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## PowerPoint Slideshow about 'Empirical Issues' - adamdaniel

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Content

- Simple Investment Return Measurement
- Time-weighted VS Dollar-weighted Returns
- Arithmetic VS Geometric Returns
- Risk-adjusted Measures
- Jensen’s
- Treynor’s
- Sharpe
- Characteristics of Investment Portfolio
- Style Box
- Sector Weighting

Return Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Motivation

Main question: how well does our investment portfolios do?

- As trivial as this question, a scientific measurement is tricky to formulate.
- Even average portfolio return is not as straightforward to measure
- Adjusted for risk is even more problematic

Return Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Rate of Return

ONE PERIOD

Return (R) = Total Proceeds/Initial Investment

Total Proceeds includes cash distributions and capital gains.

Return Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Trivial Example IReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Suppose you have invested $10,000 in a carefully-chosen investment portfolio. Exactly 1 year from the time of initial investment, the investment portfolio gives out $100 of cash dividends, and the investment portfolio has a market value of $11,000.

R = (Dividends + Capital gains)/Initial Investment

= [$100 + ($11,000 - $10,000)] /$10,000

= 11%

Trivial Example IIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Suppose you have invested $10,000 in a carefully-chosen investment portfolio. Exactly 1/2 year from the time of initial investment, the investment portfolio gives out $100 of cash dividends, and exactly 1 year from the time of initial investment, the investment portfolio has a market value of $11,000.

MULTI-Period

Let r be the rate of return such that

Initial Investment= Present Value of All cash flows from investment discounted at r

Trivial Example IIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Suppose you have invested $10,000 in a carefully-chosen investment portfolio. Exactly 1/2 year from the time of initial investment, the investment portfolio gives out $100 of cash dividends, and exactly 1 year from the time of initial investment, the investment portfolio has a market value of $11,000.

MULTI-Period

Let r be the rate of return such that

$10,000 = $100/[(1+r)1/2] + $11,000 /[(1+r)1]

SOLVE for r, the rate of return of investment.

Trivial Example IIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Initial Investment= Present Value of All cash flows from investment discounted at r

This is extremely similar to the internal rate of return. I’ve talked about IRR having some problems in Lecture 2 when I compared IRR rule to NPV rule for project selection.

Bottom Line: Calculating returns is really not that simple once we’re dealing with multi-periods.

Multi-periods, ΔCash ≠ 0Return Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- When you add or withdraw cash from your investment portfolio, measuring the rate of return becomes more difficult.

Trivial Example III

- Continuing with our example, with $10,000 initial investment, $100 year-end cash dividend payout, and the portfolio has a market value of $11,000. At this point, you think the portfolio is doing great and decide to invest $11,000 more on this portfolio without changing the proportions of the content in it. By the end of year 2, the portfolio is worth $23,500 with no cash dividend during year 2.

Trivial Example IIIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Dollar-Weighted Return:

- Calculate the internal rate of return:

Present value of= Present Value of All cash Initial Investment flows from investment discounted at r

$10,000 =$100/[(1+r)1]

+ $11,000/[(1+r)1] + $23,500/[(1+r)2]

SOLVE for r, the dollar-weighted rate of return of investment.

Trivial Example IIIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Dollar-Weighted Return:

- It is dollar-weighed because when you double the size of the portfolio, it has a greater influence on the average overall return than when you hold less of this portfolio in year 1.

Trivial Example IIIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Time-Weighted Return:

- Alternative to the dollar-weighed returns
- Ignores the number of shares of stock held in each period.
- For the example, it ignores the changing size of your investment portfolio when you decided to double up the investment in year-end.

Trivial Example IIIReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Time-Weighted Return:

- 1st year return = 11% as calculated in Trivial Example I
- 2nd year return = 6.82%
- Because: at the beginning of year 2, the portfolio is worth $22,000. By the end of year 2, it is worth $23,500.
- 6.82% = ($23,500 – $22,000)/$22,000

Time-weighted return = (11% + 6.82%)/2 = 8.91%

Time VS DollarReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Which one to use? Time-weighted or dollar-weighted?

Time VS DollarReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Which one to use? Time-weighted or dollar-weighted?
- ANSWER: it depends (Typical answer from economists)

Shopping for mutual funds

- Time-weighted is better
- Since the value and the composition of most mutual funds do change frequently

Assessing your own portfolio for the past years

- Dollar-weighted is better
- Since more money you invest when the portfolio performs well, the more money you earn.

