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

Chapter 26


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?


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?


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?


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?


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?


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?


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?


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


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


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


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


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:


Treynor Portfolio Performance Measure

  • Comparison to see whether actual return of portfolio G was above or below expectations can be made using:


Sharpe Portfolio Performance Measure

  • Risk premium earned per unit of risk


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


Jensen Portfolio Performance Measure

  • Also based on CAPM

  • Expected return on any security or portfolio is


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


The Information Ratio Performance Measure

  • Appraisal ratio

  • measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return


Application of Portfolio Performance Measures


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


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


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:


Components of Investment Performance

  • The market line then becomes a benchmark for the manager’s performance


Components of Investment Performance

  • The selectivity component can be broken into two parts

    • gross selectivity is made up of net selectivity plus diversification


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:


Relationship Among Performance Measures

  • Treynor

  • Sharpe

  • Jensen

  • Information Ratio

  • Fama net selectivity measures

    Highly correlated, but not perfectly so


Performance Attribution Analysis

  • Allocation effect

  • Selection effect


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


Measuring Market Timing Skills


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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