CHAPTER FIVE: PORTFOLIO PERFORMANCE

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EVALUATION

5.1 Meaning and need of Portfolio revision

5.2. Portfolio revision strategy
5.3. Meaning and need of portfolio evaluation
5.4. Portfolio Performance Evaluation model
5.4.1 Sharpe Model
5.4.2 Treynor ratio
5.4.3. Jensen measure or ratio
 5.1 Meaning and need of Portfolio revision
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 Portfolio revision is the process of selling certain issues in

portfolio and purchasing new ones to replace them.
 The main reasons for the necessity of the investment
portfolio revision:
• As the economy evolves, certain industries and companies
become either less or more attractive as investments;
• The investor over the time may change his/her investment
objectives and in this way his/ her portfolio isn’t longer
optimal;
• The constant need for diversification of the portfolio.
Individual securities in the portfolio often change in risk-
return characteristics and their diversification effect may be
lessened.
 5.2. Portfolio revision strategy
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 When monitoring the changes in the investor’s

circumstances, following aspects must be taken into
account:
• Change in wealth
• Change in time horizon
• Change in liquidity requirements
• Change in tax circumstances
• Change in legal considerations
• Change in other circumstances and investor’s needs.
 Any changes identified must be assessed very carefully
before usually they generally are related with the
noticeable changes in investor’s portfolio.
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 Thus we need to revise it periodically.

 Rebalancing portfolio is the process of periodically
adjusting it to maintain certain original conditions.
 Rebalancing reduces the risks of losses – in
general, a rebalanced portfolio is less volatile than
one that is not rebalanced.
 Several methods of rebalancing portfolios are
used:
1. Constant proportion portfolio;
2. Constant Beta portfolio;
3. Indexing.
 1. Constant proportion portfolio
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 A constant proportion portfolio is one in which adjustments are made so as to

maintain the relative weighting of the portfolio components as their prices
change.
 Investors should concentrate on keeping their chosen asset allocation
percentage (especially those following the requirements for strategic asset
allocation). There is no one correct formula for when to rebalance.
 One rule may be to rebalance portfolio when asset allocations vary by 10% or
more.
 But many investors find it bizarre that constant proportion rebalancing
requires the purchase of securities that have performed poorly and the sale of
those that have performed the best.
 This is very difficult to do for the investor psychologically, But the investor
should always consider this method of rebalancing as one choice, but not
necessarily the best one.
 2. Constant Beta portfolio
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 The base for the rebalancing portfolio using this alternative is

the target portfolio Beta.
 Over time the values of the portfolio components and their
Betas will change and this can cause the portfolio Beta to shift.
 For example, if the target portfolio Beta is 1.10 and it had risen
over the monitored period of time to 1.25, the portfolio Beta
could be brought back to the target (1.10) in the following ways:
• Put additional money into the stock portfolio and hold cash.
Diluting the stocks in portfolio with the cash will reduce
portfolio Beta, because cash has Beta of 0. But in this case cash
should be only a temporary component in the portfolio rather
than a long-term;
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 Put additional money into the stock portfolio and buy

stocks with a Beta lower than the target Beta figure. But
the investor may be is not able to invest additional money
and this way for rebalancing the portfolio can be
complicated.
 • Sell high Beta stocks in portfolio and hold cash. As with
the first alternative, this way reduces the equity holdings in
the investor’s portfolio which may be not appropriate.
 • Sell high Beta stocks and buy low Beta stocks. The stocks
bought could be new additions to the portfolio, or the
investor could add to existing positions.
 3. Indexing.
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 This alternatives for rebalancing the portfolio are more

frequently used by institutional investors (often mutual funds),
because their portfolios tend to be large and the strategy of
matching a market index are best applicable for them.
 Managing index based portfolio investor (or portfolio manager)
eliminates concern about outperforming the market, because
by design, it seeks to behave just like the market averages.
 Investor attempts to maintain some predetermined
characteristics of the portfolio, such as Beta of 1.0.
 The extent to which such a portfolio deviates from its intended
behaviours called tracking error.
5.3. MEANING AND NEED OF PORTFOLIO EVALUATION

 Can anyone consistently earn an “excess” return, thereby “beating”

the market?
 Proper performance evaluation should involve a recognition of both
the return and the riskiness of the investment
 Performance evaluation is a term for assessing how well a money
manager achieves a balance between high returns and acceptable
risks.
 Portfolio performance evaluation involves determining periodically
how the portfolio performed in terms of not only the return earned,
but also the risk experienced by the investor.
 Practical performance measures typically involve a comparison of
the fund’s performance with that of a benchmark.
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 Portfolio performance evaluation methods

1. The Conventional Theory of Performance

Evaluation
2. Adjusting Returns for Risk
1. The Conventional Theory of Performance Evaluation

