Chapter 18

Chapter 18
Evaluating Investment Performance
BH Jeon Investment Analysis 1 / 20

Reference to Textbook
• 18.1 The Conventional Theory of Performance Evaluation

• Average Rates of Return
• Time-Weighted Returns versus Dollar-Weighted Returns
• Adjusting Returns for Risk
• The Sharpe Ratio for Overall Portfolios
• The Treynor Ratio
• The Information Ratio
• The Role of Alpha in Performance Measures
• Implementing Performance Measurement: An Example
• Selection Bias and Portfolio Evaluation

Reference to Textbook
• 18.3 Morningstar’s Risk-Adjusted Rating

• 18.4 Performance Measurement with Changing Portfolio Co
mposition
• 18.6 Performance Attribution Procedures
• Asset Allocation Decisions
• Sector and Security Selection Decisions
• Summing Up Component Contributions

Overview
• High return is always better?

• High risk / high return
• Evaluating performance based on average return alone is not very
useful because returns must be adjusted for risk before they can be
compared meaningfully
• Qualitative way
• Quantitative way
• Relative ratio between return and risk
• Jensen’s alpha
• Sharpe ratio / M2
• Treynor measure / T2
• Information ratio

Adjusting Returns for Risk
• Simplest and most popular ways is to compare investment ret

urns with those of other investment funds with similar risk ch
aracteristics
• High-yield bond portfolios are grouped into one comparison unive
rse
• Average returns of each fund within the universe are ordered
• Portfolio manager receives a percentile ranking within the group

• 95th
• 75th
• 50th (median)
• 25th
• 5th

• They are not truly comparable. The rankings can be misleadin

g
• Within a particular universe, some managers may concentrate on p
articular subgroups
• Benchmark performance is not an investable strategy
• You cannot know median fund in advance

Symbols
• rp,t: raw return of portfolio p

• Rp,t = rp,t − rf : excess return of portfolio p
• Single factor model
• Rp,t = αp + βp RM,t + ep,t
• (rp,t − rf ) = αp + βp(rM,t − rf ) + ep,t
• Variance
•
• Total risk = Systematic risk + Firm-specific risk
• Average return
• : average of
• : average of

Jensen’s Alpha
•
• Absolute measure of average return on the portfolio over and

above that predicted by the CAPM

Example
• Information on a portfolio
• Average return = 10%
• Std. Dev. = 15%
• Beta = 1.5
• Information on the market
• Std. Dev. = 10%
• Information on the risk-free asset
• Risk-free rate = 2%
• What is Jensen’s Alpha?

Example
• Jensen’s Alpha of the portfolio
• Jensen’s Alpha of the market

• 0

Sharpe Ratio
• Sharpe ratio
• Measure performance of an investor’s entire risky portfolio
• Divide average portfolio excess return over the sample period by t
he standard deviation of returns over that period
• Reward to volatility measure

Sharpe Ratio
• If preferences can be summarized by a mean-variance choice,

investors seek the risky portfolio with the highest possible Sh
arpe ratio
• Focused on total risk instead of systematic risk
• Adequate to evaluate performance of the full (or overall) portfolio
rather than a small part of it
• Benchmark for Sharpe ratio is the market index
• Actively managed portfolio must offer a higher Sharpe ratio than t
he market index

M2 Measure
• Suppose Sharpe ratio is 4% higher than the market index. The

number 4% is hard to interpret. Is the 4% big or small?
• A variation of Sharpe ratio is called M2 measure (Modigliani-
squared)
• Suppose your portfolio earned 5% return with 20% std. dev.
• Market portfolio earned 2% return with 10% std. dev.
• Risk-free rate is 1%
• M2
• Modigliani-squared

M2 Measure
• You
mix your portfolio with risk-free asset to match 10% std.
dev. of market return
• Invest w in risky portfolio and (1−w) in risk-free asset
• Std. Dev. of mixed portfolio (w×20%) should match 10%
• Therefore w=0.5
• Mixed portfolio (p*) return
• w×5%+(1−w) ×1% = 0.5×5% + 0.5×1% = 3%

Example
• Std. Dev. = 15%
• Beta = 1.5
• Std. Dev. = 10%
• What is Sharpe ratio, and M2?

Example
• Sharpe ratio of the portfolio p
• Sharpe ratio of the market

Example
• You mix your portfolio with risk-free asset to match 10% std.
• Therefore w = 0.67
• Mixed portfolio return
• w×10%+(1−w) ×2% = 0.67×10% + 0.33×2% = 7.36%
• M2 = rp* − rM
• M2 = 7.36% − 6% = 1.36%

In-class Exercise
• Std. Dev. = 20%
• Beta = 1.3
• Std. Dev. = 15%
• What is Sharpe ratio, and M2?

