Download Chapter 20

Chapter 20
EVALUATION OF PORTFOLIO
MANAGEMENT
Chapter 20 Questions
What are some methods used to evaluate
portfolio performance?
What are the differences and similarities
between the various portfolio performance
measures?
When we evaluate a sample of portfolios,
how do we determine how well diversified
they are?
How do the various performance measures
relate to each other in terms of rankings?
Chapter 20 Questions
What are clients’ major requirements of their
portfolio managers?
What important characteristics should any
benchmark possess?
What is the benchmark error problem, and
how does it affect portfolio performance
measures?
What impact has global investing had on the
significance of the benchmark error problem?
Chapter 20 Questions
What two methods can be used to determine
a portfolio’s style exposure over time?
What is portfolio performance attribution
analysis? How does it assist the process of
analyzing a manager’s performance?
How do bond-portfolio performance
measures differ from equity-portfolio
performance measures?
Chapter 20 Questions
What measure of risk is used in the
Wagner and Tito bond-portfolio
performance measure?
What are the components of the Dietz,
Fogler, and Hardy bond-portfolio
performance measure?
Judging Portfolio
Performance
Regardless of the style
of management, it is
important to
evaluate whether
portfolio results
match the goals of
the portfolio
managers.
Composite Portfolio
Performance Measures
How can we evaluate portfolio performance?



Calculate excess returns as the difference
between portfolio returns and a returns from a
return-generating model like the CAPM.
Relative return ratios, which measure return per
unit of risk
Scaled return methods, which adjusts the portfolio
return for risk so that it can be directly compared
to the benchmark return
Composite Portfolio
Performance Measures
Excess Returns Methods

Jensen Measure




Calculates excess returns based on the CAPM
Jensen’s alpha represents how much the manager
contributes to portfolio (j) returns
aj = Rjt –(RFRt + bj(Rmt-RFRt))
Superior managers will generate a significantly positive
alpha; inferior managers will generate a significantly
negative alpha
Could use APT as the return-generating model
Composite Portfolio
Performance Measures
Relative Return Ratios

Sharpe Portfolio Performance Measure
Based on the Capital Market Line, considers
the total risk of the portfolio being evaluated
S=(Rportfolio-RFR)/sportfolio
 Shows the risk premium earned over the risk
free rate per unit of total risk
 Sharpe ratios greater than the ratio for the
market portfolio indicate superior performance
(plot above the CML)

Composite Portfolio
Performance Measures
Relative Return Ratios

Treynor Portfolio Performance Measure
Based on the CAPM, considers the risk that
cannot be diversified, systematic risk
T=(Rportfolio-RFR)/bportfolio
 Shows the risk premium earned over the risk
free rate per unit of systematic risk
 Treynor ratios greater than the market risk
premium indicate superior performance (plot
above the SML)

Information Ratios
Let Rpt = the return on a portfolio in period t
RBt = the return on the benchmark portfolio in period t
Dt = the differential return in period t
Dt = Rpt - RBt
D = the average value of Dt over the period examined
T
D
D
t 1
t
sD = the standard deviation of the
differential return during the period
N
The historic (ex post) Sharpe Ratio (S) is:
S
D
sD
Composite Portfolio
Performance Measures
Scaled Returns

Risk-Adjusted Performance Measure (RAP)




Adjust the risk of the portfolio to equalize the risk of the
market or benchmark portfolio
Compare the returns after risk adjustment to the
benchmark portfolio returns
For instance, using the Sharpe index (S):
RAPportfolio = RFR+(smarket)xS
Resulting values larger than the market return (or other
benchmark used) would indicate superior performance
Composite Portfolio
Performance Measures
Comparing Measures
Sharpe and RAP both use the portfolio
standard deviation as the risk measure, so
use total risk to evaluate performance
 Treynor and Jensen use only systematic
risk (beta) to evaluate performance

Composite Portfolio
Performance Measures
Comparing Measures

All measures will give consistent results for
completely diversified portfolios


When reviewing both diversified and undiversified
portfolios, a poorly diversified portfolio could have high
beta-adjusted performance but lower s-adjusted
performance
Statistical analysis indicates high correlations
across performance measures when evaluating
mutual fund performance


