Risk Adjusted Performance

Performance Evaluation
Timothy R. Mayes, Ph.D.

FIN 4600
Performance and the Market Line
Risk
i
E(R
i
)
M
R
F
Risk
M
E(R
M
)
ML
Undervalued
Overvalued
Note: Risk is either | or o
Performance and the Market Line
(cont.)
Risk
i
E(R
i
)
M
RFR
Risk
M
E(R
M
)
ML
A
B
C
D
E
Note: Risk is either | or o
The Treynor Measure
The Treynor measure calculates the risk premium per
unit of risk (|
i
)

Note that this is simply the slope of the line between the
RFR and the risk-return plot for the security
Also, recall that a greater slope indicates a better risk-
return tradeoff
Therefore, higher T
i
generally indicates better
performance
T
R RFR
i
i
i
=

|

The Sharpe Measure
The Sharpe measure is exactly the same as the
Treynor measure, except that the risk measure is
the standard deviation:
S
R RFR
i
i
i
=

o
Sharpe vs Treynor
The Sharpe and Treynor measures are similar,
but different:
S uses the standard deviation, T uses beta
S is more appropriate for well diversified portfolios,
T for individual assets
For perfectly diversified portfolios, S and T will give
the same ranking, but different numbers (the ranking,
not the number itself, is what is most important)
Sharpe & Treynor Examples
Portfolio Return RFR Beta Std. Dev. Trenor Sharpe
X 15% 5% 2.50 20% 0.0400 0.5000
Y 8% 5% 0.50 14% 0.0600 0.2143
Z 6% 5% 0.35 9% 0.0286 0.1111
Market 10% 5% 1.00 11% 0.0500 0.4545
Risk vs Return
0%
5%
10%
15%
0.00 0.50 1.00 1.50 2.00 2.50
Beta
R
e
t
u
r
n
M
X
Y
Z
Risk vs Return
0%
5%
10%
15%
0% 5% 10% 15% 20%
Std. Dev.
R
e
t
u
r
n
M
X
Y
Z
Jensens Alpha
Jensens alpha is a measure of
the excess return on a
portfolio over time
A portfolio with a consistently
positive excess return
(adjusted for risk) will have a
positive alpha
A portfolio with a consistently
negative excess return
(adjusted for risk) will have a
negative alpha ( )
R RFR R RFR
i i i M i
= + + o |
R
i
s
k

P
r
e
m
i
u
m

Market Risk Premium
0
o > 0
o = 0
o < 0
Modigliani & Modigliani (M2)
M
2
is a new technique (Fall 1997) that is closely
related to the Sharpe Ratio.
The idea is to lever or de-lever a portfolio (i.e.,
shift it up or down the capital market line) so that
its standard deviation is identical to that of the
market portfolio.
The M
2
of a portfolio is the return that this
adjusted portfolio earned. This return can then
be compared directly to the market return for the
period.
Calculating M
2
The formula for M
2
is:

As an example, the M
2
for our example portfolios is calculated
below:

Recall that the market return was 0.10, so only X outperformed.
This is the same result as with the Sharpe Ratio.
( )
f f i
i
M
2
R R R M +
|
.
|
\
|
o
o
=
( )( )
( )( )
( )( ) 062 . 0 05 . 0 05 . 0 06 . 0
09 . 0
11 . 0
M
074 . 0 05 . 0 05 . 0 08 . 0
14 . 0
11 . 0
M
105 . 0 05 . 0 05 . 0 15 . 0
20 . 0
11 . 0
M
2
Z
2
Y
2
X
= + =
= + =
= + =
Famas Decomposition
Fama decomposed excess return into two main
components:
Risk
Managers risk
Investors risk
Selectivity
Diversification
Net selectivity
Excess return is defined as that portion of the
return in excess of the risk-free rate
Famas Decomposition (cont.)
Manager's Risk Investor's Risk
Risk Premium Due to Risk
Diversification Net Selectivity
Risk Premium Due to Selectivity
Total Risk Premium
Famas Decomposition: Risk
This is the portion of the excess return that is
explained by the portfolio beta and the market
risk premium:
( )
RP R RFR
Risk P M
= |
Famas Decomposition: Investors
Risk
If an investor specifies a particular target level of
risk (i.e., beta) then we can further decompose
the risk premium due to risk into investors risk
and managers risk.
Investors risk is the risk premium that would
have been earned if the portfolio beta was
exactly equal to the target beta:
( )
f M T sk InvestorRi
R R RP = |
Famas Decomposition: Managers
Risk
If the manager actually takes a different level of
risk than the target level (i.e., the actual beta was
different than the target beta) then part of the risk
premium was due to the extra risk that the
managers took:
( )( )
f M T i k ManagerRis
R R RP = | |
Famas Decomposition: Selectivity
This is the portion of the excess return that is not
explained by the portfolio beta and the market
risk premium:

