Portfolio Management

PORTFOLIO
PERFORMANCE EVALUATION

Lecture: Ngo Sy Nam

Faculty of Finance
 CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION

COURSE LEARNING CONTENT OF THE REQUIREMENTS

OUTCOME CHAPTER 7 FOR STUDENTS
 CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATIO

I. COURSE LEARNING OUTCOME

After completing Chapter 7, students should be able to:

❑ Understand the concepts that related to portfolio performance

evaluation.

❑ Calculate the performance of investment portfolios.

CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION

7.1. Principles of Portfolio Performance Evaluation

7.2. Methods of Portfolio Performance Evaluation

7.2.1. Average Rate of Return

7.2.2. Risk-Adjusted Rate of Return

7.2.3. The M2 Performance Measure

 CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION

III. REQUIREMENTS FOR STUDENTS

❑ Read the material/reference books of Chapter 7 before

attending class.

❑ Construct an investment portfolio based on the requirements

from previous lessons.

❑ Monitor and calculate the performance of the constructed

investment portfolio.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation
▪ Performance evaluation refers to the measurement, attribution, and appraisal
of investment results.
▪ Performance evaluation provides information about the return and risk of
investment portfolios over specified investment period(s).
▪ Performance evaluation information helps in understanding and controlling
investment risk and should, therefore, lead to improved risk management.
➔ By providing accurate data and analysis on investment decisions and their
consequences, performance evaluation allows portfolio managers to take corrective
measures to improve investment decision-making and management processes.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation

Performance evaluation seeks to answer the following questions:

✓ What was the investment portfolio’s past performance, and what may be
expected in the future?

✓ How did the investment portfolio produce its observed performance, and
what are the expected sources of expected future performance?

✓ Was the observed investment portfolio’s performance the result of

investment skill or luck?
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation
THE TWO QUESTIONS OF PERFORMANCE MEASUREMENT
The actual return a manager produces over an investment horizon can be split
into:
(1) The return she should have earned given her capital commitment and the
amount of risk in the portfolio (the expected return).
(2) Any incremental return due to her superior investment skills (alpha).
This was expressed as:
Total Actual Return = [Expected Return] + [Alpha]
= [Risk-Free Rate + Risk Premium] + [Alpha]
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation

THE TWO QUESTIONS OF PERFORMANCE MEASUREMENT

First, how did the portfolio manager actually perform?

Second, why did the portfolio manager perform as he or she did?

CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation

There are three ways that investors can estimate expected returns:

1. The average contemporaneous return to a peer group of comparably

managed portfolios.

2. The contemporaneous return to an index (or index fund) serving as a

benchmark for the managed portfolio.

3. The return estimated by a risk factor model, such as the CAPM or

multifactor model.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation
 CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation
SIMPLE PERFORMANCE MEASUREMENT TECHNIQUES
Peer Group Comparisons
A peer group comparison, which Kritzman (1990) describes as the most
common manner of evaluating portfolio managers, collects the returns
produced by a representative set of investors over a specific period of time and
displays them in a simple boxplot format.
➔The universe is typically divided into percentiles, showing the relative
ranking of a given investor.
For instance, a manager who produced a one-year return of 12.4 percent would be in the 10th percentile if only 9
other portfolios in a universe of 100 produced a higher return. Although these comparisons can get quite detailed,
it is common for the boxplot graphic to include the maximum and minimum returns, as well as the returns falling
at the 25th, 50th (the median), and 75th percentiles.
CHAPTER 7:
PORTFOLIO
PERFORMANCE
EVALUATION

Peer Group
Comparisons
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
SIMPLE PERFORMANCE MEASUREMENT TECHNIQUES
Peer Group Comparisons
There are several potential problems with the peer group comparison
method of evaluating an investor’s performance.
▪ First, the Peer Group Comparisons do not make any explicit adjustment
for the risk level of the portfolios in the universe.
▪ Second, it is almost impossible to form a truly comparable peer group
that is large enough to make the percentile rankings meaningful.
▪ Finally, by just focusing on relative returns, the comparison loses sight
of whether the investor in question has accomplished his individual
objectives and satisfied his investment expectations
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.1. Principles of Portfolio Performance Evaluation
SIMPLE PERFORMANCE MEASUREMENT TECHNIQUES
Portfolio Drawdown
A portfolio manager has done is to consider how well he has protected the
investor against losses over time.
➔ If we look at a time series illustration of the portfolio’s market value during
the investment horizon, what is the largest downturn the fund experienced?
This is what portfolio drawdown measures.
➔ maximum drawdown calculates the largest percentage decline in value—
from peak to trough—wherever during the horizon that occurs
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
Portfolio Drawdown
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
Portfolio Drawdown
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION

