Portfolio Performance Evaluation
Part 2: Advanced Performance Evaluation
Lecturer: Ilaria Piatti
School of Economics and Finance
Overview
• Style Analysis
• Performance Measurement with Changing Portfolio Composition
• Market Timing
• Performance Attribution Procedures
Selection Bias and Portfolio Evaluation
• Selection Bias:
− In selecting outperforming funds recall that performance in one period is not predictive of
future performance!
− Survivorship bias: limiting a sample of funds to those for which returns are available over
an entire sample period
Style Analysis
• Style analysis was introduced by William Sharpe (1992) as a tool to systematically
measure the exposures of managed portfolios
• The idea is to regress fund returns on indexes representing a range of asset classes
• The regression coefficient to each index is the fund’s implicit allocation to that style
• The R-squared of the regression is the return variability due to style choice rather than
security selection
• The intercept of the regression is the average return from security selection
Style Analysis - Example
Sharpe’s style analysis
Example
Style Analysis for Fidelity’s Magellan Fund: Example
Style analysis for Fidelity’s Magellan Fund:
(Table 6)
Changing Portfolio Composition
• One potential problem of risk-adjustment techniques is that portfolio risk is assumed
constant over the period under analysis. . .
• Not a reasonable assumption when the time interval is long and the manager can
change portfolio composition!
• It’s important for actively managed portfolios to keep track of portfolio composition
and changes in portfolio average return and risk
• For example, if the manager decides to increase β to profit from a bullish market, the
Sharpe ratio of the full period might give misleading results
Changing Portfolio Composition - Example
Example
• Suppose that the Sharpe ratio of the market is SM = 0.4
• One year, the portfolio manager executes a low-risk strategy, with mean returns of 1%
and standard deviation of 2% ⇒ SP = 0.5
• Over the following year the manager executes a high-risk strategy with mean of 9%
and standard deviation 18% ⇒ SP = 0.5
• Over the 2 years (8 quarters) the mean and standard deviation are 5% and 13.42%
⇒ SP = 0.37
Changing Portfolio Composition - Example
Changing Portfolio Composition
Example
Market Timing
• Market timing involves shifting funds between a market index portfolio and a safe
asset, depending on whether the market index is expected to outperform
• Suppose an investor holds only the market index portfolio and T-Bills
• If the investor could correctly time the market, the β should increase with market
returns!
Market Timing Market Timing
Market Timing
• Treynor and Mazuy (1966) estimated the regression line:
rP − rF = a + b (rM − rF ) + c (rM − rF )2 + eP
• c > 0 implies market timing ability!
• Henriksson and Merton (1981) estimated a portfolio characteristic line as in Panel C:
rP − rF = a + b (rM − rF ) + c (rM − rF )D + eP
• D is a dummy variable that equals 1 when rM − rF > 0 and 0 otherwise
• The beta is b in bear markets and b + c in bull markets ⇒ c > 0 implies market
timing ability!
Performance Attribution Procedures
• Performance attribution attempts to decompose overall performance into different
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 allocation choices across equity, fixed income and money market
2. Industry (sector) choice within each market
3. Security choice within each sector
Performance Attribution Procedures
• Attribution method explains the difference between a managed portfolio P and a
benchmark portfolio B (Bogey)
• Bogey is designed to measure the returns the portfolio manager would earn if she were
to follow a completely passive strategy
• In this context, ’passive’ has two attributes:
1. Allocation of funds across asset classes is set in accord with a notion of usual allocation
across sectors
2. Within each asset class, the portfolio manager holds an indexed portfolio
Performance Attribution Procedures - Example
Performance Attribution Example
Example
Performance of the managed portfolio vs the Bogey:
(Table 7)
Performance Attribution Procedures - Example
Example
Performance Attribution Example
Performance attribution to asset allocation and security selection: