CHAPTER 24

Portfolio Performance Evaluation

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McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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Introduction

• Two common ways to measure

average portfolio return:

1. Time-weighted returns
2. Dollar-weighted returns

• Returns must be adjusted for risk.

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Dollar- and Time-Weighted Returns

Time-weighted returns

• The geometric average is a time-

weighted average.
• Each period’s return has equal weight.

(1 + rG )n
= (1 + r1 )(1 + r2 )...(1 + rn )

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Dollar- and Time-Weighted Returns

Dollar-weighted returns
• Internal rate of return considering the
cash flow from or to investment
• Returns are weighted by the amount
invested in each period:
C1 C2 Cn
PV = + + ...
(1 + r )1 (1 + r )2 (1 + r )n

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Example of Multiperiod Returns

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Dollar-Weighted Return

$2 $4+$108

-$50 -$53

Dollar-weighted Return (IRR):

− 51 112
− 50 = +
(1 + r ) (1 + r ) 2
1

r = 7.117%
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Time-Weighted Return

53 − 50 + 2
r1 = = 10%
50
54 − 53 + 2
r2 = = 5.66%
53
rG = [ (1.1) (1.0566) ]1/2 – 1 = 7.81%

The dollar-weighted average is less than the

time-weighted average in this example
because more money is invested in year two,
when the return was lower.

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Adjusting Returns for Risk

• The simplest and most popular way to
adjust returns for risk is to compare
the portfolio’s return with the returns
on a comparison universe.
• The comparison universe is a
benchmark composed of a group of
funds or portfolios with similar risk
characteristics, such as growth stock
funds or high-yield bond funds.
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Figure 24.1 Universe Comparison

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Risk Adjusted Performance: Sharpe

1) Sharpe Index
(rP − rf )
P
rp = Average return on the portfolio
rf = Average risk free rate

p = Standard deviation of portfolio

return
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Risk Adjusted Performance: Treynor

2) Treynor Measure
(rP − rf )
P
rp = Average return on the portfolio
rf = Average risk free rate
ßp = Weighted average beta for portfolio

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Risk Adjusted Performance: Jensen

3) Jensen’s Measure
 P = rP −  rf +  P (rM − rf ) 

p = Alpha for the portfolio

rp = Average return on the portfolio
ßp = Weighted average Beta
rf = Average risk free rate
rm = Average return on market index portfolio

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Information Ratio

Information Ratio = p / (ep)

The information ratio divides the alpha of the

portfolio by the nonsystematic risk.
Nonsystematic risk could, in theory, be
eliminated by diversification.

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2
M Measure
• Developed by Modigliani and
Modigliani
• Create an adjusted portfolio (P*) that
has the same standard deviation as
the market index.
• Because the market index and P*
have the same standard deviation,
their returns are comparable:
M = rP* − rM
2

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2
M Measure: Example
Managed Portfolio: return = 35% standard deviation = 42%
Market Portfolio: return = 28% standard deviation = 30%
T-bill return = 6%
P* Portfolio:
30/42 = .714 in P and (1-.714) or .286 in T-bills
The return on P* is (.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market, the managed
portfolio underperformed.
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2
Figure 24.2 M of Portfolio P

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Which Measure is Appropriate?

It depends on investment assumptions
1)If the portfolio represents the entire risky
investment, then use the Sharpe
measure.
2) If the portfolio is one of many combined
into a larger investment fund, use the
Jensen  or the Treynor measure. The
Treynor measure is appealing because it
weighs excess returns against systematic
risk.
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Table 24.1 Portfolio Performance

Is Q better than P?

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Figure 24.3 Treynor’s Measure

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Table 24.3 Performance Statistics

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Interpretation of Table 24.3

• If P or Q represents the entire investment, Q
is better because of its higher Sharpe
measure and better M2.
• If P and Q are competing for a role as one of
a number of subportfolios, Q also dominates
because its Treynor measure is higher.
• If we seek an active portfolio to mix with an
index portfolio, P is better due to its higher
information ratio.
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Performance Measurement for

Hedge Funds
• When the hedge fund is optimally
combined with the baseline portfolio,
the improvement in the Sharpe
measure will be determined by its
information ratio:
2
 H 
S =S +
2 2

  (eH ) 
P M

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Performance Measurement with

Changing Portfolio Composition
• We need a very long • What if the mean
observation period and variance are not
to measure constant? We need
performance with to keep track of
any precision, even portfolio changes.
if the return
distribution is stable
with a constant
mean and variance.

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Figure 24.4 Portfolio Returns

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Market Timing
• In its pure form, market timing
involves shifting funds between a
market-index portfolio and a safe
asset.
• Treynor and Mazuy:
rP − rf = a + b(rM − rf ) + c(rM − rf ) + eP 2

• Henriksson and Merton:

rP − rf = a + b(rM − rf ) + c(rM − rf ) D + eP
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Figure 24.5 : No Market Timing; Beta Increases with Expected
Market Excess. Return; Market Timing with Only Two Values of
Beta.

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Figure 24.6 Rate of Return of a Perfect Market

Timer

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Style Analysis
• Introduced by William Sharpe
• Regress fund returns on indexes
representing a range of asset classes.
• The regression coefficient on each index
measures the fund’s implicit allocation to
that “style.”
• R–square measures return variability due
to style or asset allocation.
• The remainder is due either to security
selection or to market timing.
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Table 24.5 Style Analysis for Fidelity’s

Magellan Fund

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Figure 24.7 Fidelity Magellan Fund

Cumulative Return Difference

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Figure 24.8 Average Tracking Error for 636

Mutual Funds, 1985-1989

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Evaluating Performance Evaluation

• Performance evaluation has two key
problems:
1. Many observations are needed for
significant results.
2. Shifting parameters when portfolios
are actively managed makes
accurate performance evaluation
all the more elusive.

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Performance Attribution
• A common attribution system decomposes
performance into three components:

1. Allocation choices across broad asset

classes.
2. Industry or sector choice within each
market.
3. Security choice within each sector.

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Attributing Performance to
Components
Set up a ‘Benchmark’ or ‘Bogey’
portfolio:
• Select a benchmark index portfolio for
each asset class.
• Choose weights based on market
expectations.
• Choose a portfolio of securities within
each class by security analysis.
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Attributing Performance to
Components

• Calculate the return on the ‘Bogey’ and on

the managed portfolio.
• Explain the difference in return based on
component weights or selection.
• Summarize the performance differences
into appropriate categories.

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Formulas for Attribution

n n
rB =  wBi rBi & rp =  w pi rpi
i =1 i =1
n n
rp − rB =  w pi rpi −  wBi rBi =
i =1 i =1
n

 (w
i =1
pi pi r − wBi rBi )

Where B is the bogey portfolio and p is the managed

portfolio
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Figure 24.10 Performance Attribution of

ith Asset Class

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Performance Attribution
• Superior performance is achieved by:
– overweighting assets in markets that
perform well
– underweighting assets in poorly
performing markets

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Table 24.7 Performance Attribution

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Sector and Security Selection

• Good performance • Good performance

(a positive also derives from
contribution) underweighting
derives from poorly performing
overweighting sectors.
high-performing
sectors

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