In-class Exercise
• Sharpe ratio of the portfolio p
• Sharpe ratio of the market

In-class Exercise
• Therefore w = 0.75
• Mixed portfolio return
• w×12%+(1−w) ×2% = 0.75×12% + 0.25×2% = 9.5%
• M2 = rp* − rM
• M2 = 9.5% − 8% = 1.5%

Treynor Ratio
• Treynor ratio
• In many circumstances, you should select one fund that will be mi
xed with existing risky portfolio
• Therefore, you do not need to consider unsystematic risk that will
eventually disappear when mixed with existing risky portfolio
• Reward to systematic risk (beta) measure

T2 Measure
• A variation of Treynor ratio is called T2 measure

• Suppose your portfolio earned 5% average return with 15% std. de
v. and beta of 1.5
• Market portfolio earned 3% average return with 10% std. dev.
• Risk-free rate=1%

T2 Measure
• You
mix your portfolio with risk-free asset to match beta of m
arket portfolio (1)
• Beta of mixed portfolio (w×1.5+(1−w)×0) should match 1
• Therefore w=0.67
• w×5%+(1−w) ×1% = 0.67×5% + 0.33×1% = 3.68%

Example
• Std. Dev. = 15%
• Beta = 1.5
• Std. Dev. = 10%
• What is Treynor ratio, and T2?

Example
• Treynor ratio of the portfolio p
• Treynor ratio of the market

Example
• You mix your portfolio with risk-free asset to match beta of m

arket portfolio (1)
• w×10%+(1−w) ×2% = 0.67×10% + 0.33×2% = 7.36%
• T2 = rp* − rM
• T2 = 7.36% − 6% = 1.36%

In-class Exercise
• Std. Dev. = 20%
• Beta = 1.3
• Std. Dev. = 15%
• What is Treynor ratio, and T2?

In-class Exercise

In-class Exercise

arket portfolio (1)
• w×12%+(1−w) ×2% = 0.77×12% + 0.23×2% = 9.7%
• T2 = rp* − rM
• T2 = 9.7% − 8% = 1.7%

Information Ratio
• Consider
a pension fund with a largely passive and well-diver
sified position
• The fund decides to add a position in an active portfolio to its
current position
• The increment in Sharpe ratio from adding the active portfoli
o = Information ratio

Information Ratio
• When
the hedge fund is optimally combined with the baseline
indexed portfolio, the improvement in Sharpe measure will be
determined by its information ratio
• Another reward to risk ratio

Summary

Example
• Consider the index-model regression result for a portfolio p

• The risk-free rate is 6%
• The average market return is 15%
• The average portfolio return is 17.8%
• Regression shows that
• /
• Calculate Jensen’s alpha, Sharpe ratio, M2, Treynor ratio, T2, I
nformation ratio

Example
• Jensen’s
Alpha: 1%
• Sharpe Ratio
• Sharpe ratio of the portfolio=0.118/0.206=0.5728

• Sharpe ratio of the market=0.09/0.15=0.6

Example
dev. of market
• Std. Dev. of mixed portfolio (w×20.6%) should match 15%
• w×17.8%+(1−w) ×6% = 0.73×17.8% + 0.27×6% = 14.61%
• M2 = rp* − rM
• M2 = 14.61% − 15% = − 0.39%

Example

• 9

Example

arket portfolio (1)
• w×17.86%+(1−w) ×6% = 0.83×17.86% + 0.17×6% = 15.84%
• T2 = rp* − rM
• T2 = 15.84% − 15% = 0.84%

Example
• Information ratio of the portfolio p

• 0.1
• Information ratio of the market
• ?

Implementing Performance Measurement: An E
xample
• EXCEL
• How to estimate single factor model
• How to calculate performance measures

xample

xample
• Overall
• Q is riskier than P (beta)
• P is better diversified than Q (σ(e))
• Both outperform the market (Sharpe ratio)
• If P or Q represents the entire investment fund
• Q>P (Sharpe)
• If P and Q are competing for a role as one of a number of sub-
portfolios
• Q>P (Treynor)
• Active portfolio to be mixed with index portfolio
• P>Q (Information ratio)

18.3 Morningstar’s Risk-adjusted Rating
• Morningstar: the premier source of information on mutual fun

ds
• Morningstar provides RAR
• Risk Adjusted Rating
• Widely used performance measures
• Comparison of each fund to a peer group
• Peer group based on fund’s investment universe (international, gro
wth, fixed income etc.)

