SAPM

Session 9
Objectives

 At the end of the session , you will be able to

 Evaluate the performance of the fund manager through
 Sharpe’s ratio
 Treynor’s ratio
 Jensen’s alpha
 Information Ratio
 Msquare
 Explore active strategies used by the portfolio managers
Performance evaluation

 Performance evaluation is a critical aspect of portfolio

management
 Proper performance evaluation should involve a
recognition of both the return and the riskiness of the
investment
Traditional
Performance Measures
 Sharpe Measure
 Treynor Measures
 Jensen Measure
 Performance Measurement in Practice
Sharpe and Treynor Measures

 The Sharpe and Treynor measures:

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 The Sharpe measure evaluates return relative to total
risk
 Appropriate for a well-diversified portfolio, but not for
individual securities
 The Treynor measure evaluates the return relative to
beta, a measure of systematic risk
 It ignores any unsystematic risk
Example

 Over the last four months, XYZ Stock had excess returns
of 1.86 percent, –5.09 percent, –1.99 percent, and 1.72
percent. The standard deviation of XYZ stock returns is
3.07 percent. XYZ Stock has a beta of 1.20.
 What are the Sharpe and Treynor measures for XYZ
Stock?
SML vs. CML

 Treynor’s measure uses Beta and hence examines

portfolio return performance in relation to the SML.
 Sharpe’s measure uses total risk and hence examines
portfolio return performance in relation to the CML.
 For a totally diversified portfolio, both measures give
equal rankings.
 If it is not a diversified portfolio, the Sharpe measure
could give lower rankings than the Treynor measure.
 Thus, the Sharpe measure evaluates the portfolio
manager in terms of both return performance and
diversification.
Jensen Measure

 The Jensen measure stems directly from the CAPM

 According to the Jensen measure, if a portfolio manager

is better-than-average, the alpha of the portfolio will be
positive
 Unlike the Sharpe Ratio, Jensen’s method does not
consider the ability of the manager to diversify, as it is
only accounts for systematic risk.
Information ratio 1

 Information ratio

 Note that the risk here is nonsystematic risk, that could,

in theory, be eliminated by diversification.
Information Ratio 2

 Measures excess returns relative to a benchmark portfolio.

 Sharpe Ratio is the special case where the benchmark
equals the risk-free asset.
 Risk is measured as the standard deviation of the excess
return (Recall that this is the Tracking Error)
 For an actively managed portfolio, we may want to
maximize the excess return per unit of nonsystematic risk
we are bearing.
 Portfolio Tracking Error
Excess Return relative
to benchmark portfolio b

Average Excess Return

Variance in Excess Difference

Tracking Error

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M2 Measure

Developed by Leah and her grandfather Franco Modigliani.

M2 = rp*- rm

rp* is return of the adjusted portfolio that matches the volatility of the
market index rm. It is mixed with a position in T-bills.

If the risk of the portfolio is lower than that of the market, one has to
increase the volatility by using leverage.

Because the market index and the adjusted portfolio have the same standard
deviation, we may compare their performances by comparing returns.
Example

 Managed Portfolio: return = 35% st dev = 42%

 Market Portfolio: return = 28% st dev = 30%
 T-bill return = 6%
 Hypothetical Portfolio:
 42/30 = 1.4 in P (1-1.4) or -0.4 in T-bills
 Return = (1.4) (.28) + (-0.4) (.06) = 36.8%
 Since the return of the portfolio is less than the adjusted
portfolio , M2 is negative, and the managed portfolio
underperformed the market.
M2 of Portfolio P

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Excess Returns for Portfolios P and Q
and the Benchmark M

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Which Portfolio is Best?

 It depends.
 If P or Q represent the entire portfolio, Q would be
preferable based on having higher sharp ratio and a
better M2.
 If P or Q represents a sub-portfolio, the Q would be
preferable because it has a higher Treynor ratio.
 For an actively managed portfolio, P may be preferred
because it’s information ratio is larger (that is it
maximizes return relative to nonsystematic risk, or the
tracking error).

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Excel

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Questions
Thank you