7.2. Methods of Portfolio Performance Evaluation

7.2.1. Average Rate of Return

7.2.2. Risk-Adjusted Rate of Return

7.2.3. The M2 Performance Measure

CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.1. Average Rate of Return
(We defined the holding-period return (HPR) in Chapter 2 and explained the
difference between the arithmetic and geometric average.)
a. Return and Risk for Individual Investment
Measuring Historical Rates of Return

❑ Holding Period Return (HPR)

𝑃1 − 𝑃0 + 𝐷1
𝐻𝑃𝑅 =
𝑃0

• P0 = Beginning price
• P1 = Ending price
• D1 = Dividend during period one

Example: an investment that costs $250 and is worth $350 after being held for
two years. Calculate HPR and EAR (APY).
20
a. Return and Risk for Individual Investment
Measuring Historical Rates of Return
• Arithmetic Mean Return (AM)
AM =  HPR / T
where  HPR = the sum of all the annual HPRs
T = number of years

• Geometric Mean Return (GM)

GM = [ (1 + HPR)]1/T – 1
where  HPR = the product of all the annual HPRs

Year Beginning Value Ending Value HPR

1 100 115 15%
2 115 138 20%
3 138 21 110.4 -20%
a. Return and Risk for Individual Investment
Computing Mean Historical Return
Arithmetic Mean vs. Geometric Mean Return
• GM is considered a superior measure of the long-term mean rate of return
because:
• GM indicates the compound annual rate of return based on the ending value
of the investment versus its beginning value (checking the prior example)
• AM is biased upward if you are attempting to measure an asset’s long-term
performance, especially for a volatile security. For example:

Year Beginning Value Ending Value HPR

1 50 100
2 100 22 50
a. Return and Risk for Individual Investment
Computing Mean Historical Return

Arithmetic Mean vs. Geometric Mean Return

• Both AM and GM are used because:

• AM is best used as an expected value for an individual year
• GM is the best measure of long-term performance since it measures the
compound annual rate of return for the asset being measured.

23
a. Return and Risk for Individual Investment

24
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.1. Average Rate of Return
Consider a stock paying a dividend of $2 annually that currently sells
for $50. You purchase the stock today, collect the $2 dividend, and
then sell the stock for $53 at year-end. Your rate of return is:
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.1. Average Rate of Return
To continue our example, suppose that you purchase a second share of
the same stock at the end of the first year and hold both shares until
the end of year 2, at which point you sell each share for $54:
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.1. Average Rate of Return
Using the discounted cash flow (DCF) approach, we can solve for
average return by equating the present values of the cash inflows and
outflows:
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.1. Average Rate of Return
The time-weighted (geometric average) return is 7.81%:

The dollar-weighted average is less than the time-weighted average in this

example because the return in the second year, when more money was
invested, is lower.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation

7.2.2. Risk-Adjusted Rate of Return

▪ The Sharpe Ratio

▪ The Treynor Ratio

▪ The Jensen’s Alpha

CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
▪ The Sharpe Ratio
Sharpe (1966) developed one of the first composite portfolio performance
that included risk. The measure followed closely his earlier work on the
capital market theory dealing specifically with the capital market line (CML).
➔Performance has two components, risk and return.
Although return maximization is a laudable objective, comparing just the return
of a portfolio with that of the market is not sufficient. Because investors are risk
averse, they will require compensation for higher risk in the form of higher
returns.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Sharpe Ratio
Sharpe ratio, which is defined as the portfolio’s risk premium divided by
its risk. E(R ) − R
SR =
p F

p
The equation defines the ex ante Sharpe ratio in terms of three inputs:
(1) the portfolio’s expected return, E(Rp);
(2) the risk-free rate of interest, RF;
(3) the portfolio’s ex ante standard deviation of returns (return
volatility), σp, a quantitative measure of total risk
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Sharpe Ratio
The Sharpe ratio can also be used on an ex post basis to evaluate historical
risk-adjusted returns. Assume we have a sample of historical data that can
be used to determine the sample mean
R portfolio return, R p ; the standard
p

deviation of the sample returns, here denoted by  p (sp is a familiar notation

in other contexts); and the sample mean risk-free rate, R f .The ex post (or
realized or historical) Sharpe ratio can then be determined by using the
following: R p − RF
SR =
p
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
❑ The Sharpe Ratio
Suppose that during the most recent 10-year period, the average annual total
rate of return (including dividends) on an aggregate market portfolio, such as
the S&P 500, was 14 percent (RM =0.14) and the average nominal rate of
return on government T-bills was 8 percent (RFR =0.08). You are told that the
standard deviation of the annual rate of return for the market portfolio over
the past 10 years was 20 percent σM = 0.20. You want to examine the risk-
adjusted performance of the following portfolios:
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Sharpe Ratio
The Sharpe ratio, however, suffers from two limitations.
▪ First, it uses total risk as a measure of risk when only systematic
risk is priced.
▪ Second, the ratio itself (e.g., 0.2 or 0.3) is not informative.
➔ To rank portfolios, the Sharpe ratio of one portfolio must be
compared with the Sharpe ratio of another portfolio. Nonetheless,
the ease of computation makes the Sharpe ratio a popular tool.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Treynor Portfolio ratio
Treynor (1965) likewise conceived of a composite measure to
evaluate the performance of mutual funds.
He postulated two components of risk:
(1) risk produced by general market fluctuations.
(2) risk resulting from unique fluctuations in the portfolio securities.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Treynor Portfolio ratio
The Treynor ratio is a simple extension of the Sharpe ratio and
resolves the Sharpe ratio’s first limitation by substituting beta
(systematic risk) for total risk. The ex ante and ex post Treynor
ratios are provided below.