18.3 Morningstar’s Risk-adjusted Rating
• Similar but not identical to Sharpe ratio

18.4 Performance Measurement with Changing
Portfolio Composition
• One potential problem with risk adjustment
• It assumes that portfolio risk is constant over the relevant time peri
od
• Portfolio manager may change risk of the portfolio depending on e
conomic situation
• Performance measures are biased

18.4 Performance Measurement with Changing
Portfolio Composition
• First four quarters
• −1%, 3%, −1%, and 3%
• Quarterly Sharpe ratio: 0.5
• Next four quarters
• −9%, 27%, −9%, and 27%
• Eight quarters
• −1%, 3%, −1%, 3%, −9%, 27%, −9%, and 27%

18.6 Performance Attribution Procedures
• Why did you make (lose) money

• Right securities at the right time
• Performance−Benchmark = Timing + Stock selection
• Out/Underperformance= Asset allocation + Stock selection

• Out/Underperformance= Asset allocation + Stock selection

• Explain the difference in returns between a managed portfoli
o, P, and a selected benchmark portfolio, B, called the bogey.
• Bogey is designed to measure the returns the portfolio manag
er would earn if he or she were to follow a completely passive
strategy.

Asset Class Actual Weight Actual Return Benchmark Weight Benchmark return
(=Index Return)
Stock 0.6 6% 0.4 5% (S&P500)
Bonds 0.2 1% 0.3 1.5% (Bond Index)
Cash 0.2 0.5% 0.3 0.5%
1) Calculate your investment return

2) Calculate benchmark return
3) Calculate the difference
• Calculate the difference from asset allocation
• Calculate the difference from security selection

(=Index Return)
•
Stock 0.6 6% 0.4 5% (S&P500)
Cash 0.2 0.5% 0.3 0.5%
• =actual weight on ith asset class

• =actual return on ith asset class

(=Index Return)
•
Stock 0.6 6% 0.4 5% (S&P500)
Cash 0.2 0.5% 0.3 0.5%
• =benchmark weight on ith asset class

• =benchmark return on ith asset class

(=Index Return)
Stock 0.6 6% 0.4 5% (S&P500)
Cash 0.2 0.5% 0.3 0.5%

• 3.9% vs 2.6%
• Outperform the benchmark (Bogey) by 1.3%
• Why?
• Weight on each asset class is different
• Asset allocation / Market timing
• Return from each asset class is different
• Security selection

(=Index Return)
•
Stock 0.6 6% 0.4 5% (S&P500)
Cash 0.2 0.5% 0.3 0.5%
• 3-1) The difference from asset allocation

• What if youActual
Asset Class
justWeight
followedActual
benchmark
Return
return?
Benchmark Weight Benchmark return
(Hypothetical) (Hypothetical) (=Index Return)
Stock 0.6 5% 0.4 5% (S&P500)
Bonds 0.2 1.5% 0.3 1.5% (Bond Index)
Cash 0.2 0.5% 0.3 0.5%
• (Hypothetical)
• Outperform the benchmark (2.6%) by 0.8%

(=Index Return)
•
Stock 0.6 6% 0.4 5% (S&P500)
Cash 0.2 0.5% 0.3 0.5%
3-2) The difference from stock selection

• What is the weighted average of outperformance over bench
mark?
Asset Class Actual Weight Actual Return
− Benchmark return
Stock 0.6 6%−5%=1%
Bonds 0.2 1%−1.5%=−0.5%
Cash 0.2 0.5%−0.5%=0%

(=Index Return)
Stock 0.6 6% 0.4 5% (S&P500)
Cash 0.2 0.5% 0.3 0.5%
1) Calculate your investment return=3.9%

2) Calculate benchmark return=2.6%
3) Calculate the difference=1.3%
• Calculate the difference from asset allocation=0.8%
• Calculate the difference from security selection=0.5%

In-class Exercise
(=Index Return)
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%

• Calculate the difference from asset allocation
• Calculate the difference from security selection

In-class Exercise
(=Index Return)
•
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%
• =actual weight on ith asset class

• =actual return on ith asset class

In-class Exercise
(=Index Return)
•
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%
• =benchmark weight on ith asset class

• =benchmark return on ith asset class

In-class Exercise
(=Index Return)
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%

