Lecture 12

INVESTMENT PORTFOLIO & WEALTH

MANAGEMENT PERFORMANCE
 Click to edit Master title style
CONTENT

1. Performance of wealth management

2. Performance of portfolio management

2.1. Investment rate of return

2.2. Passively managed portfolio

2.3. Actively managed portfolio

3. Limitation and constraints

 Performance of Wealth Management

Wealth management effectiveness encompasses multiple interconnected dimensions that work together to achieve client financial
objectives. Each component plays a critical role in overall portfolio success.

Financial Goals Cashflow Management Investment Effectiveness

Setting clear, measurable objectives Balancing income streams and Evaluating asset performance and
aligned with client risk tolerance and expenses to maintain liquidity and effectiveness to optimize returns
time horizons support investment strategies relative to risk

Financial Protection Tax Optimization

Implementing risk management strategies to safeguard Structuring investments to minimize tax burden and
wealth against unexpected events maximize after-tax returns
Performance of Portfolio Management

Portfolio Management Process

The portfolio management process follows a systematic approach that
ensures consistent evaluation and adjustment of investment strategies. This
cyclical process enables managers to respond to changing market
conditions while maintaining alignment with client objectives.
 Portfolio Management Process

(6) Rebalancing (4a)

Investment policy
(1a) (1b) monitoring
Identify and quantify Building investment
investor objectives, policies
limitations, and (3) Portfolio
preferences Construction
Asset Allocation,
(5) Evaluating
Optimal Portfolio,
Security Selection portfolio
(2b) management
(2a) performance
Assessment of
Reassess the capital market
economic, political, expectations
social and financial (4b)
conditions Monitor economic
and market factors

(6) Rebalancing
 Purpose of Portfolio Management Performance Evaluation

Key Evaluation Objectives

1 2

Assess Management Capability Demonstrate Excess Returns

Evaluate the portfolio manager's skills in generating superior • Asset allocation expertise
returns through strategic asset allocation, security selection, and
market timing • Asset selection ability

• Market timing proficiency

2

Provide Concrete Evidence Portfolio Diversification

Deliver quantifiable proof of management effectiveness through
specific metrics and benchmarks • Systematic risk

• Unsystematic risk
3

Monitor Investment Policy

Track adherence to investment strategies and policy

guidelines, including systematic and non-systematic risk
management
 Portfolio Management Performance

Investment Goal Achievement:

- Rate of Return: Average Rate of Return v.s. Time –weighted & Money –weighted rate of return,
Beating the market
- Risk: Standard Deviation, Beta, VaR, Expected Shortfall, Tracking Error

Risk-adjusted Performance Measures (Risk adjusted return)

- Sharpe
- Treynor
- Jensen’s Alpha
- ….
 Return Calculation Methods:
Time-Weighted vs Money-Weighted

Portfolio performance can be measured using two

distinct methodologies

Time-Weighted Return (TWR)

Money-Weighted Return (MWR)

 Time-Weighted Return (TWR) Methodology

The rate of return must be recalculated when capital flows arise.

Link Sub-Period Returns

Calculate Period Returns Calculate the rate of return for the
Identify Cash Flow Periods Compute the return for each entire investment period
Divide the investment period into individual sub-period
sub-periods based on when cash
flows occur

TWR Formulas
Total Period Return: R(twr) = (1+Rt,1) × (1+ Rt,2) × … × (1+Rt,n) – 1
Average Period Return: R(twr) (period) = [1+R(twr)]1/n – 1
Where n represents the number of investment periods
 Money-Weighted Return (MWR) Methodology

Money-Weighted Return measures the actual return experienced by investors, accounting for
both the timing and magnitude of cash flows.

Key Formula Components

• MV1 and MV0: Portfolio value at the end and beginning of the period
• m: Number of time units in the period (e.g., days in a month)
• CFi: The i-th cash flow amount
• L(i): Number of time units from period start to the i-th cash flow
• R: Return per time unit during the investment period

MWR for the entire investment period =

where m is the number of periods in the investment horizon

TWR vs MWR: Comprehensive Comparison
Understanding the distinction between Time-Weighted and Money-Weighted returns is crucial for proper
performance evaluation and selecting the appropriate metric for different analytical purposes.