They tend to rate and rank performance consistently
Still may make sense to use different measures at times
What is Required of a
Portfolio Manager?
1. Follow the client’s policy statement
2. Earn above-average returns for a given
risk class
3. Diversify the portfolio to eliminate
unsystematic risk
Benchmark Portfolios
Provides a performance evaluation
standard to judge whether the portfolio
manager is meeting requirement

Usually a passive index or portfolio
May need benchmark for entire portfolio
and separate benchmarks for segments
to evaluate individual managers
Benchmark Portfolios
Required Characteristics of Benchmarks
Unambiguous
Investable
Measurable
Appropriate
Reflective of current investment opinions
Specified in advance
Benchmark Portfolios
Sometimes no
appropriate single
benchmark exists, so
you “build your own”
Specialize as
appropriate
Be sure to consider risk
and ensure that
performance standards
are not met simply
through taking on
additional risk.
Performance Measures
and Benchmark Error
The market portfolio problem
The theoretical market portfolio is an efficient,
diversified portfolio that contains all risky
assets in the economy, weighted by their
market values

Typically use the S & P 500 Index


This is not a complete market proxy (this is benchmark
error)
Further, betas derived using an incomplete
benchmark may also differ from a company’s “true
beta”
Performance Measures
and Benchmark Error
Benchmark Errors and Global Investing



Concern with the benchmark error increases with
global investing
The Dow 30 stocks have higher betas against the
S&P 500 than against the Morgan Stanley World
Stock Index
The benchmark problem is one of measurement in
evaluating portfolio performance
Might want to give greater weight to the
standard deviation-based portfolio
performance measures (Sharpe measures)
Taxable Performance
and Benchmarking
Another difficulty in evaluating
performance
No standard way of adjusting pre-tax
performance to after-tax performance

Need to adjust for capital gains and income
flows to be reinvested
A difficult issue to resolve
Benchmarking and
Portfolio Style
Two means of determining a portfolio
manager’s style
Returns-based analysis
 Characteristic analysis

Returns-based analysis
Also called effective mix
analysis
Portfolio’s historical return
pattern is compared to
various well-specified
indexes
Analysis uses
sophisticated
programming techniques
to indicate styles most
similar to the portfolio’s
actual returns
Characteristic analysis
Based on the idea that current make-up will
be a good predictor for the next period’s
returns
Classifies manager into four styles:

Value, growth, market-oriented, smallcapitalization
Decision tree approach to classify a portfolio’s
stocks
Develop a “sector deviation measure”
Results combined to determine style
Attributions for Portfolio
Performance
Possible explanations of superior
performance:
Insightful asset allocation strategy that
overweighted an asset class that earned
high returns
 Investing in undervalued sectors
 Selecting individual securities that earned
above average returns
 Some combination of these reasons

Attributions for Portfolio
Performance
Client’s policy statement is the place to start
and compare against actual values

Effects of asset allocation decision

Compare actual performance against the policy
statement allocation strategy earning benchmark returns
across all allocations


Look for differences in allocations and returns within
allocations to explain performance differences
Impact of sector and security selection

Repeat the same exercise as above, looking to explain
either strong or weak performance
Evaluation of BondPortfolio Performance
How did performance compare among
portfolio managers relative to the overall
bond market or specific benchmarks?
What factors explain or contribute to
superior or inferior bond-portfolio
performance?
A Bond Market Line
Need a measure of risk such as beta
coefficient for equities

Difficult to achieve due to bond maturity
and coupon effect on volatility of prices
Composite risk measure is the bond’s
duration

Duration replaces beta as risk measure in
a bond market line
Bond Market Line
Evaluation
Explains differences from benchmark returns as
a function of the following:

Policy effect


Interest rate anticipation effect


Differentiated returns from changing duration of the
portfolio
Analysis effect


Difference in expected return due to portfolio duration
target
Acquiring temporarily mispriced bonds
Trading effect

Short-run changes
Decomposing Portfolio
Returns
Dietz, Fogler, and Hardy decomposition of
portfolio returns into income, interest rate,
sector/quality, and residual effects
Total return during a period is the income
effect if the yield curve remained constant
during the period
Interest rate effect measures changes in the
caused by changes in the term structure of
interest rates during the period
Decomposing Portfolio
Returns
The sector/quality effect measures impact on
returns because of changing yield spreads
between bonds in different sectors/ratings
The residual effect is what is left after
accounting for the first three factors

A large positive residual would indicate superior
selection capabilities
Examining these effects over time should
help to determine the strengths and
weaknesses of a bond portfolio manager