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

Chapter 26

chapter 26 evaluation of portfolio performance
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 performance1
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 performance2
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 performance3
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 performance4
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 performance5
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 performance6
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
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
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 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 measure1
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 measure2
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 measure3
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
Sharpe Portfolio Performance Measure
  • Risk premium earned per unit of risk
treynor versus sharpe measure
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
Jensen Portfolio Performance Measure
  • Also based on CAPM
  • Expected return on any security or portfolio is
jensen portfolio performance measure1
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
The Information Ratio Performance Measure
  • Appraisal ratio
  • measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return
potential bias of one parameter 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
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 performance1
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 performance2
Components of Investment Performance
  • The market line then becomes a benchmark for the manager’s performance
components of investment performance3
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 performance4
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
Relationship Among Performance Measures
  • Treynor
  • Sharpe
  • Jensen
  • Information Ratio
  • Fama net selectivity measures

Highly correlated, but not perfectly so

performance attribution analysis
Performance Attribution Analysis
  • Allocation effect
  • Selection effect
measuring market timing skills
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
factors that affect use of performance measures
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