Bodie Investments 12e IM CH24

CHAPTER TWENTY-FOUR
PORTFOLIO PERFORMANCE EVALUATION
CHAPTER OVERVIEW
This chapter discusses and calculates various return measures and risk-adjusted return measures that are
used for portfolio evaluation. The process of decomposing portfolio returns into the various components
of the portfolio-building process is presented.
LEARNING OBJECTIVES
After studying this chapter, the student should be able to: calculate various risk-adjusted return measures,
and use these measures to evaluate investment performance. The student will also be able to decompose
excess returns into components attributable to asset allocation choices.
PRESENTATION OF MATERIAL
24.1 The Conventional Theory of Performance Evaluation
Obtaining an accurate estimate of risk-adjusted performance for a portfolio manager is very difficult.
Most of the sound measures of risk adjusted returns require stability for the portfolio. Most portfolios are
actively managed and the stability assumptions are not met. Many industry measures of performance are
based on comparisons to some benchmark portfolio. The comparison to the benchmark is only
appropriate if the risk is similar.
The section starts with the concept of average returns and contrasts different approaches. Dollar-
weighted and time-weighted returns are presented here. For an investor that has control over
contributions to the investment portfolio, the dollar-weighted return is the more comprehensive measure.
Time-weighted returns are more likely appropriate to judge the performance of an investor that does not
control the timing of contributions.
Evaluating performance based on average return alone is not very useful. Returns must be adjusted for
risk before they can be compared meaningfully. The simplest and most popular way to adjust returns for
portfolio risk is to compare rates of return with those of other investment funds with similar risk
characteristics. For example, high-yield bond portfolios are grouped into one “universe,” growth stock
equity funds are grouped into another universe. Figure 24.1 provides a comparison with periods ending in
2025. The relative rankings of the S&P 500 and The Markowill Group are displayed by quarter.
The Sharpe Measure [ ] is also widely accepted in industry. The slope measure is based on
the portfolio risk premium and the total risk of the portfolio as measured by standard deviation. The
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Treynor measure [ ] also looks at a measure of reward to variability with the difference
being the measure of risk. The measure of risk used in the Treynor measure is the beta coefficient of the
portfolio. The Sharpe and the Treynor measures should result in similar rankings for most widely
diversified portfolios. With portfolios that are widely diversified, most of the risk will be systematic.
The chapter presents other measures of performance. Jensen’s alpha [ ] is a

measure of the percentage abnormal return using the adjustment of the market model. The Jensen
measure does not scale returns for risk and is therefore not as complete as the Treynor measure. The
information ratio [ ] measures the alpha relative to the unsystematic or diversifiable risk. The
Morningstar Risk-adjusted Return ( ) is introduced, factoring levels

of risk aversion into risk-free equivalent excess returns. The M2 measure facilitates interpretation of the
reward-to-variability measure. Example 24.1 considers a portfolio and the market index portfolio, from
the concept check 24.2 and works through an expanded example. Using the relevant data from the market
index in Table 24.1, one would prefer portfolio Q however by using Figure 24.3, similar to Figure 24.2,
the portfolios are plotted on a return-risk graph and measure risk using beta. Tables 24.2 and 24.3 present
excess returns for portfolios P and Q and the market index M over 12 months and performance statistics
of the portfolios respectively.
24.2 Style Analysis

One of the significant findings on performance was done by William Sharpe. He analyzed performance
of mutual funds and concluded that over 90% of the returns could be contributed to asset allocation.
Later studies have concluded that 97% of returns are due to asset allocation; see Table 24.4. An
application of this style analysis is shown for the Fidelity Magellan Fund. While the performance of
Magellan was extraordinary over the period from 1986 through 1990, examinations of a large universe of
funds show lack of abnormal performance. Figure 24.4 plots the combined impact of the intercept plus
monthly residuals relative to the tracking portfolio to illustrate Magellan’s superior performance. Figure
24.5 shows the frequency distribution of average residuals across 636 mutual funds.
24.3 Performance Measurement with Changing Portfolio Composition

When a manager is changing the portfolio composition, performance measures over longer periods can be
misleading. An example in the text illustrates. The Sharpe measure in this example is inferior to an
indexed approach when measured over eight quarters but the two four-quarter measures are superior.
Example 24.3 works through an example of changing portfolio risk considering the Sharpe measure.
Figure 24.6 graphically demonstrates portfolio returns; returns in the last four quarters are more variable
than in the first four quarters.
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The question of which measure is most appropriate depends on additional investment assumptions. If the
investment is limited to a single managed portfolio, the Sharpe measure is the most appropriate. If non-
systematic risk can be diversified away, the appropriate measure becomes Treynor’s, which takes into
account excess return over beta. Finally, a discussion of performance manipulation is raised, showing
how the use of leverage can amplify returns, increasing profits but simultaneously increasing potential
losses for investors. A study by Ingersoll, et al. introduces the concept of a manipulation-proof
performance measure (MPPM) and how the MRAR fits into it. Figure 24.7 demonstrates the fit between
ranking by RAR and by Sharpe ratios.
24.4 Market Timing

If the manager has the ability to time the market, the portfolio manager will increase the beta when the
market has high levels of performance. When the market experiences lower returns or losses, the
manager reduces the beta of the portfolio. In Figure 24.8, Panel A illustrates a straight line with a slope
of .6, while in Panels B and C the slope is represents a curved line that is steadily increasing and a kinked
curve with only two values of beta respectively.
A discussion on market timing follows and is summarized by Table 24.5 which presents a summary of
statistics for each of the three passive strategies discussed. Figure 24.9 graphically illustrates the rate of
return is at least the risk-free rate. Finally the section ends with the value of imperfect forecasting.
24.5 Performance Attribution Procedures
The measures used in industry are often based on performance attribution. An overview of the concept of
performance attribution is presented here. The simplest form of attribution breaks the portfolio into
common stock, long-term debt and cash equivalents. The purpose is to compare the components and
returns in the portfolio whose performance is being measured against the standard mix portfolio.
Attribution can also be based on smaller components such as large and small stocks, and government and
corporate debt.
The process of attributing performance to the components is presented next. If the benchmark, or bogey,
portfolio was comprised of 60% stock, 30% debt and 10% money market, the first step would be to
calculate the returns on the benchmark. Indexes are used to calculate the benchmark return. Performance
for the portfolio in question is then compared to the benchmark portfolio. Differences in return are
attributed to return differentials in the categories and to differences in the weight structures. Application
of performance attribution is contained in Tables 24.6 and 24.7. Students can perform performance
attribution in the Excel model presented below. Table 24.8 documents the decisions that led to the
superior equity market performance discussed in this section and Table 24.9 details the contributions of
each aspect of performance.
Excel Models
Two excel models that cover material in this chapter are available on the Online Learning Center
(www.mhhe.com/bkm). The first model calculates all of the performance measures covered in the
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chapter and can be used to rank funds or managed portfolios by each of the ranks. The second model
constructs an attribution analysis.
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CHAPTER TWENTY-FOUR

PORTFOLIO PERFORMANCE EVALUATION

The chapter presents other measures of performance. Jensen’s alpha [ ] is a

Morningstar Risk-adjusted Return ( ) is introduced, factoring levels

24.2 Style Analysis

24.3 Performance Measurement with Changing Portfolio Composition

24.4 Market Timing

24.5 Performance Attribution Procedures

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