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Chapter 26

Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown. Chapter 26. Chapter 26 - Evaluation of Portfolio Performance. Questions to be answered:

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Chapter 26

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  1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown Chapter 26

  2. Chapter 26 - Evaluation of Portfolio Performance Questions to be answered: • What major requirements do clients expect from their portfolio managers? • What can a portfolio manager do to attain superior performance? • What is the peer group comparison method of evaluating an investor’s performance?

  3. Chapter 26 - Evaluation of Portfolio Performance • What is the Treynor portfolio performance measure? • What is the Sharpe portfolio performance measure? • What is the critical difference between the Treynor and Sharpe portfolio performance measures?

  4. Chapter 26 - Evaluation of Portfolio Performance • What is the Jensen portfolio performance measure, and how does it relate to the Treynor measure? • What is the information ratio and how is it related to the other performance measures? • When evaluating a sample of portfolios, how do you determine how well diversified they are?

  5. Chapter 26 - Evaluation of Portfolio Performance • What is the bias found regarding the composite performance measures? • What is the Fama portfolio performance measure and what information does it provide beyond other measures? • What is attribution analysis and how can it be used to distinguish between a portfolio manager’s market timing and security selection skills?

  6. Chapter 26 - Evaluation of Portfolio Performance • What is the Roll “benchmark error” problem, and what are the two factors that are affected when computing portfolio performance measures? • What is the impact of global investing on the benchmark error problem? • What are customized benchmarks? • What are the important characteristics that any benchmark should possess?

  7. Chapter 26 - Evaluation of Portfolio Performance • How do bond portfolio performance measures differ from equity portfolio performance measures? • In the Wagner and Tito bond portfolio performance measure, what is the measure of risk used? • What are the components of the Dietz, Fogler, and Hardy bond portfolio performance measure?

  8. Chapter 26 - Evaluation of Portfolio Performance • What are the sources of return in the Fong, Pearson, and Vasicek bond portfolio performance measure? • What are the time-weighted and dollar-weighted returns and which should be reported under AIMR’s Performance Presentation Standards?

  9. What is Required of a Portfolio Manager? 1.The ability to derive above-average returns for a given risk class Superior risk-adjusted returns can be derived from either • superior timing or • superior security selection 2. The ability to diversify the portfolio completely to eliminate unsystematic risk. relative to the portfolio’s benchmark

  10. Composite Portfolio Performance Measures • Portfolio evaluation before 1960 • rate of return within risk classes • Peer group comparisons • no explicit adjustment for risk • difficult to form comparable peer group • Treynor portfolio performance measure • market risk • individual security risk • introduced characteristic line

  11. Treynor Portfolio Performance Measure • Treynor recognized two components of risk • Risk from general market fluctuations • Risk from unique fluctuations in the securities in the portfolio • His measure of risk-adjusted performance focuses on the portfolio’s undiversifiable risk: market or systematic risk

  12. Treynor Portfolio Performance Measure • The numerator is the risk premium • The denominator is a measure of risk • The expression is the risk premium return per unit of risk • Risk averse investors prefer to maximize this value • This assumes a completely diversified portfolio leaving systematic risk as the relevant risk

  13. Treynor Portfolio Performance Measure • Comparing a portfolio’s T value to a similar measure for the market portfolio indicates whether the portfolio would plot above the SML • Calculate the T value for the aggregate market as follows:

  14. Treynor Portfolio Performance Measure • Comparison to see whether actual return of portfolio G was above or below expectations can be made using:

  15. Sharpe Portfolio Performance Measure • Risk premium earned per unit of risk

  16. Treynor versus Sharpe Measure • Sharpe uses standard deviation of returns as the measure of risk • Treynor measure uses beta (systematic risk) • Sharpe therefore evaluates the portfolio manager on the basis of both rate of return performance and diversification • The methods agree on rankings of completely diversified portfolios • Produce relative not absolute rankings of performance

  17. Jensen Portfolio Performance Measure • Also based on CAPM • Expected return on any security or portfolio is

  18. Jensen Portfolio Performance Measure • Also based on CAPM • Expected return on any security or portfolio is Where: E(Rj) = the expected return on security RFR = the one-period risk-free interest rate j= the systematic risk for security or portfolio j E(Rm) = the expected return on the market portfolio of risky assets

  19. The Information Ratio Performance Measure • Appraisal ratio • measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return

  20. Application of Portfolio Performance Measures

  21. Potential Bias of One-Parameter Measures • positive relationship between the composite performance measures and the risk involved • alpha can be biased downward for those portfolios designed to limit downside risk

  22. Components of Investment Performance • Fama suggested overall performance, which is its return in excess of the risk-free rate Portfolio Risk + Selectivity • Further, if there is a difference between the risk level specified by the investor and the actual risk level adopted by the portfolio manager, this can be further refined Investor’s Risk + Manager’s Risk + Selectivity

  23. Components of Investment Performance • The selectivity measure is used to assess the manager’s investment prowess • The relationship between expected return and risk for the portfolio is:

  24. Components of Investment Performance • The market line then becomes a benchmark for the manager’s performance

  25. Components of Investment Performance • The selectivity component can be broken into two parts • gross selectivity is made up of net selectivity plus diversification

  26. Components of Investment Performance • Assuming the investor has a target level of risk for the portfolio equal to bT, the portion of overall performance due to risk can be assessed as follows:

  27. Relationship Among Performance Measures • Treynor • Sharpe • Jensen • Information Ratio • Fama net selectivity measures Highly correlated, but not perfectly so

  28. Performance Attribution Analysis • Allocation effect • Selection effect

  29. Measuring Market Timing Skills • Tactical asset allocation (TAA) • Attribution analysis is inappropriate • indexes make selection effect not relevant • multiple changes to asset class weightings during an investment period • Regression-based measurement

  30. Measuring Market Timing Skills

  31. Factors That Affect Use of Performance Measures • Market portfolio difficult to approximate • Benchmark error • can effect slope of SML • can effect calculation of Beta • greater concern with global investing • problem is one of measurement • Sharpe measure not as dependent on market portfolio

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