Portfolio Performance Measures1

Portfolio Management
The art and science of making decisions

about investment mix and policy, matching
investments to objectives, asset allocation
for individuals and institutions, and
balancing risk against. performance.
What we have learnt till date
Concept and calculation of factors affecting

portfolio performance.
Risk and Return
Performance of a portfolio depends on the balance

of Return V/s Risk
Factors for Portfolio Performance
Risk
• Variance
• Standard Deviation
• Beta
• Correlation Coefficient
• Covariance
Return
• Expected Rate of Return
• Require Rate of Return
• Risk Free Rate of Return
• Market Return
Risk Return relationship
• Coefficient of variation
• Sharpe measure
• Treynor’s measure
• Jensen’s Alpha
• Benchmark
Portfolio management is all about
strengths, weaknesses,
opportunities and threats in the
choice of tradeoffs encountered in
the attempt to maximize return at a
given appetite for risk
Trade offs
• debt vs. equity
• domestic vs. international
• growth vs. safety
• Sector Specific vs Market
• Mid Cap vs Large Cap
• etc
Portfolio Performance Measures
• What do we require of portfolio
managers?
– 1. Earn an average (or fair) return for the

level of risk in the portfolio
– 2. Ability to manage risk
– 3. Eliminate unnecessary risks
Portfolio Performance
Measurement
• Benchmarking
– Gives us a reference point for comparison
– Comparison of return and risk
Measurement
• Choosing a benchmark
– The most important consideration for portfolio
performance measurement is benchmark
choice. All portfolio evaluation is dependent on
benchmark choice
• 1. Make sure the benchmark is unambiguous
• 2. Make sure the benchmark is an investable index
• 3. Make sure the benchmark has a measurable
value
Measurement
• Choosing a benchmark
– 4. Make sure that the benchmark is appropriate
for the style of portfolio that you are evaluating
– 5. Make sure the benchmark is specified in
advance
– 6. Make sure the benchmark reflects current
knowledge and opinion
– 7. Don’t change indices. Be consistent across
portfolios
Ri  R f
Ti 
i
– Treynor’s measure basically gives us a
measure of return per unit of market risk (or
systematic risk) that our investment earns
– Strictly speaking, the larger the Treynor
measure the better. However, we would like
to have some benchmark with which to
compare our individual Treynor measures.
• Tryenor’s measure
– Benchmark comparison
Rm  R f
Tm   Rm  R f
m
– If Ti > Tm, the portfolio would plot above the
security market line, indicating superior
performance by the portfolio manager.
– If Ti < Tm, the portfolio would plot below the
security market line, indicating poor
performance by the portfolio manager.
• Sharpe performance measure
Ri  R f
Si 
i
– Thus, the Sharpe measure gives us a
measure of return per unit of total risk. Again,
the higher the Sharpe measure, the better the
performance. We can also compare
individual Sharpe measures to a benchmark:
Rm  R f
Sm 
m
– Instead of plotting deviations from the security
market line, like the Treynor measure, we are
plotting deviations from the market determine
price of risk as defined by the capital market
line (CML).
• Sharpe measure
– If Si > Sm, the asset earn more than the risk
premium required by the capital market line,
indicating superior performance by the
portfolio manager.
– If Si < Sm the asset earn less than the risk
premium required by the capital market line,
indicating poor performance by the portfolio
manager.
• Comparing the Treynor and Sharpe
measures
– For a completely diversified portfolio of
assets, the Sharpe and Treynor measures
would be identical in what they are measuring
– Treynor measures performance relative to
systematic risk
– Sharpe measure s performance relative to
total risk
• Comparing the Treynor and Sharpe
measures
– Sharpe measure gives some indication of how
good the portfolio manager is at diversifying
away unsystematic risk
– A poorly diversified portfolio could have a high
Treynor ranking
– Jensen’s alpha is based on the ideas
contained in the CAPM. It, like the Treynor
measure, measures how well a portfolio
manager does at dealing with systematic risk
– To calculate Jensen’s alpha we need to
estimate the following regression model:
Ri ,t  R f ,t   i   i ( Rm ,t  R f ,t )
  measures the degree to which managers
are earning significant returns after
accounting for market risk, as measured by
beta. If the manager is earning a fair return
for the given portfolio’s systematic risk, then 
would be zero.
– (+)  indicates good performance
– (-)  indicates poor performance
– Jensen’s alpha allows us to statistically test
whether the return the manager earns is
significantly more (or less) than what we would
expect using the CAPM.
– Jensen’s alpha allows us to get a performance
measure that incorporates information from more
than one time period.
– The validity of the Jensen performance
measure is tied to the validity of the CAPM.
Thus, some individuals will choose estimate
Jensen's alpha performing the regression
model without subtracting the risk-free rate.
This gives us the alpha from the characteristic
line. Its interpretation is the same as the
interpretation of Jensen's alpha.
• Fama and French (1993) three factor model
– The alpha in this model can be interpreted in the
same way as the Jensen's alpha. A positive
Fama/French alpha would indicate performance
better than expectations.
– Given that the Fama/French model predicts
returns better than the CAPM, the Fama/French
alpha should be a more precise measure of
portfolio performance than the Jensen's alpha.
• Fama’s performance measure
– Fama breaks performance by a portfolio
manager into two categories: selectivity and
diversification. Fama’s measure incorporates
measures for managing both systematic and
unsystematic risk.
– Selectivity: measures the ability of the
portfolio manager to earn a return that is
consistent with the portfolio’s market
(systematic) risk. The selectivity measure is:
( Ri  ( R f   i ( Rm  R f ))
– (+) selectivity indicates that the manager
earned a higher return than the systematic
risk of the portfolio would indicate. Basically,
you are just comparing the return on the asset
with the return earned by the CAPM.
– Diversification: Diversification measures the
extent to which the portfolio may not have
been completely diversified. Diversification is
measured as:
 i 
 R f  ( Rm  R f )    R f  ( Rm  R f )  i 
 m 
– If the portfolio is completely diversified, contains
no unsystematic risk, then diversification measure
would be zero. A positive diversification measure
indicates that the portfolio is not completely
diversified; it would contain unsystematic risk.
– If the diversification measure is positive, it
represents the extra return that the portfolio should
earn for not being completely diversified.
– Net selectivity = selectivity - diversification
– Net selectivity measures how well the portfolio
manager did at earning a fair return for the
portfolio’s systematic risk and how well the portfolio
manager did at diversifying away unsystematic risk.
– Positive net selectivity indicates the portfolio
manager did a good job. Negative net selectivity
indicates that the portfolio manager did a poor job.
The Following Information is available on
performance of the seven portfolio
Portfolio Return SD Beta Correlation

