BKM PPT Ch24 10e

Chapter Twenty Four
Portfolio Performance
Evaluation
INVESTMENTS | BODIE, KANE,

MARCUS
Introduction
If markets are efficient, investors must be
able to measure asset management
performance
Two common ways to measure average
portfolio return:
1. Time-weighted returns
2. Dollar-weighted returns
Returns must be adjusted for risk.
MARCUS
Dollar- and Time-Weighted

Returns
Time-weighted returns
The geometric average is a timeweighted average.
Each periods return has equal
weight.
1 rG
1 r1 1 r2 ...1 rn
MARCUS
Dollar- and Time-Weighted

Returns
Dollar-weighted returns
Internal rate of return considering the

cash flow from or to investment
Returns are weighted by the amount
invested in each period:
Cn
C1
C2
PV
...
1
2
n
1 r 1 r
1 r
MARCUS
Example of Multiperiod
Returns

MARCUS

5
1
1
2
5
0
1
(r7.%
r)(r)2
Dollar-Weighted Return
$4+$108
$2
-$50
-$53
Dollar-weighted Return
(IRR):

MARCUS
5
3
2
r124
150.6%
Time-Weighted Return
rG = [ (1.1) (1.0566) ]1/2 1 = 7.81%
The dollar-weighted average is less than the

time-weighted average in this example
because more money is invested in year two,
when the return was lower.

MARCUS
Dollar-Weighted Return
Households should maintain a
spreadsheet of time-dated cash flows
(in and out) to determine the
effective rate of return for any given
period.
Examples include:
IRA, 401(k), 529
MARCUS
Adjusting Returns for Risk

The simplest and most popular way
to adjust returns for risk is to
compare the portfolios return with
the returns on a comparison
universe.
The comparison universe is a
benchmark composed of a group of
funds or portfolios with similar risk
characteristics, such as growth stock
funds or high-yield bond
funds.
INVESTMENTS
| BODIE, KANE,
MARCUS
Figure 24.1 Universe Comparison

MARCUS
(rP
f)
Risk Adjusted Performance:

Sharpe
1) Sharpe Index
rp = Average return on the portfolio

rf
= Average risk free rate

= Standard deviation of portfolio
return

MARCUS
(rP
f)

Treynor
2) Treynor Measure

rf = Average risk free rate
p = Weighted average beta for

portfolio
MARCUS
rP fP()rMf

Jensen
3) Jensens Measure
=
p Alpha for the portfolio

p = Weighted average Beta
rf = Average risk free rate
rm = Average return on market index

portfolio
MARCUS
Information Ratio
Information Ratio = p / (ep)
The information ratio divides the alpha
of the portfolio by the nonsystematic
risk.
Nonsystematic risk could, in theory, be
eliminated by diversification.
MARCUS
Morningstar Risk-Adjusted
Return

MARCUS
M
r
M Measure
2P
*M
Developed by Modigliani and

Modigliani
Create an adjusted portfolio (P*)that
has the same standard deviation as
the market index.
Because the market index and P*
have the same standard deviation,
their returns are comparable:

MARCUS
M Measure: Example
Managed Portfolio: return = 35%
deviation = 42%
Market Portfolio: return = 28%
deviation = 30%
standard
standard
T-bill return = 6%
P* Portfolio:
30/42 = .714 in P and (1-.714) or .286
in T-bills
The return on P* is (.714) (.35) + (.286)
(.06) = 26.7%
MARCUS
Figure 24.2 M of Portfolio P

MARCUS
Which Measure is Appropriate?

It depends on investment assumptions
1)If P is not diversified, then use the Sharpe
measure as it measures reward to risk.
2) If the P is diversified, non-systematic risk
is negligible and the appropriate metric is
Treynors, measuring excess return to
beta.

MARCUS
Table 24.1 Portfolio

Performance
Is Q better than P?
MARCUS
Figure 24.3 Treynors

Measure

MARCUS
Table 24.3 Performance

Statistics

MARCUS
Interpretation of Table 24.3

If P or Q represents the entire investment,
Q is better because of its higher Sharpe
measure and better M2.
If P and Q are competing for a role as one
of a number of subportfolios, Q also
dominates because its Treynor measure is
higher.
If we seek an active portfolio to mix with
an index portfolio, P is better due to its
higher information ratio.
MARCUS
Performance Manipulation and the

MRAR
Assumption: Rates of return are
independent and drawn from same
distribution.
Managers may employ strategies to
improve performance at the loss of
investors.
Ingersoll, et al. study leads to MPPM.
Using leverage to increase potential
returns.
MRAR fulfills requirements
of the
MARCUS
Figure 24.4 MRAR scores with and

w/o manipulation

MARCUS
S
(e)
2
2PM
2H
Performance Measurement for

Hedge Funds
When the hedge fund is optimally

combined with the baseline portfolio,
the improvement in the Sharpe
measure will be determined by its
information ratio:

MARCUS
Performance Measurement with

Changing Portfolio Composition
We need a very
What if the mean
long observation
and variance are
period to measure
not constant? We
performance with
need to keep
any precision, even
track of portfolio
if the return
changes.
distribution is
stable with a
constant mean and
variance.
MARCUS
Figure 24.5 Portfolio Returns

MARCUS
rab()rc(r)e
2
P
fM
fM
fP
rP
a
b(r
)
c(r
)D
e
fM
fM
fP
Market Timing
In its pure form, market timing

involves shifting funds between a
market-index portfolio and a safe
asset.
Treynor and Mazuy:
Henriksson and Merton:

MARCUS
Figure 24.6 : No Market Timing; Beta Increases with

Expected Market Excess. Return; Market Timing with
Only Two Values of Beta.

