing
• Market timing is the act of moving in and out of the market or
switching between asset classes by attempting to predict
future market price movements. The prediction may be based on an
outlook of market or economic conditions resulting from technical or
fundamental analysis.