1 15.60 27.00 1.823 0.81
2 11.80 18.00 0.825 0.55
3 8.30 15.20 0.481 0.38
4 19.00 21.20 1.325 0.75
5 -6.00 4.00 0.150 0.45
6 23.50 19.30 1.013 0.63
7 12.10 8.20 0.670 0.98
Market 13.00 12.00
T Bill 6.00
Measurement of Performance
• Rank the portfolios based on sharpe ratio

• Rank the portfolios based on treynor ratio
• Compare the ratings between sharpe and
treynor and explain the reason for
differences
• Rank based on Jensen measure
Sharpe Measure
Port Return T Bill R- Rf SD Sharpe Rank

1 15.60 6 9.60 27.00 0.36 4
2 11.80 6 5.80 18.00 0.32 5
3 8.30 6 2.30 15.20 0.15 6
4 19.00 6 13.00 21.20 0.61 3
5 -6.00 6 -12.00 4.00 -3.00 7
6 23.50 6 17.50 19.30 0.91 1
7 12.10 6 6.10 8.20 0.74 2
Treynor Measure
Port Return T Bill R- Rf Beta Trenyor Rank
1 15.60 6 9.60 1.823 5.27 5
2 11.80 6 5.80 0.825 7.03 4
3 8.30 6 2.30 0.481 4.78 6
4 19.00 6 13.00 1.325 9.81 2
5 -6.00 6 -12.00 0.150 -80.00 7
6 23.50 6 17.50 1.013 17.27 1
7 12.10 6 6.10 0.670 9.11 3
Reason for Difference
The measure of risk for treynor is Beta ,
higher the correlation of the stock with the
market higher the beta and lower the
treynor .
Port Sharpe Rank Trenyor Rank Correlation
1 0.36 4 5.27 5 0.81
2 0.32 5 7.03 4 0.55
3 0.15 6 4.78 6 0.38
4 0.61 3 9.81 2 0.75
5 -3.00 7 -80.00 7 0.45
6 0.91 1 17.27 1 0.63
7 0.74 2 9.11 3 0.98
Jensen differential return Rank
Port ER Rm Rf Rm-Rf Beta R Alfa Rank
1 15.60 13.00 6.00 7.00 1.82 12.76 2.84 6
2 11.80 13.00 6.00 7.00 0.83 5.78 6.03 4
3 8.30 13.00 6.00 7.00 0.48 3.37 4.93 5
4 19.00 13.00 6.00 7.00 1.33 9.28 9.73 2
5 -6.00 13.00 6.00 7.00 0.15 1.05 -7.05 7
6 23.50 13.00 6.00 7.00 1.01 7.09 16.41 1
7 12.10 13.00 6.00 7.00 0.67 4.69 7.41 3
Consider the following data
Return of Stock 30% Market Return 18%

