CHAPTER EIGHT

PORTFOLIO MANAGEMENT
Learning Objectives

• Explain the major requirements do clients expect from their portfolio

managers.
• Discuss what can a portfolio manager do to attain superior performance.
• Show the peer group comparison method of evaluating an investor’s
performance.
• Discuss the Treynor portfolio performance measure.
• Discuss the Sharpe portfolio performance measure.
• Identify the critical difference between the Treynor and Sharpe
portfolio performance measures.
• Discuss the Jensen portfolio performance measure and how can it be
adapted to include multifactor models of risk and expected return?
The Concept of Portfolio
Performance Evaluation
• Investors always are interested in evaluating the
performance of their portfolios.
• The portfolio management process can be viewed in
three steps:
1) Analysis of Capital Market and Investor-Specific
Conditions; Strategic Asset Allocation Decision
2) Formation of Asset Class-Specific Portfolios; Security
Selection Decision
3) Analysis of Investment Performance; Performance
Measurement Analytics
Need for Portfolio Evaluation

• Whenever an investor employs resources, be it in

the form of hiring employees for his company,
establishing a charitable fund or investing money
in an investment fund he will want to measure the
performance of his investment.
• The investment manager will be bound to the
investment policy and subject to a constant
evaluation of his achievements. His achievement
will be the return on the capital the investor
provided.
Cont…

• At this point one will have to determine whether

the achieved return was good or poor and
whether it was skill or luck? This is the punch
line investors are always facing when entrusting
their money to an investment manager.
• The evaluation now boils down to two main
questions. The first question the investor will
want to address is the question of performance.
Cont…

• What is good and what is poor performance

and where is the line in between – the
benchmark – and what to take as the
benchmark.
• Should we employ the performance of a
riskless asset e.g. a T-bond, a generic like the
S&P 500 or other portfolio manager's
performance as the benchmark?
Cont…

• Unfortunately, these simplistic measures of

performance generally do not produce the
desired degree of specification.
• The investor will also want to find out whether his
investment manager is skillful of fortunate
through an evaluation process, which can be
applied to his manager and thereby finding what
kind of constraints may help to get the
investment manager to achieve the goal set by
the investor.
8-7
Composite Portfolio
Performance Measures
• There are four portfolio performance
evaluation techniques (referred to as
composite performance measures) that
consider return and risk.
• These measures are:
1) Peer group comparisons (simple performance measure)
2) Treyor portfolio performance measure
3) Sharpe portfolio performance measure
4) Jensen portfolio performance measure.
Peer Group Comparisons (Simple
Performance Measure)
• The most straightforward way to evaluate the
investment performance of a particular portfolio
manager is a peer group comparison.
• This is accomplished by calculating a portfolio’s relative
return ranking compared to a collection of similar funds.
• It is the most common manner of evaluating portfolio
managers, collects the returns produced by a
representative universe of investors over a specific
period of time and displays them in a simple boxplot
format.
Advantages of a peer group
comparison
• It is relatively simple to produce.
• The goal is to compare the return generated
by a given fund relative to other portfolios that
follow the same investment mandate.
Disadvantages of a peer group
comparison
• It requires the designation of a peer group, which
may be difficult depending on the degree of
specialization for the fund in question.
• It does not make an explicit adjustment for risk
differences between portfolios in the peer group.
• Risk adjustment is implicit assuming that funds
with the same objective should have the same
level of risk.
Treynor Portfolio Performance
Measure
• Treynor developed the first composite measure of
portfolio performance that included risk.
• He postulated two components of risk:
1) risk produced by general market fluctuations and
2) risk resulting from unique fluctuations in the portfolio
securities.
• To identify risk due to market fluctuations, he introduced
the characteristic line, which defines the r/p b/n the rates
of return for a portfolio over time and the rates of return
for an appropriate market portfolio.
Cont…

• He noted that the characteristic line’s slope

measures the relative volatility of the
portfolio’s returns in relation to returns for the
aggregate market.
• The slope of characteristic line is the
portfolio’s beta coefficient.
• A higher slope (beta) characterizes a portfolio
that is more sensitive to market returns and
that has greater market risk.
Cont…

• Deviations from the characteristic line indicate

unique returns for the portfolio relative to the market.
• These differences arise from the returns on
individual stocks in the portfolio.
• In a completely diversified portfolio, these unique
returns for individual stocks should cancel out.
• As the correlation of the portfolio with the market
increases, unique risk declines and diversification
improves.
Cont…

• Treynor was interested in a measure of performance

that would apply to all investors regardless of their risk
preferences.
• Building on developments in capital market theory, he
introduced a risk-free asset that could be combined with
different portfolios to form a straight portfolio possibility
line.
• He showed that rational, risk-averse investors would
always prefer portfolio possibility lines with larger slopes
because such high-slope lines would place investors on
higher indifference curves.
Cont…

• The slope of this portfolio possibility line

(designated T) is equal to:
Cont…

• As noted, a larger T value indicates a larger

slope and a better portfolio for all investors
(regardless of their risk preferences).
• Because the numerator of this ratio (R─RFR) is
the risk premium and the denominator is a
measure of risk, the total expression indicates
the portfolio’s risk premium return per unit of risk.
• All risk-averse investors would prefer to
maximize this value.
Cont…

• Note that the risk variable beta measures

systematic risk and tells us nothing about the
diversification of the portfolio.
• It implicitly assumes a completely diversified
portfolio, which means that systematic risk is
the relevant risk measure.
Cont…

• Comparing a portfolio’s T value to a similar

measure for the market portfolio indicates
whether the portfolio would plot above the
SML.
• Calculate the T value for the aggregate
market as follows:
Example: Treynor Portfolio
Performance Measure
• To understand how to use and interpret this
measure of performance, suppose that during
the most recent 10-year period, the average
annual total rate of return (including
dividends) on an aggregate market portfolio,
such as the S&P 500, was 14 percent (RM =
0.14) and the average nominal rate of return
on government T-bills was 8 percent (RFR=
0.08).
Cont…

• Assume that, as administrator of a large

pension fund that has been divided among
three money managers during the past 10
years, you must decide whether to renew your
investment management contracts with all
three managers. To do this, you must
measure how they have performed.
Cont…

• Assume you are given the following results:

Cont…

• You can compute T values for the market

portfolio and for each of the individual portfolio
managers as follows:
Sharpe Portfolio Performance
Measure
• Sharpe likewise conceived of a composite
measure to evaluate the performance of
mutual funds.
• The measure followed closely his earlier work
on the capital asset pricing model (CAPM),
dealing specifically with the capital market line
(CML).
Cont…

• The Sharpe measure of portfolio performance

(designated S) is stated as follows:
Cont…

• The following examples use the Sharpe

measure of performance. Again, assume that
RM = 0.14 and RFR = 0.08.
• Suppose you are told that the standard
deviation of the annual rate of return for the
market portfolio over the past 10 years was
20 percent (σM = 0.20).
Cont…

• Now you want to examine the performance of

the following portfolios:
Cont…

• The sharp measures for these portfolios are

as follow:
Cont…

• The D portfolio had the lowest risk premium

return per unit of total risk, failing even to
perform as well as the aggregate market
portfolio.
• In contrast, Portfolios E and F performed
better than the aggregate market: Portfolio E
did better than Portfolio F.
© 2012 Pearson Prentice Hall. All rights reserved. 8-30
© 2012 Pearson Prentice Hall. All rights reserved. 8-31
© 2012 Pearson Prentice Hall. All rights reserved. 8-32
End of Chapter Seven

• Questions???