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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 + j(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 RatiosSharpe Portfolio Performance Measure
Based on the Capital Market Line, considers the total risk of the portfolio being evaluated
S=(Rportfolio-RFR)/portfolio
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 RatiosTreynor Portfolio Performance Measure
Based on the CAPM, considers the risk that cannot be diversified, systematic risk
T=(Rportfolio-RFR)/portfolio
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 RatiosLet 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
N
DD
T
tt
1
D = the standard deviation of the differential return during the period
D
DS
The historic (ex post) Sharpe Ratio (S) is:
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+(market)xS Resulting values larger than the market return (or other
benchmark used) would indicate superior performance
Composite Portfolio Performance Measures
Comparing MeasuresSharpe 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 -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 requirementUsually 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 appropriateBe 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 problemThe 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 performanceNeed 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 analysisCharacteristic analysis
Returns-based analysisAlso called effective mix analysisPortfolio’s historical return pattern is compared to various well-specified indexesAnalysis uses sophisticated programming techniques to indicate styles most similar to the portfolio’s actual returns
Characteristic analysisBased on the idea that current make-up will be a good predictor for the next period’s returnsClassifies manager into four styles: Value, growth, market-oriented, small-
capitalization
Decision tree approach to classify a portfolio’s stocksDevelop 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 sectorsSelecting individual securities that earned
above average returnsSome 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 Bond-Portfolio 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 equitiesDifficult to achieve due to bond maturity
and coupon effect on volatility of prices
Composite risk measure is the bond’s durationDuration 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
Difference in expected return due to portfolio duration target
Interest rate anticipation effect Differentiated returns from changing duration of the
portfolio Analysis effect
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/ratingsThe 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