Time-Weighted Return (TWR) Money-Weighted Return (MWR)

Total Period Return: Period Return (from formula):

R(TWR) = (1+Rt,1) × (1+ Rt,2) × … × (1+Rt,n) – 1 Solve for R in the MWR equation

Average Period Return:

R(TWR) = [1+R(TWR giai đoạn đầu tư)]1/n – 1

Total Period Return:
• Eliminates cash flow timing effects
R(MWR) = (1+R)^m - 1
• Best for comparing managers
• Reflects actual investor experience
• Industry standard for performance reporting
• Incorporates timing of contributions
• Useful for personal performance tracking
 Example 1: TWR and MWR Calculation

Scenario: A stock portfolio begins with an initial investment of $2,500,000 and generates returns of 25% in year one and 18% in year
two. At the beginning of year two, an additional $50,000 is contributed. Calculate both TWR and MWR.

Time-Weighted Return Money-Weighted Return

Total 2-Year Return: Ending period Portfolio Value:

R(2 years) = (1+25%)×(1+18%) – 1 = 0.475 = 47.5% MV1 = [(2,500,000 + 2,500,000×25%) + 50,000]×(1+18%) =

3,082,750
Average Annual Return:
Solve for R:
R(annual) = [1+0.475]^(1/2) – 1 = 0.214 = 21.4%
3,082,750 = 2,500,000(1+R)² + 50,000(1+R)

R = 22.41% (average annual)

Notice that MWR (22.41%) exceeds TWR (21.4%) because the additional contribution was made after strong first-year
performance, allowing it to benefit from second-year gains.
 Example 1: Step-by-Step Solution Framework

Time-Weighted Return Calculation

TWR for entire period: (1+25%)(1+18%) - 1 = ____%

TWR average per year: (1+____)^(1/2) – 1 = ____%

Money-Weighted Return Calculation

Set up equation:

[50,000 + 2,500,000(1+25%)](1+18%) = 2,500,000(1+R)² + 50,000(1+R)¹

Solve quadratic equation: R = MWR average annual = ____

Total period MWR: (1+MWR)^m - 1 = ____

This framework demonstrates the systematic approach to calculating both return metrics, highlighting the mathematical
differences between the two methodologies.
 Example 2: Larger Cash Flow Impact

Same portfolio with $2,500,000 initial investment, 25% return in year one, and 18%

return in year two. However, the additional contribution at the beginning of year two

is now $1,000,000. Calculate both TWR and MWR.

 Example 2: Calculation with Large Cash Flow

Time-Weighted Return
TWR for entire period:
(1+25%)(1+18%) - 1 = ____%
TWR average per year:
(1+____)^(1/2) – 1 = ____%

Money-Weighted Return
Setup equation:
[1,000,000 + 2,500,000(1+25%)] × (1+18%) = 2,500,000(1+R)² + 1,000,000(1+R)¹
Solve for R: MWR average annual = ____
Total period: (1+MWR)^m - 1 = ____
 Example 3: Multi-Period with Multiple Cash Flows

Complex Scenario: Stock portfolio with $2,500,000 initial investment generates returns of 25% (year 1), 18%
(year 2), and 15% (year 3). Additional contributions occur at the beginning of year two ($50,000) and year
three ($35,000). Calculate TWR and MWR.

Year 3
Year 1
Contribution: +$35,000
Initial: $2,500,000
Return: 15%
Return: 25%
Final period
No cash flow

1 2 3

Year 2
Contribution: +$50,000
Return: 18%
Growing base
 Click to edit Master title style
CONTENT

1. Portfolio effectiveness

2. Evaluation of portfolio management

performance

2.1. Investment rate of return

2.2. Passively managed portfolio

2.3. Actively managed portfolio

3. Limitation and constraints

 Return-Based Performance Measurement

If fund managers are producing high returns simply by accepting more risk, they should not be
compensated for that.

Benchmark Alpha

AlphaBM = E[(Active Return) – (Benchmark Return)]

This metric isolates the value added beyond what could be achieved
through passive benchmark exposure.
 Return-Based Performance Measurement

Consider a portfolio manager who borrows $1 for every $1 raised and invests entirely in the
benchmark portfolio.

Return Formula:
Active Return = 2×Benchmark Return - Rf
Benchmark Alpha:
AlphaBM = E[(Benchmark Return – Rf)] > 0

The benchmark's alpha always equals zero: AlphaBM = E[(Active Return) – (Benchmark
Return)] = 0.

