Portfolio Performance Measures

Portfolio Performance Measures
What do we require of portfolio

managers?

1. Earn an average (or fair) return for the
level of risk in the portfolio
2. Ability to manage risk
3. Eliminate unnecessary risks

Portfolio Performance
Measurement
Benchmarking
Gives us a reference point for comparison
Comparison of return and risk
Measurement
Choosing a benchmark
The most important consideration for
portfolio performance measurement is
benchmark choice. All portfolio evaluation
is dependent on benchmark choice
1. Make sure the benchmark is unambiguous
2. Make sure the benchmark is an investable
index
3. Make sure the benchmark has a
measurable value
Measurement
Choosing a benchmark
4. Make sure that the benchmark is
appropriate for the style of portfolio that you
are evaluating
5. Make sure the benchmark is specified in
advance
6. Make sure the benchmark reflects current
knowledge and opinion
7. Dont change indices. Be consistent
across portfolios
Treynors measure
i
f i
i
R R
T
|
=
Treynors measure
Treynors measure basically gives us a
measure of return per unit of market risk (or
systematic risk) that our investment earns
Strictly speaking, the larger the Treynor
measure the better. However, we would like
to have some benchmark with which to
compare our individual Treynor measures.
Tryenors measure
Benchmark comparison
f m
m
f m
m
R R
R R
T =
=
|
Treynors measure
If Ti > Tm, the portfolio would plot above the
security market line, indicating superior
performance by the portfolio manager.
If Ti < Tm, the portfolio would plot below the
security market line, indicating poor
performance by the portfolio manager.
Sharpe performance measure
i
f i
i
R R
S
o
=
Thus, the Sharpe measure gives us a
measure of return per unit of total risk.
Again, the higher the Sharpe measure, the
better the performance. We can also
compare individual Sharpe measures to a
benchmark:
m
f m
m
R R
S
o
=
Instead of plotting deviations from the security
market line, like the Treynor measure, we are
plotting deviations from the market determine
price of risk as defined by the capital market
line (CML).
Sharpe measure
If Si > Sm, the asset earn more than the risk
premium required by the capital market line,
indicating superior performance by the
portfolio manager.
If Si < Sm the asset earn less than the risk
premium required by the capital market line,
indicating poor performance by the portfolio
manager.
Comparing the Treynor and Sharpe
measures
For a completely diversified portfolio of
assets, the Sharpe and Treynor measures
would be identical in what they are measuring
Treynor measures performance relative to
systematic risk
Sharpe measure s performance relative to
total risk
Comparing the Treynor and Sharpe
measures
Sharpe measure gives some indication of how
good the portfolio manager is at diversifying
away unsystematic risk
A poorly diversified portfolio could have a high
Treynor ranking
Jensens Alpha
Jensens alpha is based on the ideas
contained in the CAPM. It, like the Treynor
measure, measures how well a portfolio
manager does at dealing with systematic
risk
To calculate Jensens alpha we need to
estimate the following regression model:
) (
, , , , t f t m i i t f t i
R R R R + = | o
Jensens Alpha
o measures the degree to which managers
are earning significant returns after
accounting for market risk, as measured by
beta. If the manager is earning a fair return
for the given portfolios systematic risk, then o
would be zero.
Jensens Alpha
(+) o indicates good performance
(-) o indicates poor performance
Jensens alpha allows us to statistically test
whether the return the manager earns is
significantly more (or less) than what we
would expect using the CAPM.
Jensens alpha allows us to get a
performance measure that incorporates
information from more than one time period.
Jensens Alpha
The validity of the Jensen performance
measure is tied to the validity of the CAPM.
Thus, some individuals will choose estimate
Jensen's alpha performing the regression
model without subtracting the risk-free rate.
This gives us the alpha from the characteristic
line. Its interpretation is the same as the
interpretation of Jensen's alpha.
Fama and French (1993) three factor
model alpha

t i t i t i t m i i t i
HMLSIZE HMLBEME R R
, , 3 , 2 , , 1 , 1 ,
c | | | o + + + + =
Fama and French (1993) three factor
model
The alpha in this model can be interpreted in
the same way as the Jensen's alpha. A
positive Fama/French alpha would indicate
performance better than expectations.
Given that the Fama/French model predicts
returns better than the CAPM, the
Fama/French alpha should be a more precise
measure of portfolio performance than the
Jensen's alpha.
Famas performance measure
Fama breaks performance by a portfolio
manager into two categories: selectivity and
diversification. Famas measure incorporates
measures for managing both systematic and
unsystematic risk.
Selectivity: measures the ability of the
portfolio manager to earn a return that is
consistent with the portfolios market
(systematic) risk. The selectivity measure is:
)) ( ( (
f m i f i
R R R R + |
(+) selectivity indicates that the manager
earned a higher return than the systematic
risk of the portfolio would indicate. Basically,
you are just comparing the return on the asset
with the return earned by the CAPM.
Diversification: Diversification measures the
extent to which the portfolio may not have
been completely diversified. Diversification is
measured as:
( )
i f m f
m
i
f m f
R R R R R R |
o
o
) ( ) ( +
|
|
.
|
\
|
+
If the portfolio is completely diversified, contains
no unsystematic risk, then diversification measure
would be zero. A positive diversification measure
indicates that the portfolio is not completely
diversified; it would contain unsystematic risk.
If the diversification measure is positive, it
represents the extra return that the portfolio
should earn for not being completely diversified.
Net selectivity = selectivity - diversification
Net selectivity measures how well the
portfolio manager did at earning a fair
return for the portfolios systematic risk and
how well the portfolio manager did at
diversifying away unsystematic risk.
Positive net selectivity indicates the
portfolio manager did a good job. Negative
net selectivity indicates that the portfolio
manager did a poor job.

Portfolio Performance Measures

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Portfolio Performance Measures

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Portfolio Performance Measures

What do we require of portfolio

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