 The essential idea behind performance evaluation is to compare

the returns which were obtained on portfolio with the results
that could be obtained if more appropriate alternative
portfolios had been chosen for the investment.
 Such comparison portfolios are often referred to as benchmark
portfolios.
 In selecting them investor should be certain that they are
relevant, feasible and known in advance.
 The benchmark should reflect the objectives of the investor.
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 In general, the market value of a portfolio at a point of time

is determined by adding the markets value of all the securities
held at that particular time.
 The market value of the portfolio at the end of the period
is calculated in the same way, only using end-of-period prices
of the securities held in the portfolio.
 The return on the portfolio (rp) = (Ve-Vb)/Vb
 Here: Ve - beginning value of the portfolio;
Vb - ending value of the portfolio.
 2. Adjusting Returns for Risk
 Evaluating performance based on average return alone is not
very useful.
 Comparison with other managers of similar investment style
may be misleading
 Because some managers may concentrate on particular
subgroups, so that portfolio characteristics are not truly
comparable
 using universe comparison is therefore necessary
 To adjust the return for risk before comparison of performance risk
adjusted measures of performance can be used:
1. Sharpe Measure
2. Treynor Measures
3. Jensen Measure
Universe
Comparison
 Risk Adjusted
Performance
1) Sharpe Index
 It measures the reward to (total) volatility trade-off.
 divides average portfolio excess return over the sample period
by the standard deviation of returns over that period.
 Introduced by William Sharpe
 The Sharpe measure relates return to total risk.
 It can be used effectively with a portfolio where unsystematic
risk has been diversified away.
 Based on the Capital Market Line, considers the total risk of
the portfolio being evaluated
S = (Rportfolio - RFR)/portfolio
 Cont’d………..
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 Shows the risk premium earned over the risk free

rate per unit of total risk
 Sharpe ratios greater than the ratio for the market
portfolio indicate superior performance.
 Assume the market return is 14% with a standard
deviation of 20%, and risk-free rate is 8%. The
average annual returns for Managers D, E, and F are
13%, 17%, and 16% respectively. The corresponding
standard deviations are 18%, 22%, and 23%. What are
the Sharpe measures for the market and managers?
 Cont’d……….
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 The Sharpe Measures

 SM = (14%-8%) / 20% =0.300

 SD = (13%-8%) / 18% =0.273

 SE = (17%-8%) / 22% =0.409
 SF = (16%-8%) / 23% =0.348
 Cont’d………
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 Treynor Portfolio Performance Measure

 Developed by Treynor (1965)
 Examines differential return when beta is the risk
measure.
 The Treynor measure relates return to systematic
risk, as measured by the security (or portfolio) beta.
 It is an appropriate measure for both single
securities as well as for portfolios.
 Based on the CAPM, considers the risk that cannot
be diversified, systematic risk
T = (Rportfolio - RFR)/portfolio
 Cont’d……….
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 Shows the risk premium earned over the risk free

rate per unit of systematic risk
 Treynor ratios greater than the market risk
premium indicate superior performance.
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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?
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Solution: First, compute the average excess

return for Stock XYZ:
1.86%  5.09%  1.99%  1.72%
R 
4
 0.88%
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 Solution (cont’d): Next, compute the Sharpe and

Treynor measures:
R  Rf 0.88%
Sharpe measure    0.29
 3.07%
R  Rf 0.88%
Treynor measure    0.73
 1.20
 Cont’d………..
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 Excess Returns Methods

 Jensen Measure

 Jensen (1968 & 1969) has proposed a measure

referred to as the Jensen differential performance
index (Jensen’s measure or JM).
 Calculates excess returns based on the CAPM
 Jensen’s alpha represents how much the portfolio
manager contributes to portfolio (j) returns
aj = [Rjt –(RFRt)] – [bj(Rmt-RFRt)]
 Cont’d………
24  Superior managers will generate a significantly
positive alpha; inferior managers will generate a
significantly negative alpha.
 According to the Jensen measure, if a portfolio manager
is better-than-average, the alpha of the portfolio will be
positive
 Example
Portfol Ri (%)  (%) i
io
A 50 50 2.5
B 19 15 2.0
C 12 9 1.5
D 9 5 1.0
 Cont’d……….
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Rank portfolios based on JM:

(1)When RM = 10% and Rf = 8%,
JM A  37 %,JM B  7 %,JM C  1%,JM D  2 %,JM E  0 %
A>B>C>E>D

2)When RM=12% and Rf=8%,

JM A  32%,JM B  3 %,JM C   2 %,JM D  3 %,JM E   0.5 %
A>B>E>C>D

(3)When RM=8% and Rf=8%,

JM A  42%,JM B  11 %,JM C  4 %,JM D  1 %,JM E  0.5 %
A>B>C>D>E
(4)When RM=12% and Rf=4%,
JM A  26 %,JM B   1 %,JM C   4 %,JM D   3 %,JM E  2.5 %
A>E>B>D>C
 COMPARING MEASURES OF
PERFORMANCE
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 TREYNOR V. SHARPE
 Sharpe Ratio measures uses s as a measure of risk
while Treynor uses beta (systematic risk).
 Sharpe Ratio evaluates the manager on the basis of
both rate of return performance as well as
diversification
 COMPARING MEASURES OF
PERFORMANCE
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 for a completely diversified portfolio

 Sharpe Ration and Treynor give identical rankings
because total risk is really systematic variance
 Any difference in ranking comes directly from a
difference in diversification

END OF THE CHAPTER