Arithmetic VS GeometricReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Time-weighted return = (11% + 6.82%)/2 = 8.91%

This is an arithmetic average. It ignores compounding.

Geometric average return takes into account the effect of compounding.

- If invest for 2 years, 1st year got 11%, 2nd year got 6.82%.
- Compound growth rate = (1+11%) (1 + 6.82%) = 1.17502
- Geometric average return (rG)

(1+rG) (1+rG) = (1+11%) (1 + 6.82%)

=> rG = 8.398%

RulesReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

RULE 1:

Arithmetic average return > Geometric average return

=> 8.91%> 8.398%

RULE 2:

“(Arithmetic average - Geometric average) ↑” as period-by-period returns are more volatile.

RulesReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

RULE 2:

(Arithmetic average - Geometric average) ↑ as period-by-period returns are more volatile.

In general, relationships between the two returns:

rG = r – 0.5(σ2)

Arithmetic VS GeometricReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Which one to use? Arithmetic avg. or Geometric avg.?

Arithmetic VS GeometricReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Which one to use? Arithmetic avg. or Geometric avg.?
- ANSWER: it depends (AGAIN!)

Past returns

- Use geometric average for looking at past returns
- Geometric average represents the constant rate of return needed to earn in each year to match the actual performance over some past investment period. Thus, it serves its purpose as the right measurement of the past performance

Arithmetic VS GeometricReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Which one to use? Arithmetic avg. or Geometric avg.?
- ANSWER: it depends (AGAIN!)

Future expected returns

- Use arithmetic average for future expected returns
- It is an unbiased estimate of the portfolio’s expected future return. In contrast, since geometric average is always lower than the arithmetic average, it gives a downward biased estimate.

Trivial Example IVReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Why Unbiased?

- Suppose your investment portfolio has the risk of 50% of the chance, it doubles in value; and another 50% of the chance, its value drops by half. Suppose it did double in value in the first year, but dropped by half in value in the second year. The geometric average is exactly equal to zero.
- Arithmetic average return

= [100% + (-50%)]/2 = 25%

- True Expected return

= 50%(100%) + 50%(-50%) = 25% (UNBIASED!!!)

Risk-adjusted MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Why Risk-adjusted?

- Does earning 11% return in year 1 means you are smart?

Risk-adjusted MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Why Risk-adjusted?

- Does earning 11% return in year 1 means you are smart?
- ANSWER: It depends!
- Case 1: Suppose for the same level of risk, on average other investors would get 20% in year 1. 11% is really low, and you are really not that smart.
- Case 2: Suppose for the same level of risk, on average other investors would get 10% in year 1. 11% is good, and you are lucky.

Bottom line: Returns must be adjusted for risk before they can be compared meaningfully.

Jensen’s MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Formula:

αp = E(Rp) – {Rf + E(RM) – Rf]βp}

- Also known as Portfolio’s Alpha.
- Uses CAPM as benchmark.

Treynor’s MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Formula:

Tp = [E(Rp)– Rf]/βp

- Measures the slope of the line that connects the point of the portfolio in question to the y-intercept on the SML graph.
- Also uses CAPM as benchmark.

Treynor’s Jensen’sReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Tp = [E(Rp)– Rf]/βp αp = E(Rp) – {Rf + E(RM) – Rf]βp}

e.g., 2 Portfolios: A ~ βA = 0.9, E(RA)– Rf = 0.11, αA = 0.02

B ~ βB = 1.6, E(RB)– Rf = 0.19, αB = 0.03

M ~ βM = 1.0, E(RM)– Rf = 0.10, αM = 0

E(Ri)

Security Market

Line

E(RM)

slope = [E(RM) - Rf] = Eqm. Price of risk = 0.1

Rf

b =

[COV(Ri, RM)/Var(RM)]

bM= 1.0

Treynor’s Jensen’sReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Tp = [E(Rp)– Rf]/βp αp = E(Rp) – {Rf + E(RM) – Rf]βp}

e.g., 2 Portfolios: A ~ βA = 0.9, [E(RA)– Rf] = 0.11, αA = 0.02

B ~ βB = 1.6, [E(RB)– Rf] = 0.19, αB = 0.03

M ~ βM = 1.0, [E(RM)– Rf] = 0.10, αM = 0

E(Ri)

