PORTFOLIO PERFORMANCE

MEASUREMENT
How well did the portfolio perform???
 Conventional Ways of Performance
Measurement – Arithmetic Mean
• Holding Period Returns (HPR) are analysed by taking arithmetic mean (average)
of the returns at equally spaced time intervals (annual most often).
• If holding period is n years then the average annual return, r over n years is
Average Holding Period Return, %
Stock price Dividend Return
Year
(Rs) (Rs) %
0 100.00 ARITHMETIC MEAN, r
1 116.00 5.00 21.00
2 108.00 5.00 -2.59 𝑟1 + 𝑟2 + 𝑟3−−−−−−−𝑟𝑛
3 127.00 6.00 23.15 𝑟=
4 130.00 8.00 8.66 𝑛
5 135.00 8.00 10.00
Holding Period Return, % 12.04

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 Conventional Ways of Performance
Measurement – Geometric Mean
Time Weighted Return, % • Cumulative return over whole
Stock price Dividend Return investment period is given by
Year (Rs) (Rs) % 1 + Return geometric mean of the annual
0 100.00 returns.
1 116.00 5.00 21.00 1.21
• Geometric mean is called time –
2 108.00 5.00 -2.59 0.97
weighted return because each
3 127.00 6.00 23.15 1.23
past return is given equal weight
4 130.00 8.00 8.66 1.09
in the process of averaging.
5 135.00 8.00 10.00 1.10
Holding Period Return, % 12.04 • Geometric average is always
Time Weighted Return, % 11.65 smaller than arithmetic average.

GEOMETRIC MEAN, rg
𝑛
1 + 𝑟𝑔 = 1 + 𝑟1 1 + 𝑟2 1 + 𝑟3 … 1 + 𝑟𝑛
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 Arithmetic Mean Vs Geometric Mean
• Geometric average is always smaller than arithmetic average.
𝑟𝑔 = 𝑟 2 − 1ൗ2 σ2
• We can measure actual past performance from the geometric
mean but while projecting future expected performance one
should use arithmetic mean.
• Arithmetic mean implies that investment in period after period is
kept constant.
• Geometric mean would be realised only when same series of prices
used in its computation is repeated in future.
• For prospective return we use arithmetic mean.
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 Rupee Weighted Return
Rupee Weighted Return
Year Stock price, (Rs) Dividend, (Rs) Action Cash Flow, (Rs)
0 100.00 Bought one share -100.00
1 116.00 5.00 Bought one more share -111.00
2 108.00 10.00 No further investment 10.00
3 127.00 12.00 Sold one share 139.00
4 130.00 8.00 No further investment 8.00
5 135.00 8.00 Sells remaining share 143.00
Rupee Weighted Return, % IRR of Cash Flow 10.98%

• When investment does not remain constant, but changes over different periods
then the returns would be equal to the IRR of the cash flow.
• If investment intervals are not equally spaced over time then the return can be
found using XIRR function.

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 Return and Risk
• Measurement of return is incomplete without consideration of risk.
• Four different measures of portfolio performance, that compares returns with
risk.

𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 𝑟 − 𝑟𝑓
𝑆𝐻𝐴𝑅𝑃𝐸 ′ 𝑠 𝑅𝐴𝑇𝐼𝑂 = =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 σ

𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛 𝑟 − 𝑟𝑓
𝑇𝑅𝐸𝑌𝑁𝑂𝑅′𝑠 𝑅𝐴𝑇𝐼𝑂 = =
𝐵𝑒𝑡𝑎 β

𝐽𝐸𝑁𝑆𝐸𝑁 ′ 𝑠 𝐴𝐿𝑃𝐻𝐴 = 𝐸𝑥𝑐𝑒𝑠𝑠 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑣𝑒𝑟 𝐶𝐴𝑃𝑀 = 𝑟 − 𝑟𝑓 − β 𝑟𝑚 − 𝑟𝑓