Critical Questions
• Why would you choose this manager?
• Could you replicate this strategy yourself with leverage?
• How do we measure the investment performance?
 CAPM-Based Performance Measurement

The Capital Asset Pricing Model provides a framework for evaluating

portfolio performance by comparing actual returns to theoretically
expected returns based on systematic risk exposure.
Core Principle
Compare the actual portfolio return with the return that could be
achieved by combining the market portfolio and the risk-free rate

No consideration for investment form

Total Risk Measures Systematic Risk Measures

Evaluate performance considering all Focus on market-related risk only,
sources of portfolio volatility, including assuming diversification has
both systematic and unsystematic risk eliminated unsystematic risk

Information Ratios
The Information Ratio (IR) is a measure of a portfolio's risk-adjusted performance
relative to a benchmark. It assesses a fund manager's or investment strategy's ability
to generate returns that exceed the risk of the portfolio.
 CAPM-Based Performance Measurement

Total risk measures capture the complete volatility

E(r)
of a portfolio
P
P’

Standard Deviation (σ)

Measures the total volatility of returns, including
M
both systematic (market) risk and unsystematic
(specific) risk. Higher standard deviation indicates
greater uncertainty in expected returns.
STD
 The Sharpe Ratio

The Sharpe Ratio: Use the capital market line as a benchmark to evaluate portfolio
performance.
Evaluate the risk premium of the portfolio based on the overall risk of the portfolio
𝑬(𝑹)𝑷 − 𝑹𝒇
Sharpe Ratio =
𝜹(𝑹𝒑)

• E(R)p = Portfolio return

• Rf = Risk-free rate
• σ(Rp) = Portfolio standard deviation

Higher Sharpe = Better Performance

A higher ratio indicates more return per unit of risk, suggesting more efficient use of
volatility
 Sharpe Ratio: Example

Given Information: Market return (RM) = 14%, Risk-free rate (RFR) = 8%, Market
standard deviation (σM) = 20%

Evaluate the following portfolios using the Sharpe Ratio and compare them to the
market portfolio M:

Portfolio D 13% 18%

Portfolio E 17% 22%
Portfolio F 16% 23%
 Sharpe Ratio: Example

0.14-0.08
SM = -------------- = 0.3
0.2
0.13-0.08
SD = -------------- = 0.278
0.18
SE = 0.17-0.08
-------------- = 0.409
0.22
SF = 0.16-0.08
-------------- = 0.348
0.23

Portfolio E delivers the highest excess return per unit of risk, significantly
outperforming both the market and other portfolios.
 Sharpe Ratio: Example

SE CML
SF

0.14
SM

SD
0.08

0.2 STD
 M² (M-Squared) ratio

Developed by Leah and Franco Modigliani, M² adjusts portfolio risk to market risk using the risk-free borrowing or lending rate
(similar to CAL)

M² > 0 indicates outperformance M² < 0 indicates underperformance A larger M2 value implies better
relative to the market relative to the market investment performance.

Portfolios can be ranked similarly to

the Sharpe ratio.

Formula
𝑀2 = 𝑟𝑝∗ − 𝑟M
𝑟𝑝∗ = 1 − w 𝑟ഥ𝑓 + w. 𝑟ഥp
𝜎𝑀
w= ൗ𝜎p = Investment weight in portfolio P

Where the portfolio is scaled to have the same volatility as the market, then performance is compared.
 M² (M-Squared) ratio

Advantage of M²
Easier to interpret than Sharpe Ratio because
results are expressed in familiar percentage-
point terms rather than abstract ratio values
Source: Andrey Ukhov, Portfolio Performance Evaluation,
Indiana University
 M² (M-Squared) ratio

Example
Portfolio P: Rp=10%; standard deviation = 18%.
Portfolio M: Rp=11%; standard deviation =20%.

w = .20 / .18 = 1.1111

*
rP = ( −0.1111)(.05) + (1.1111)(.10) = .1056
2
MP = .1056 − .11 = −.0044

Portfolio P underperforms the market by 44 basis points (based on risk-adjusted returns)

This measure is easier to understand than Sharpe
 Systematic Risk Measures

Systematic risk measures focus exclusively on market-related

risk, assuming that diversification has eliminated unsystematic
(specific) risk. These metrics are appropriate for well-diversified
E(r)-rf portfolios
P
SML
P’