E ( Rp ) − RF R p − RF
TR = TR =
p p
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Treynor Portfolio ratio
▪ The numerators must be positive for the Treynor ratio to give
meaningful results.
▪ the Treynor ratio does not work for negative-beta assets—that is, the
denominator must also be positive for obtaining correct estimates
and rankings.
➔ Although both the Sharpe and Treynor ratios allow for ranking of
portfolios, neither ratio gives any information about the economic
significance of differences in performance.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
❑ The Treynor Portfolio ratio
Assume again that RM = 0.14 and RFR = 0.08. You are deciding between
three different portfolio managers, based on their past performance.

Calculate the Treyner Portfolio ratio of each portfolio manager.

CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Jensen’s Alpha
The Jensen measure (Jensen, 1968) was originally based on the capital asset
pricing model (CAPM), which calculates the expected one-period return on
any security or portfolio by the following expression:
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Jensen’s Alpha
Jensen’s alpha is also the vertical distance from the SML measuring the excess
return for the same risk as that of the market and is given by:


 p = Rp − R f +  p  E ( Rm ) − R f  
➔ Jensen’s alpha is based on systematic risk. The coefficient on the market return
is an estimate of the beta risk of the portfolio.
➔ We can calculate the risk-adjusted return of the portfolio using the beta of the
portfolio and the CAPM.
The difference between the actual portfolio return and the calculated risk-adjusted
return is a measure of the portfolio’s performance relative to the market portfolio
and is called Jensen’s alpha.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
❑ The Jensen’s Alpha
The sign of αp indicates whether the portfolio has outperformed the market.
▪ If αp is positive, then the portfolio has outperformed the market;
▪ If αp is negative, the portfolio has underperformed the market.
➔ Jensen’s alpha is commonly used for evaluating most institutional
managers, pension funds, and mutual funds.
➔ Values of alpha can be used to rank different managers and the
performance of their portfolios, as well as the magnitude of
underperformance or overperformance.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
❑ The Jensen’s Alpha
For example, if a portfolio’s alpha is 2 percent and another portfolio’s
alpha is 5 percent, the second portfolio has outperformed the first
portfolio by 3 percentage points and the market by 5 percentage points.

➔ Jensen’s alpha is the maximum amount that you should be willing to

pay the manager to manage your money. As with other performance
appraisal measures, Jensen’s alpha has ex ante and ex post forms. The
use context usually clarifies which one is being referred to.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
EXAMPLE: Portfolio Performance Evaluation
A British pension fund has employed three investment managers, each of
whom is responsible for investing in one-third of all asset classes so that the
pension fund has a well-diversified portfolio. Information about the managers
is given below.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
EXAMPLE: Portfolio Performance Evaluation
Calculate the expected return for each manager, based on using the
average market return and the CAPM. Then also calculate for the
managers (ex post) Sharpe ratio, Treynor ratio, M2 alpha, and
Jensen’s alpha. Analyze your results and plot the returns and betas
of these portfolios.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2.2. Risk-Adjusted Rate of Return
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.3. The M2 Performance Measure
▪ In 1997, Nobel Prize winner Franco Modigliani and his granddaughter,
Leah Modigliani, developed what they called a risk-adjusted performance
measure, or RAP. The RAP measure has since become more commonly
known as M2 reflecting the Modigliani names.
▪ M2 provides a measure of portfolio return that is adjusted for the total risk
of the portfolio relative to that of some benchmark.
▪ It is related to the Sharpe ratio and ranks portfolios identically.
CHAPTER 7: PORTFOLIO PERFORMANCE EVALUATION
7.2. Methods of Portfolio Performance Evaluation
7.2.3. The M2 Performance Measure
The M2 equations below provide the ex ante and ex post formulas
for M2, where σm is the standard deviation of the market portfolio and
σm/σp is the portfolio-specific leverage ratio.
m
M =  E ( Rp ) − R f 
2
+ R f = SR   m + R f ) (ex ante)
p
m
(
M = Rp − R f
2
) p
+ R f = SR   m + R f (ex post)

➔ M2 can be thought of as a rescaling of the Sharpe ratio that allows

for easier comparisons among different portfolios.