Security Market

Line

M

αA = 0.02

E(RM)

slope = [E(RM) - Rf] = Eqm. Price of risk = 0.1

Rf

b =

[COV(Ri, RM)/Var(RM)]

bM= 1.0

Treynor’s Jensen’sReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Tp = [E(Rp)– Rf]/βp αp = E(Rp) – {Rf + E(RM) – Rf]βp}

e.g., 2 Portfolios: A ~ βA = 0.9, [E(RA)– Rf] = 0.11, αA = 0.02

B ~ βB = 1.6, [E(RB)– Rf] = 0.19, αB = 0.03

M ~ βM = 1.0, [E(RM)– Rf] = 0.10, αM = 0

E(Ri)

Slope = TA = 0.11/0.9 = 0.12222

Security Market

Line

M

E(RM)

slope = [E(RM) - Rf] = Eqm. Price of risk = 0.1

Rf

b =

[COV(Ri, RM)/Var(RM)]

bM= 1.0

Treynor’s Jensen’sReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Tp = [E(Rp)– Rf]/βp αp = E(Rp) – {Rf + E(RM) – Rf]βp}

e.g., 2 Portfolios: A ~ βA = 0.9, [E(RA)– Rf] = 0.11, αA = 0.02

B ~ βB = 1.6, [E(RB)– Rf] = 0.19, αB = 0.03

M ~ βM = 1.0, [E(RM)– Rf] = 0.10, αM = 0

E(Ri)

Security Market

Line

αB = 0.03

M

E(RM)

slope = [E(RM) - Rf] = Eqm. Price of risk = 0.1

Rf

b =

[COV(Ri, RM)/Var(RM)]

bM= 1.0

Treynor’s Jensen’sReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Tp = [E(Rp)– Rf]/βp αp = E(Rp) – {Rf + E(RM) – Rf]βp}

e.g., 2 Portfolios: A ~ βA = 0.9, [E(RA)– Rf] = 0.11, αA = 0.02

B ~ βB = 1.6, [E(RB)– Rf] = 0.19, αB = 0.03

M ~ βM = 1.0, [E(RM)– Rf] = 0.10, αM = 0

E(Ri)

Slope = TB = 0.19/1.6 = 0.11875

Security Market

Line

M

E(RM)

slope = [E(RM) - Rf] = Eqm. Price of risk = 0.1

Rf

b =

[COV(Ri, RM)/Var(RM)]

bM= 1.0

Sharpe’s MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

Formula:

Sp = [E(Rp)– Rf]/σ(Rp)

- Measures the slope of the line that connects the point of the portfolio in question to the y-intercept on the CML graph.
- Also uses CAPM as benchmark, but built on the portfolio theory and the Capital Market line.

Sharpe’s MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

E(Rp)

Sp = [E(Rp)– Rf]/σ(Rp)

Slope = Sp

M

Portfolio P

E(RM)

Rf

σp

σM

Which Measure?Return Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Which one to use?
- Answer: It depends (Our friend again!!!)
- If the portfolio represents the entire investment for an individual, Sharpe’s Measure should be used.
- If many alternatives are possible, use Jensen’s measure or the Treynor’s Measure because both are measures appropriately adjusted for risk.

Other MeasuresReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Morningstar’s Risk-adjusted rating
- Widely used in the industry
- Lots of research about mutual funds in Morningstar’s website.
- Please check out the details from the website. Will not be tested in the exam, but I want you to know it.

Portfolio CharacteristicsReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Based on the idea that current make-up of a portfolio will be a good predictor for the next period’s returns.
- Mainly uses classifications of different risky assets, into different types of assets or different sectors of assets.
- 2 examples are shown as follows:

Portfolio CharacteristicsReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Style Box

Vertical Axis – Dividing stocks by market capitalization.

Horizontal Axis – Dividing stocks by P/E ratios and Book-to-Price Ratio to determine whether a fund is classified as growth, blend or value.

Portfolio CharacteristicsReturn Measurement Time VS Dollar Arithmetic VS Geometric Risk-Adjusted Measure Portfolio Characteristics

- Sector Weighting
- Display the percentage of stocks in the fund or portfolio that is invested in each sector.e.g., BMO Dividend Fund

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