Beta (β) Diversification Assumption

M Measures sensitivity to These measures assume
market movements. β=1 unsystematic risk has
moves with market; β>1 been diversified away,
amplifies market moves; leaving only market-
β β<1 dampens market related volatility
moves
 Jensen's Alpha

Jensen's Alpha compares actual portfolio returns to CAPM-predicted returns, isolating the value added (or
destroyed) by active management after accounting for systematic risk. High αP coefficient means better
investment efficiency

Positive Alpha (αP > 0) Zero Alpha (αP = 0)

Portfolio outperforms Portfolio performs exactly
CAPM expectations as predicted by CAPM,
indicating no value added
beyond market exposure

Negative Alpha (αP < 0)

Portfolio underperforms CAPM expectations

In practice, αP is estimated by running the regression: rp,t – rf,t = αp + βp[rm,t – rf,t] + εp,t.
Jensen's Alpha
 The Treynor Ratio

Jack Treynor pioneered the evaluation of portfolio performance based on systematic risk.

Market risk, measured by the SML Slope

Measures the relative volatility of a

portfolio's return compared to the
Two Risk Components market return – Beta
Market risk (systematic), and
specific risk (unsystematic)

Specific risk
The volatility around the SML is considered
the portfolio's individual risk due to the
individual risk of each security – fully
diversified away.
 Treynor Ratio: Formula and Calculation

Formula
P
𝑬(𝑹)𝑷 − 𝑹𝒇 Modified Treynor ratio TP =
Treynor Ratio: 𝑻(𝑷) = P
𝜷𝒑
Where:

• E(Rp): Portfolio expected return

• Rf: Risk-free rate
• 𝛽𝑝 : Portfolio beta (systematic risk)

Interpretation Risk Premium Measure Applicable Portfolios

Higher Treynor Ratio indicates Measures the risk premium per Applies to portfolios that are
steeper SML slope, unit of systemic risk correlated with the SML line
representing better risk-
adjusted performance and
more excess return per unit of
market risk
 Treynor Ratio: Interpretation and Meaning

The Treynor Ratio provides powerful insights when compared against benchmarks or other portfolios.

Market Comparison

Market Treynor Ratio: TM = (RM - Rf) / βM

Since βM = 1: TM = RM - Rf

TP > TM TP = TM TP < TM
Portfolio P lies above the SML Portfolio lies exactly on the SML, Portfolio lies below the SML,
and exhibits a greater risk- earning fair compensation for indicating underperformance
adjusted excess return than the systematic risk with no alpha relative to expected returns
market. generation given its systematic risk
 Calculating Beta in Excel: Two Methods

Method 1: Covariance Formula Method 2: Slope Function

Mathematical approach using covariance and variance: Direct calculation using Excel's regression slope:

β = Covar(rs, rm) / Var(rm) Excel formula:

Excel formula:

=COVAR.S(range of % change of equity, range of % change =SLOPE(range of % change of equity, range of % change of
of index) / VAR.S(range of % change of index) index)
 Example: Calculating Sharpe and Treynor

Given: S&P500 average return over 10 years (Rm) = 14%, Risk-free rate (Rf) = 8%
The managers' average portfolio management results over the past 10 years are presented in the
following table.
Calculate Sharpe and Treynor ratios for each portfolio manager and evaluate their performance:

Manager Average Beta Standard Sharpe Treynor

annual return deviation

W 0.12 0.9 0.11 (0.12-0.08)/0.11 (0.12-0.08)/0.9

X 0.16 1.05 0.18 (0.16-0.08)/0.18 (0.16-0.08)/1.05

Y 0.18 1.2 0.175 (0.18-0.08)/0.175 (0.18-0.08)/1.2

 Example

Return
0.14-0.08 TY
TM ------------- 0.060
1
SML
TX
0.12-0.08
TW ------------- 0.044
0.09 0.14
TM
0.16-0.08
TX ------------- 0.076
1.05 TW

0.08
0.18-0.08
TY ------------- 0.083
1.2

1
beta
 Special Case: Negative Beta Portfolios

The Treynor Ratio can produce negative values in some scenarios,

Scenario 1: Poor Performance Scenario 2: Negative Beta

Poor portfolio management results, below the This portfolio still has the potential to lie above the
risk-free rate of return, leading to a negative risk SML. In this case, compare the required return
premium. This portfolio will lie below the SML. (CAPM) with the actual return of the portfolio.

