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  • 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 25
  • 2. Chapter 25 - 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 25 - Evaluation of Portfolio Performance
    • What is the Treynor portfolio performance measure?
    • What is the Sharpe portfolio performance measure and how can it be adapted to include multifactor models of risk and expected return?
    • What is information ratio and how it related to the other performance measures?
  • 4. Chapter 25 - Evaluation of Portfolio Performance
    • When evaluating a sample of portfolios, how do you determine how well diversified they are?
  • 5. Chapter 25 - Evaluation of Portfolio Performance
    • 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 25 - Evaluation of Portfolio Performance
    • What is the benchmark error problem, and what are the two factors that are affected when computing portfolio performance measures?
    • What are customized benchmarks and 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?
  • 8. Chapter 25 - Evaluation of Portfolio Performance
    • What are the time-weighted and dollar-weighted returns and which should be reported under CFA’s Performance Presentation Standards?
    • How can investment performance be measured by analyzing the security holdings of a portfolio?
  • 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. Early Performance Measures Techniques
    • Portfolio evaluation before 1960
      • rate of return within risk classes
    • Peer group comparisons
      • no explicit adjustment for risk
      • difficult to form comparable peer group
  • 11. Treynor Portfolio Performance Measure
    • Treynor portfolio performance measure
      • market risk
      • individual security risk
      • introduced characteristic line
    • 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 ‘s Composite 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 ‘s Composite 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. Demonstration of Comparative Treynor 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. Demonstration of Comparative Sharpe Measure
    • The D portfolio had the lowest risk premium return per unit of total risk, failing even to perform as well as the aggregate market portfolio. In contrast, Portfolio E and F performed better than the aggregate market: Portfolio E did better than Portfolio F.
    0.22 0.17 E 0.18 0.13 D 0.23 0.16 F Standard Deviation of Return Average Annual Rate of Return Portfolio
  • 17. 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
  • 18. Jensen Portfolio Performance Measure
    • Also based on CAPM
    • Expected return on any security or portfolio is
  • 19. Jensen Portfolio Performance Measure
    • Also based on CAPM
    • Expected return on any security or portfolio is
    • Where: E(R j ) = the expected return on security
    • RFR = the one-period risk-free interest rate
    •  j = the systematic risk for security or portfolio j
    • E(R m ) = the expected return on the market portfolio of risky assets
  • 20. Applying the Jensen Measure
    • Jensen Measure of performance requires using a different RFR for each time interval during the sample period
    • It does not directly consider the portfolio manager’s ability to diversify because it calculates risk premiums in term of systematic risk
  • 21. Jensen Measure and Multifactor Models
    • Advantages:
      • It is easier to interpret
      • Because it is estimated from a regression equation, it is possible to make statements about the statistical significance of the manger’s skill level
      • It is flexible enough to allow for alternative models of risk and expected return than the CAPAM. Risk-adjusted performance can be computed relative to any of the multifactor models:
  • 22. The Information Ratio Performance Measure
    • Appraisal ratio
    • measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return
  • 23. Application of Portfolio Performance Measures
  • 24. 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
  • 25. Measuring Performance with Multiple Risk Factors
    • Form of the estimation equation
  • 26. Relationship between Performance Measures
    • Although the measures provide a generally consistent assessment of portfolio performance when taken as a whole, they remain distinct at an individual level.
