CHAPTER FIVE
PORTFOLIO PERFORMANCE EVALUATION
Portfolio Performance Measures
Portfolio performance evaluation involves determining
periodically
how the portfolio performed in terms of not only the return
earned,
but also the risk experienced by the investor.
The market value of a portfolio at a point of time is
determined by adding the markets value of all the securities
held at that particular time.
The essential idea behind performance evaluation is to
compare the returns which were obtained on portfolio if more
appropriate alternative portfolios had been chosen for the
investment.
Conti--
Such comparison often referred to as benchmark portfolios.
The benchmark should reflect the objectives of the investor.
1. Simple benchmark index(peer group comparison)
This is probably the most commonly used approach to involves a simple
comparison between the portfolio’s return and the return on a benchmark index
2. Risk Adjusted Performance Measures
Investment performance measures combine the return measure of the fund
with the risk measure of the fund.
There are four well-established portfolio performance measures (Risk
Adjusted Performance Measures) used widely in practice:
The four commonly used measures are:
Sharpe Ratio
Treynor Ratio
Jensen’s Alpha
Information Ration
Sharpe Ratio:
This measure ranks investment performance on the basis of the portfolio's risk
premium earned per unit of risk,
where risk is measured by the standard deviation of the set of historical returns
(i.e., σp). That is, for the p-th portfolio calculate
S p = (Rp - R F )
p
Example: Assume the market return is 14% with a standard deviation of 20%, and
risk-free rate is 8%. The average annual returns for Managers D, E, and F are
13%, 17%, and 16% respectively. The corresponding standard deviations are
18%, 22%, and 23%. What are the Sharpe measures for the market and
managers?
Ans: The Sharpe Measures
Sharpe Measures for the Market
– SM = (14%-8%) / 20% =0.300
Sharpe Measures for the Managers
– SD = (13%-8%) / 18% =0.273
– SE = (17%-8%) / 22% =0.409
– SF = (16%-8%) / 23% =0.34
Conti---
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, Portfolio E and F performed better than the aggregate
market: Portfolio E did better than Portfolio F.
2. Treynor Ratio:
Like the Sharpe ratio, the Treynor measure assesses performance on
the basis of a ratio of average excess return to risk.
The difference is that Treynor considers only the systematic
component of a portfolio's risk to be relevant.
Letting βp be the portfolio's beta coefficient, the Treynor ratio is
calculated as follows:
Tp = (Rp - RF)
p
Conti------
Example: Assume the market return is 14% and
risk-free rate is 8%. The average annual returns for
Managers W, X, and Y are 12%, 16%, and 18%
respectively. The corresponding betas are 0.9, 1.05,
and 1.20.
What are the the Treynor ratio (T values) for the
market and managers?
Ans:
– TM = (14%-8%) / 1 =6%
– TW = (12%-8%) / 0.9 =4.4%
– TX = (16%-8%) / 1.05 =7.6%
– TY = (18%-8%) / 1.20 =8.3%
3. Jensen’s Alpha:
Unlike the previous two measures, which summarize the
historical return data by taking simple averages, the Jensen
procedure estimates the coefficients of the following time-
series regression for each portfolio:
(Rpt - RFt) = αp + βp(Rmt - RFt) + εt ; t = 1, ... , N
In this procedure, αp is the performance index.
According to the CAPM, Jensen's alpha should be equal to
zero.
Thus, if it is significantly above (below) zero, you can
conclude that the portfolio manager has significantly
outperformed (underperformed) the market, after adjusting for
the risk of his or her investment.
There are three advantages to Jensen's alpha as a
performance measure:
a) It is a byproduct of a regression, its statistical
validity can be established directly,
b) it can be interpreted as the level of return that
the manager generated in excess (deficient) of
what he or she should have earned given the
risk of the investment, and
c) it can be adapted to other models of estimating
expected returns besides the CAPM (e.g.,
Fama-French three-factor model).
4. Information Ratio
The information ratio (also known as an appraisal
ratio) measures a portfolio’s average return in
excess of that of a comparison or benchmark
portfolio divided by the standard deviation of this
excess return.
Formally, the information ratio (IR) is calculated as:
Information Ratio = αp / s(ep)
R
p,t − rf, t = p + p (RM,t − rf ,t )+ p,t
Note that : Nonsystematic risk could, in theory, be
eliminated by diversification
•
Exercise: Consider the following data for a particular sample
period:
Portfolio P Market M
Average return 35% 28%
Beta 1.20 1.00
Standard deviation 42% 30%
Nonsystematic risk, σ(e) 18% 0
The T-bill rate during the period was 6%.
Required : Compute the Sharp ratio Treynor ration ,
Jensens alpha and Information ratio for portfolio P and
Market M and evaluate the performance of the portfolio
with the market
Quize
1. list down the four portfolio performance measuring
indicators? (1.5 point)
2. To analyse security we have to use three fundamental
analysis tools. List down them (1 point)
3. What is GDP? (1 point)
4. Explain some key variables to describe the state of economy?
(1.5 point)