𝐽𝑒𝑛𝑠𝑒𝑛′ 𝑠 𝐴𝑙𝑝ℎ𝑎 α
𝐼𝑁𝐹𝑂𝑅𝑀𝐴𝑇𝐼𝑂𝑁 𝑅𝐴𝑇𝐼𝑂 = =
𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑅𝑖𝑠𝑘 σ𝑖
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 Return and Risk
• Four measures of portfolio performance may not assign same rank to a
portfolio, among the same set of portfolios being assessed for performance.
Performance Measurement
Parameter Portfolio Market
Return, % 35 28
Beta 1.20 1.00
σ 42 30
σi 18 -
rf 6.00 6.00
(35−6) (28−6)
Sharpe’s Ratio = 0.69 = 0.733
42 42
(35−6) (28−6)
Treynor’s Ratio = 24.2 = 22.0
1.2 1
Jensen’ Alpha 35 – [6 + 1.2 (28 - 6)] = 2.6 -
2.6
Information Ratio = 0.144 -
18
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 Which Measure to Use When
Performance Measurement
Measure When to Use
Measures excess return over total risk of the portfolios;
Sharpe’s Ratio
May be used for choosing an optimal portfolio.
Measures excess return over systematic risk of the portfolios;
Treynor’s Ratio
May be used for choosing among the fully diversified portfolios.
Excess returns over CAPM returns;
Jensen’ Alpha Used when comparing performances of portfolios with a
benchmark
Excess returns per unit of unsystematic risk over CAPM returns;
Information Ratio Used when comparing performances of portfolios with a
benchmark.

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 Adjusting for Risk – Sharpe’s Ratio and M2
• To improve the comprehension of Sharpe’s ratio we need to modify it to be comparable
with benchmark Market.
• We need to equate the risk of the portfolio to that of benchmark and then straight away
compare returns. The difference in returns is called M2.
Parameter Portfolio Market To equate σ of portfolios, we mix the one portfolio
Return, % 35 28 with T-bills. The proportion of investment in the
Beta 1.20 1.00 portfolio should be in the inverse ratio of standard
σ 42 30 deviations of two portfolios.
rf 6.00 6.00
Sharpe’ (35−6) To increase σ: short T-bills and invest in portfolio
(28−6)
s Ratio = 0.69 = 0.733 To decrease σ: buy T bills by divesting the portfolio
42 42
Here we invest 30/42 = 0.714 in the Portfolio and (1 – 0.714 = 0.286) in T-bills. This makes σ of
the modified portfolio equal to that of Market i.e. 30%.
This modified portfolio would have return of 0.286 x 6% + 0.714 x 35% = 26.7%.
As compared to the benchmark it is M2 = (28.0 – 26.7 = - 1.3%) i.e. less than Market.
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 Adjusting for Risk – Treynor’s Ratio and T-Line
• To improve the comprehension of Treynor’s ratio we need to modify it to be comparable
with benchmark portfolio.
• We need to equate the systematic risk, β of the portfolios equal, and then compare
excess returns, i.e. Jensen’s Alpha. Portfolio with higher Alpha is superior.
Parameter Portfolio P Portfolio Q To equate β of portfolios, we mix the one portfolio
Return, % 16 24 with T-bills. The proportion of investment in the
portfolio should be in the inverse ratio of betas of
Beta 0.90 1.60 two portfolios.
rm 15
rf 5.00 5.00 To increase β: short T-bills and invest in portfolio
Alpha, % 2 3 To decrease β: buy T bills by divesting the portfolio
Here we invest 0.9/1.6 = 0.5625 in the Portfolio Q and (1 – 0.5625 = 0.4375) in T-bills. This
makes β of the modified Portfolio Q equal to that of Portfolio P, making them comparable.
This modified Portfolio Q would have Alpha of 9/16 x 3% = 1.69%.
The excess return, Alpha for Portfolio P is 2% and Portfolio P is superior.
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THANK YOU
RAJIV SRIVASTAVA
rms1234@gmail.com