Download Active Portfolio Management and Performance Measure

Chapter 18
Portfolio
Performance
Evaluation
Types of management revisited
• Passive management
1. Capital allocation between cash and the risky portfolio
2. Asset allocation within the risky portfolio.
– How passive the management actually is varies
• “Set it and forget it”
• Change allocations in 1 or 2 according to perceptions
of risk to keep current with portfolio goals.
• Active management
– Forecasting future rates of return on either/both asset
classes and individual securities
18-2
Performance evaluation
• Purpose:
– Are the returns worth the risk and the fees?
• Measures
– Average return by itself is an insufficient measure. Why?
• Average return may not = expected return
• Risk return relationship
• Major component of returns is the market
performance
– Need a measure of abnormal (excess) performance
18-3
Abnormal Performance
How is abnormal performance measured?
Comparisons to peer groups
Rank fund performance within a given category
Benchmark portfolio such as an index – choose the
right index is important
USE reward to risk measures such as the alpha, Sharpe
Measure (or variations)
18-4
Factors That Lead to Abnormal
Performance
• Successful across asset allocations (the
most important step)
• Superior allocation within each asset class
– Sectors or industries
• Overweight better performing sectors, underweight
poorer performers
• Individual security selection
• Pick the right stocks, those with performance
better than expected
18-5
Risk Adjusted Performance:
Jensen
3) Jensen’s Alpha Measure
αP  RP - βP RM
αP  Portfolio alpha
RP  Average excess return on the portfolio
βP  Portfolio beta
RM  Average excess return on the market
18-6
Measuring Risk Adjusted
Performance: Sharpe Ratios
• 1) Historical Sharpe Ratios
rp  r f
Sharpe Ratios 
σp
r p  Average return on the portfolio
r f  Average risk free rate
σ p  Portfolio standard deviation
Use:
When choosing
among competing
portfolios that will not
be mixed.
In practice:
Used when one
manager handles the
(entire) portfolio.
18-7
Risk Adjusted Performance:
Treynor
• 2) Historical Treynor Ratios
Treynor Ratios 
rp  r f
p
r p  Average return on the portfolio
r f  Average risk free rate
 p  Portfolio beta
Use:
Evaluate a portfolio
when portfolio is a
piece of a larger
portfolio that has
different managers.
18-8
Summary of measures and usage
Performance Definition
Measure
Sharpe
Treynor
Information
ratio
Rp / s
Application
When choosing
among portfolios
competing as the
optimal risky portfolio
Rp / 
When ranking many
portfolios that will be
mixed to form the
optimal risky portfolio
ap / se
When evaluating a
portfolio to be mixed
with a position in the
passive benchmark
portfolio
18-9
Alpha Capture & Transport
• If an analyst finds an undervalued security and
invests in it, market moves may wipe out any
gains.
– Can hedge out market risk via shorting stock index or
stock index futures to establish a market neutral
position.
– Process is called alpha capture or alpha transport.
– When short positions and leverage are allowed a
significant non-zero alpha is a sufficient condition for
an improvement in the Sharpe and information ratio.
18-10
Evaluation with a multi-index
model
• Evidence indicates we should use a multiindex model such as the Fama-French
model to establish the expected return:
RPt  βPRMt  βSMB rSMBt  βHML rHMLt  αP  ept
RPt  βP RMt  βSMB r SMBt  βHML r HMLt  αP
• This allows an estimation of alpha:
18-11
Style Analysis
• Complex method of performance
evaluation introduced by William Sharpe
• Recent studies of mutual fund
performance show that > 90% of variation
in returns can be explained by the funds’
allocations to bills, bonds and stocks.
18-12
Morning Star’s Risk Adjusted
Rating
•
•
•
Companies are put into peer groups based on Morningstar style
definitions
Risk adjusted fund performance is ranked and then Stars are assigned
according to the following table (5 stars is the highest rating)
Percentile
Stars
0-10
1
10-32.5
2
32.5-67.5
3
67.5-90
4
90-100
5
Star ratings are highly correlated to Sharpe measure
rankings
18-13
Problems with performance
measures
• In a large universe of funds, some funds
will have abnormal performance in every
period just by chance.
– Requires statistical work
• Volatility is quite high and creates large errors in
estimation
18-14
Performance Attribution
• Decomposing overall performance into
components
• Performance is determined by specific
portfolio choices,
• Major performance determinants:
– Broad asset allocation among types of
securities,
– Industry weighting in equity portfolio,
– Security choice,
– Timing of purchases and sales.
18-15
Market Timing
• Adjust the asset allocation for movements
in the market
– Shift between stocks and money market
instruments or bonds
– With perfect ability to forecast behaves like an
option
– Little evidence of market timing ability
18-16
Value of Market Timing
Invest $1 on December 1, 1926
Strategy
Money Markets
Stocks
Perfect Timing*
Value in 2008
Geom Avg.
Return
$20
3.71%
$1,626
9.44%
$36,699,302,473
34.54%
*Perfect Timing: Every month 100% of the funds are
placed in either stocks or cash based on which would
have the higher return.
18-17