SD of Stock 7% SD of Market 5%
Beta of Stock 1.5 Risk free Rate 7%
Using Farma measure calculate
• Selectivity
• Diversification
• Return required
• Net selectivity
Expected return on systematic risk
E r = Rf + Beta * ( Rm- Rf)
E r = 7 + 1.5 * ( 18 – 7 )
E r = 23.5%
Return from Selectivity
Return from Selectivity
Return on Stock – Expected Return on systematic risk
Return from Selectivity = 30 – 23.5 = 6.5

Return from Diversification
Return from Diversification
= Rf + SD stock / SD market * ( Rm – Rf ) – Er
= 7 + 8 / 5 * ( 18 – 7 ) – 23.5
= 24.6 – 23.5
= 1.1
Return from Net Selectivity
5.4 = 6.5 – 1.1
Net selectivity = selectivity - diversification

Consider the following information
related to the performance of two
portfolio managers A, B and Benchmark
Portfolio against which their performance
may be measured
Benchmark Manager A Manager B
Weight Return Weight Return Weight Return
Stock 60% -6% 50% -5% 30% -6%
Bonds 30% -4.50% 20% -3.50% 40% -4.50%
Cash 10% 1.30% 30% 1.30% 30% 1.30%
Based on the information calculate the
overall return for the two managers and
benchmark portfolio against which their
performance may be measured.
Benchmark
Weight Return W*R
Stock 60.00% -6.00% -3.60%
Bonds 30.00% -4.50% -1.35%
Cash 10.00% 1.30% 0.13%
Return -4.82%
Manager A
Weight Return W*R
Stock 50% -5% -2.50%
Bonds 20% -3.50% -0.70%
Cash 30% 1.30% 0.39%
Return -2.81%
Manager B
Weight Return W*R
Stock 30% -6% -1.80%
Bonds 40% -4.50% -1.80%
Cash 30% 1.30% 0.39%
Return -3.21%
Sharpe measure of Portfolio
Performance is based on
• Systematic Risk of Portfolio

• Unsystematic Risk of Portfolio
• Total Risk of Portfolio
• Market Risk of the Portfolio
• None of the above
• Ans 3
If the return of a portfolio is 13%
and risk free rate is 7% and beta is
1.2 . The Treynor measure for
portfolio is
• 5
• 6
• 6.5
• 7.5
• 8
• Ans 1
If the return of a portfolio is 15% and
risk free rate is 10% and SD is 25% .
The Sharpe measure for portfolio is
• 0.15
• 0.20
• 0.25
• 0.35
• 0.40
• Ans 2
If the Jensens alfa is positive it
indicates
• Inferior Performance of Portfolio Manager
• Superior Performance of Portfolio
Manager
• Netural Performance of Portfolio Manager
• Both 2 and 3
• None of the above
• Ans 2
The ranking of the Treynor and Sharpe
measure will be identical when
• The funds under consideration are
perfectly diversified
• The funds under consideration have the
same correlation with the market
• The funds under consideration have the
same return
• The funds under consideration have
perfectly positive correlation
• Ans 1
If selectivity is positive and net
selectivity is negative in a portfolio it
implies that
• The portfolio has outperformed the market
• The portfolio manager could have produced
better returns at lesser risk using market index
portfolio
• The portfolio has give returns superior to the
market but at a higer lever of risk
• Both 1 and 3
• All of the above
• Ans 2

Portfolio Performance Measures1

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Portfolio Management

The art and science of making decisions

Concept and calculation of factors affecting

Risk and Return

Performance of a portfolio depends on the balance

– 1. Earn an average (or fair) return for the

Portfolio Return SD Beta Correlation

• Rank the portfolios based on sharpe ratio

Port Return T Bill R- Rf SD Sharpe Rank

Return of Stock 30% Market Return 18%

E r = Rf + Beta * ( Rm- Rf)

Return from Selectivity = 30 – 23.5 = 6.5

Return from Diversification

5.4 = 6.5 – 1.1

Net selectivity = selectivity - diversification

• Systematic Risk of Portfolio

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