Since it cannot be explained by risk, it must be
due to superior security selection.
( )
RP RP RP RP R RFR
Selectivity Total Risk Total P M
= = |
Famas Decomposition: Diversification
This is the difference between the return that
should have been earned according to the CML
and the return that should have been earned
according to the SML
If the portfolio is perfectly diversified, this will
be equal to 0
( ) ( )
| |
( )
RP RFR R RFR RFR R RFR
RP R RFR
Diversification
i
M
M i M
Diversification M
i
M
i
= +
(
+
=
|
\
|
.
|
o
o
|
o
o
|
Famas Decomposition: Net Selectivity
Selectivity is made up of two components:
Net Selectivity
Diversification
Diversification is included because part of the managers
skill involves knowing how much to diversify
We can determine how much of the risk premium comes
from ability to select stocks (net selectivity) by
subtracting diversification from selectivity
Additive Attribution
Famas decomposition of the excess return was the first attempt at an
attribution model. However, it has never really caught on.
Other attribution systems have been proposed, but currently the most
widely used is the additive attribution model of Brinson, Hood, and
Beebower (FAJ, 1986)
Brinson, et al showed that the portfolio return in excess of the
benchmark return could be broken into three components:
Allocation describes the portion of the excess return that is due to
sector weighting different from the benchmark
Selection describes the portion of the excess return that is due to
choosing securities that outperform in the benchmark portfolio
Interaction is a combined effect of allocation and selection.
Additive Attribution (cont.)
The Brinson model is a single period model,
based on the idea that the total excess return is
equal to the sum of the allocation, selection, and
interaction effects.
Note that R
t
is the portfolio return, R
t
bar is the
benchmark return, and A
t
, S
t
, and I
t
are the
allocation, selection, and interaction effects
respectively:
t t t t t
I S A R R + + =
The equations for each of the components of
excess return are:
( )( )
( )
( )( )
=
=
=
=
=
=
N
1 i
t , i t , i t , i t , i t
N
1 i
t , i t , i t , i t
N
1 i
t t , i t , i t , i t
R R w w I
R R w S
R R w w A
So, looking at the formulas it should be obvious that:
Allocation measures the relative weightings of each sector in
the portfolio and how well the sectors performed in the
benchmark versus the overall benchmark return. A positive
allocation effect means that the manager, on balance, over-
weighted sectors that out-performed in the index and under-
weighted the under-performing sectors.
Selection measures the sectors different returns versus their
weightings in the benchmark. A positive selection effect means
that the manager selected securities that outperformed, on
balance, within the sectors.
Interaction measures a combination of the different weightings
and different returns and is difficult to explain. For this reason,
many software programs allocate the interaction term into both
allocation and selection.
Additive Attribution: An Example
Sector Portfolio Benchmark
Weight Return Weight Return
Equities 70.00% 7.00% 60.00% 8.00%
Bonds 20.00% 7.50% 40.00% 6.00%
Cash 10.00% 6.00% 0.00% 5.00%
Total 100.00% 7.00% 100.00% 7.20%
Sector Allocation Selection Interaction Total
Equities 0.08% -0.60% -0.10% -0.62%
Bonds 0.24% 0.60% -0.30% 0.54%
Cash -0.22% 0.00% 0.10% -0.12%
Total 0.10% 0.00% -0.30% -0.20%

Risk Adjusted Performance

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Performance Evaluation

Timothy R. Mayes, Ph.D.

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