Chapter Twenty-Four

Portfolio Performance
Evaluation

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 Overview
• If markets are efficient, investors must be able
to measure performance of their asset
managers

• Discuss methods to evaluate investment

performance

• Conventional approaches to risk adjustment

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 Time-Weighted Returns
• Time-weighted average
• Geometric average is a time-weighted average
• Each period’s return has equal weight

 1  rG    1  r1    1  r2   ...   1  rn 
n

rG   1  r1    1  r2   ...   1  rn  
1/ n
1

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 Dollar-Weighted Returns
(1 of 2)

• Dollar-weighted rate of return is the internal

rate of return on an investment
• Returns are weighted by the amount invested in
each period

C1 C2 Cn
PV    ...
1  r  1  r 
1 2
1  r  n

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 Dollar-Weighted Return
(2 of 2)

• Consider a stock paying a dividend of $2 annually that

currently sells for $50. You purchase the stock today, collect
the $2 dividend, and sell it for $53 at year-end.

• Using DCF approach, the IRR is equal to:

• The time-weighted (geometric average) return is 7.81%

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 Adjusting Returns for Risk
• Simplest and most popular way to adjust for
risk is to compare rates of return with those of
other investment funds with similar risk
characteristics
• Comparison universe is the set of money
managers employing similar investment styles,
used for assessing the relative performance of a
portfolio manager

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Universe Comparison

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 Risk-Adjusted Performance: Sharpe
• Sharpe’s ratio divides average portfolio excess
return over the sample period by the standard
deviation of returns over that period

• Measures reward to (total) volatility trade-off

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Risk-Adjusted Performance: Treynor
• Treynor’s measure is a ratio of excess return
to beta, like the Sharpe ratio, but it uses
systematic risk instead of total risk

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 Risk-Adjusted Performance: Jensen
• Jensen’s alpha is the average return on the
portfolio over and above that predicted by the
CAPM, given the portfolio’s beta and the
average market return

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 Risk-Adjusted Performance:
Information Ratio
• Information ratio divides the alpha of the
portfolio by the nonsystematic risk of the
portfolio, called “tracking error” in the
industry
• Measures abnormal return per unit of risk that in
principle could be diversified away by holding a
market index portfolio

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 M2 Measure and the Shape Ratio
• Focuses on total volatility as a measure of risk,
but its risk adjustment leads to an easy-to-
interpret differential return relative to the
benchmark index

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M2 of Portfolio P

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Appropriate Performance Measure

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 The Role of Alpha in
Performance Measures
• A positive alpha is necessary to outperform
the passive market index
• Though necessary, it’s not enough to guarantee a
portfolio will outperform the index
• Most widely used performance measure

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Performance Statistics

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 Interpretation of
Performance Statistics
• 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
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 Realized Returns versus Expected
Returns
• Must determine “significance level” of a
performance measure to know whether it
reliably indicates ability
• To estimate the portfolio alpha from the SCL, regress
portfolio excess returns on the market index
• Then, to assess whether the alpha estimate reflects
true skill and not just luck, compute the t-statistic of
the alpha estimate
• Even moderate levels of statistical noise make
performance evaluation extremely difficult
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 Survivorship Bias and Portfolio
Evaluation
• Regardless of the performance criterion, some
funds will outperform their benchmarks in any
year, and some will underperform
• Recall, performance in one period is not
predictive of future performance
• Limiting a sample of funds to those for which
returns are available over an entire sample
period introduces survivorship bias

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 Style Analysis
• Style analysis, a tool to systematically measure the
exposures of managed portfolios, was introduced by
William Sharpe
• Idea is to regress fund returns on indexes representing a
range of asset classes
• Regression coefficient on each index would then measure the
fund’s implicit allocation to that “style”
• R2 of regression would measure percentage of return variability
attributable to style choice rather than security selection
• Intercept measures average return from security selection of the
fund portfolio

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Style Analysis for Fidelity’s
Magellan Fund

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Fidelity Magellan Fund Cumulative
Return Difference

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Average Tracking Error for 636
Mutual Funds, 1985-1989

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 Performance Measurement with
Changing Portfolio Composition
• Risk-adjustment techniques all assume that
portfolio risk is constant over the relevant
time period, which isn’t necessarily true
• Performance Manipulation and the MRAR
• Managers may try to game the system, given their
compensation depends on performance
• Only measure impossible to manipulate is MRAR

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MRAR Scores with and without
Manipulation

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 Market Timing
• In its pure form, market timing involves
shifting funds between a market-index
portfolio and a safe asset
• Treynor and Mazuy:
rP  r f  a  b ( rM  r f )  c ( rM  r f )  eP 2

• Henriksson and Merton:

rP  r f  a  b ( rM  r f )  c ( rM  r f ) D  eP
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Characteristic Lines

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Performance of Bills, Equities, and
Perfect (Annual) Market Timers

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 Valuing Market Timing as a Call
Option
• Key to valuing market
timing ability is to
recognize that perfect
foresight is equivalent
to holding a call option
on the equity portfolio –
but without having to
pay for it!

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Performance Attribution Procedures
(1 of 2)

• Performance attribution studies attempt to

decompose overall performance into discrete
components that may be identified with a
particular level of the portfolio selection process
• A common attribution system decomposes
performance into three components:
1. Broad asset allocation choices across equity, fixed-
income, and money markets
2. Industry (sector) choice within each market
3. Security choice within each sector
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Performance Attribution Procedures
(2 of 2)

• Bogey is designed to measure the returns the

portfolio manager would earn if he or she
were to follow a completely passive strategy
• In this context, “passive” has two attributes
1. It means the allocation of funds across broad asset
classes is set in accord with a notion of “usual”
allocation across sectors
2. It means that within each asset class, the portfolio
manager holds an indexed portfolio

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 Asset Allocation Decisions
• Superior performance relative to the bogey is
achieved by:
• Overweighting investments in markets that turn out
to perform well
• Underweighting investments in poorly performing
markets
• Contribution of asset allocation to superior
performance equals the sum over all markets of
the excess weight in each market times the
return of the index for each market
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 Sector and Security Selection
Decisions

• Good performance (a positive contribution) derives

from overweighting well-performing sectors
• Good performance also derives from underweighting
poorly performing sectors
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