MARCUS
Figure 24.7 Rate of Return of a Perfect

Market Timer

MARCUS
Style Analysis
Introduced by William Sharpe
Regress fund returns on indexes
representing a range of asset classes.
The regression coefficient on each index
measures the funds implicit allocation to
that style.
R square measures return variability due
to style or asset allocation.
The remainder is due either to security
selection or to market timing.
MARCUS
Table 24.5 Style Analysis for

Fidelitys Magellan Fund

MARCUS
Figure 24.8 Fidelity Magellan Fund

Cumulative Return Difference

MARCUS
Figure 24.9 Average Tracking Error

for 636 Mutual Funds, 1985-1989

MARCUS
Performance Attribution
A common attribution system
decomposes performance into three
components:
1. Allocation choices across broad
asset classes.
2. Industry or sector choice within each
market.
3. Security choice within each sector.
MARCUS
Attributing Performance to
Components
Set up a Benchmark or Bogey
portfolio:
Select a benchmark index portfolio
for each asset class.
Choose weights based on market
expectations.
Choose a portfolio of securities within
each class by security analysis.
MARCUS
Attributing Performance to
Components
Calculate the return on the Bogey
and on the managed portfolio.
Explain the difference in return based
on component weights or selection.
Summarize the performance
differences into appropriate
categories.

MARCUS
w
r
&
w
r
(w
r
w
r)
n
n
B
B
i
p
p
i
ii
1
i
1
n
n
p
B
p
i
B
i
i
1
i
1
n
p
B
i
1
Formulas for Attribution
Where B is the bogey portfolio and p is the

managed portfolio

MARCUS
Figure 24.10 Performance

Attribution of ith Asset Class

MARCUS
Performance Attribution
Superior performance is achieved by:
overweighting assets in markets
that perform well
underweighting assets in poorly
performing markets

MARCUS
Table 24.7 Performance Attribution

MARCUS
Sector and Security Selection

Good performance (a positive
contribution) derives from
overweighting high-performing
sectors
Good performance also derives from
underweighting poorly performing
sectors.

MARCUS

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What are the two common ways to measure average portfolio return?

What are the two common ways to measure average portfolio return?

What is the difference between time-weighted and dollar-weighted returns?

What is the difference between time-weighted and dollar-weighted returns?

Chapter Twenty Four

INVESTMENTS | BODIE, KANE,

Dollar- and Time-Weighted

Dollar- and Time-Weighted

Internal rate of return considering the

INVESTMENTS | BODIE, KANE,

INVESTMENTS | BODIE, KANE,

rG = [ (1.1) (1.0566) ]1/2 1 = 7.81%

The dollar-weighted average is less than the

INVESTMENTS | BODIE, KANE,

Adjusting Returns for Risk

Figure 24.1 Universe Comparison

INVESTMENTS | BODIE, KANE,

Risk Adjusted Performance:

rp = Average return on the portfolio

= Average risk free rate

INVESTMENTS | BODIE, KANE,

Risk Adjusted Performance:

rp = Average return on the portfolio

p = Weighted average beta for

Risk Adjusted Performance:

rp = Average return on the portfolio

rm = Average return on market index

INVESTMENTS | BODIE, KANE,

Developed by Modigliani and

INVESTMENTS | BODIE, KANE,

Figure 24.2 M of Portfolio P

INVESTMENTS | BODIE, KANE,

Which Measure is Appropriate?

INVESTMENTS | BODIE, KANE,

Table 24.1 Portfolio

Figure 24.3 Treynors

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Table 24.3 Performance

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Interpretation of Table 24.3

Performance Manipulation and the

Figure 24.4 MRAR scores with and

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Performance Measurement for

When the hedge fund is optimally

INVESTMENTS | BODIE, KANE,

Performance Measurement with

Figure 24.5 Portfolio Returns

INVESTMENTS | BODIE, KANE,

In its pure form, market timing

INVESTMENTS | BODIE, KANE,

Figure 24.6 : No Market Timing; Beta Increases with

INVESTMENTS | BODIE, KANE,

Figure 24.7 Rate of Return of a Perfect

INVESTMENTS | BODIE, KANE,

Table 24.5 Style Analysis for

INVESTMENTS | BODIE, KANE,

Figure 24.8 Fidelity Magellan Fund