• 3.2% vs 3.85%
• The difference is −0.65%
• Underperform the benchmark (Bogey) by 0.65%
• Why?
• Weight on each asset class is different
• Asset allocation / Market timing
• Return from each asset class is different
• Security selection
In-class Exercise
(=Index Return)
•
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%
• 3-1) The difference from asset allocation

• What
Asset Class if you just
Actual followed
Weight benchmark
Actual Return return?
Benchmark Weight Benchmark return
(Hypothetical) (Hypothetical) (=Index Return)
Stock 0.3 5% 0.7 5% (S&P500)
Bonds 0.5 1.5% 0.2 1.5% (Bond Index)
Cash 0.2 0.5% 0.1 0.5%
• (Hypothetical)
• The difference is −1.5%

• Underperform the benchmark (3.85%) by 1.5%
In-class Exercise
(=Index Return)
•
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%
3-2) The difference from stock selection

• What is the weighted average of outperformance over bench
mark?
Asset Class Actual Weight Actual Return
− Benchmark return
Stock 0.3 7%−5%=2%
Bonds 0.5 2%−1.5%=0.5%
Cash 0.2 0.5%−0.5%=0%

In-class Exercise
(=Index Return)
Stock 0.3 7% 0.7 5% (S&P500)
Cash 0.2 0.5% 0.1 0.5%
1) Calculate your investment return=3.2%

2) Calculate benchmark return=3.85%
3) Calculate the difference=−0.65%
• Calculate the difference from asset allocation= −1.5%
• Calculate the difference from security selection=0.85%

Chapter 18 - Evaluating Investment Performance

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Evaluating Investment Performance

BH Jeon Investment Analysis 1 / 20

• 18.1 The Conventional Theory of Performance Evaluation

BH Jeon Investment Analysis 2 / 20

• 18.3 Morningstar’s Risk-Adjusted Rating

BH Jeon Investment Analysis 3 / 20

• High return is always better?

BH Jeon Investment Analysis 4 / 20

• Simplest and most popular ways is to compare investment ret

BH Jeon Investment Analysis 5 / 20

BH Jeon Investment Analysis 6 / 20

• They are not truly comparable. The rankings can be misleadin

BH Jeon Investment Analysis 7 / 20

• rp,t: raw return of portfolio p

BH Jeon Investment Analysis 8 / 20

• Absolute measure of average return on the portfolio over and

BH Jeon Investment Analysis 9 / 20

BH Jeon Investment Analysis 10 / 20

• Jensen’s Alpha of the portfolio

• Jensen’s Alpha of the market

BH Jeon Investment Analysis 11 / 20

BH Jeon Investment Analysis 12 / 20

• If preferences can be summarized by a mean-variance choice,

BH Jeon Investment Analysis 13 / 20

• Suppose Sharpe ratio is 4% higher than the market index. The

BH Jeon Investment Analysis 14 / 20

BH Jeon Investment Analysis 15 / 20

BH Jeon Investment Analysis 16 / 20

• Sharpe ratio of the portfolio p

• Sharpe ratio of the market

BH Jeon Investment Analysis 17 / 20

BH Jeon Investment Analysis 18 / 20

BH Jeon Investment Analysis 19 / 20

• Sharpe ratio of the portfolio p

• Sharpe ratio of the market

BH Jeon Investment Analysis 20 / 20

BH Jeon Investment Analysis 21 / 20

BH Jeon Investment Analysis 22 / 20

• A variation of Treynor ratio is called T2 measure

BH Jeon Investment Analysis 23 / 20

BH Jeon Investment Analysis 24 / 20

BH Jeon Investment Analysis 25 / 20

• Treynor ratio of the portfolio p

• Treynor ratio of the market

BH Jeon Investment Analysis 26 / 20

• You mix your portfolio with risk-free asset to match beta of m

BH Jeon Investment Analysis 27 / 20

BH Jeon Investment Analysis 28 / 20

• Treynor ratio of the portfolio p

• Treynor ratio of the market

BH Jeon Investment Analysis 29 / 20

• You mix your portfolio with risk-free asset to match beta of m

BH Jeon Investment Analysis 30 / 20

BH Jeon Investment Analysis 31 / 20

BH Jeon Investment Analysis 32 / 20

BH Jeon Investment Analysis 33 / 20

• Consider the index-model regression result for a portfolio p

BH Jeon Investment Analysis 34 / 20

• Sharpe ratio of the portfolio=0.118/0.206=0.5728

BH Jeon Investment Analysis 35 / 20

BH Jeon Investment Analysis 36 / 20