Example: RP = 6%, Rf = 8%, β = 1.2 Example: RP = 10%, Rf = 8%, β = -0.2

T = (6%-8%)/1.2 = -0.017 T = (10%-8%)/(-0.2) = -0.10

Critical Point: For negative beta portfolios, compare actual returns to CAPM expected returns rather
than relying on the Treynor Ratio value alone.
 Negative Beta Example

Since negative betas can make T values ​misleading, investors often plot their portfolios on the SML or

compare this expected return with the actual return.

This comparison tells them whether the actual return is higher or lower than the expected return.

E(RG)= RFR + βi (RM –RFR)

= 0.08 + (-0.2)x0.06 = 0.068

Comparing this required return of 6.8% with the actual return of 10% shows that portfolio manager G has

done a very good job of managing the portfolio.

Sharpe vs Treynor: Comparison

Risk Measure Difference

While Sharpe ratio measures total risk (as the degree of volatility in
returns captures all elements of risk - systematic as well as
unsystematic), the Treynor ratio captures only the systematic risk in
its computation.

Diversification Assessment
When the fund is not fully diversified, Sharpe ratio would be a better
measure of performance and when the portfolio is fully diversified,
Treynor ratio would better justify the performance of a fund.

Portfolio Rankings

For fully diversified portfolios, both metrics produce identical rankings.

 Choosing Between Sharpe and Treynor

Selecting the appropriate performance metric depends on the portfolio's characteristics and the investor's overall
portfolio context.

Single Stock or Sector Portfolio Well-Diversified Multi-Stock Portfolio

Use: Sharpe Ratio Use: Either Sharpe or Treynor
High unsystematic risk makes total risk the Unsystematic risk has been largely eliminated, so
appropriate measure. both metrics will rank portfolios similarly. Treynor may
be preferred for simplicity.

Moderately Diversified Portfolio Poorly Diversified Portfolio

Use: Sharpe Ratio Use: Sharpe Ratio
Substantial unsystematic risk makes Treynor
A moderately diversified portfolio still contains a
meaningful amount of unsystematic risk. The Treynor inappropriate. Total risk measurement is essential.
ratio ignores this risk.
 Attribution Analysis: Allocation vs Selection

A portfolio manager can add value to an investor's portfolio through one of two ways: selecting securities with
potential or choosing the timing of investments through allocating investment capital to different asset classes and
market segments. In this case, attribution analysis is used to analyze the components that make up the overall
performance of the portfolio.

Asset Allocation Effect Security Selection Effect

Allocation effect Asset selection efficiency
measures the portfolio measures a portfolio
manager's decision to manager's ability to
over- or under-weight a construct a portfolio of
particular market market/asset segments that
segment or asset class. can generate returns that
exceed those of comparable
market/asset segments
structured in a benchmark
index portfolio.
 Attribution Analysis: Allocation vs Selection

R(A) – R(B) =Alpha= Allocation + Asset Selection

Allocation = σ𝑖 (𝑤iA − 𝑤iB )𝑥 (𝑅iB − 𝑅B )

Asset Selection Effect = σ𝑖 (𝑤iA )𝑥 (𝑅iA − 𝑅iB )

In which:

𝑅A , 𝑅B : Average return of actual portfolio (A) and benchmark index portfolio (market portfolio or

Benchmark portfolio (B))

𝑤𝑖A , 𝑤𝑖B : weight of asset i in the actual portfolio of the Investment Manager and in the benchmark

index portfolio (or market portfolio

𝑅𝑖A , 𝑅𝑖B : the rate of return of the i-th asset in the actual portfolio and in the benchmark index portfolio

(market portfolio)
 Attribution Analysis: Practical Example

Evaluate a portfolio manager's asset allocation and asset selection using the following data:

Asset Actual return (2) Actual Weight (3) Benchmark weight (4) Index return (5)

Stock 5% 0.80 0.53 3.0%

Bond 1.5 0.15 0.35 1.6

Cash 0.1 0.05 0.12 0.1

1. Evaluate the manager's overall performance compared to the benchmark portfolio based on total returns

2. Assessing the manager's asset allocation and security selection performance