    • Therefore it is best to consider these composites collectively
    • The user must understand what each means
  • 27. Components of Investment Performance
    • Fama suggested overall performance, which is its return in excess of the risk-free rate
      • Overall Performance=Excess return=Portfolio Risk + Selectivity
  • 28. 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:
  • 29. Evaluating Selectivity
    • The market line then becomes a benchmark for the manager’s performance
  • 30. Evaluating Diversification
    • The selectivity component can be broken into two parts
      • gross selectivity is made up of net selectivity plus diversification
  • 31. Holding Based Performance Measurement
    • There are two distinct advantages to assessing performance based on investment returns
      • Return are usually easy for the investor to observe on a frequent basis
      • Represent the bottom line that the investor actually takes away from the portfolio manager’s investing prowess
  • 32. Holding Based Performance Measurement
    • Returns-based measures of performance are indirect indications of the decision-making ability of a manager
    • Holdings-based approach can provide additional insight about the quality of the portfolio manager
  • 33. Grinblatt -Titman (GT) Performance Measure
    • Among the first to assess the quality of the services provided by money managers by looking at adjustments they made to the contents of their portfolios
  • 34. Characteristic Selectivity (CS) Performance Measure
    • CS performance measure compares the returns of each stock held in an actively managed portfolio to the return of a benchmark portfolio that has the same aggregate investment characteristics as the security in question
  • 35. Performance Attribution Analysis
    • Allocation effect
    • Selection effect
  • 36. Performance Attribution Extensions
    • Attribution methodology can be used to distinguish security selection skills from any of several other decisions that investor might make
  • 37. 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
  • 38. Measuring Market Timing Skills
  • 39. Factors That Affect Use of Performance Measures
    • Market portfolio is 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
  • 40. Benchmark Portfolios
    • Performance evaluation standard
    • Usually a passive index or portfolio
    • May need benchmark for entire portfolio and separate benchmarks for segments to evaluate individual managers
  • 41. Demonstration of the Global Benchmark Problem
    • Two major differences in the various beta statistics:
      • For any particular stock, the beta estimates change a great deal over time.
      • There are substantial differences in betas estimated for the same stock over the same time period when two different definition of the benchmark portfolio are employed.
  • 42. Implications of the Benchmark Problems
    • Benchmark problems do not negate the value of the CAPM as a normative model of equilibrium pricing
    • There is a need to find a better proxy for the market portfolio or to adjust measured performance for benchmark errors
    • Multiple markets index (MMI) is major step toward a truly comprehensive world market portfolio.
  • 43. Required Characteristics of Benchmarks
    • Unambiguous
    • Investable
    • Measurable
    • Appropriate
    • Reflective of current investment opinions
    • Specified in advance
  • 44. Selecting a Benchmark
    • Must be selected at two levels:
    • A global level that contains the broadest mix of risky asset available from around the world
    • A fairly specific level consistent with the management style of an individual money manager (i.e., a customized benchmark).
  • 45. Evaluation of Bond Portfolio Performance
    • Returns-Based Bond Performance Measurement
      • Early attempts to analyze fixed-income performance involved peer group comparisons
      • Peer group comparisons are potentially flawed because they do not account for investment risk directly.
      • Fama and French addressed the flaw
  • 46. Bond Performance Attribution
    • How did the performance levels of portfolio managers compare to the overall bond market?
    • What factors lead to superior or inferior bond-portfolio performance?
  • 47. Bond Performance Attribution
    • A Bond Market Line
      • Need a measure of risk such as beta coefficient for equities
      • Difficult to achieve due to bond maturity and coupon effect on volatility of prices
      • Composite risk measure is the bond’s duration
      • Duration replaces beta as risk measure in a bond market line
  • 48. Bond Performance Attribution
    • This technique divides the portfolio return that differs from the return on the Lehman Brothers Index into four components:
      • Policy effect
        • Difference in expected return due to portfolio duration target
      • Rate anticipation effect
        • Differentiated returns from changing duration of the portfolio
      • Analysis effect
        • Acquiring temporarily mispriced bonds
      • Trading effect
        • Short-run changes
  • 49. Reporting Investment Performance
    • Time-Weighted and Dollar-Weight Returns
      • A better way to evaluate performance regardless of the size or timing of the investment involved.
      • The dollar-weighted and time-weighted returns are the same when there are no interim investment contributions within the evaluation period.
  • 50. Reporting Investment Performance
    • Performance Presentation Standards (PPS)
      • The goals of the AIMR-PPS are:
        • achieve greater uniformity and comparability among performance presentation
        • improve the service offered to investment management clients
        • enhance the professionalism of the industry
        • bolster the notion of self-regulation
  • 51. Reporting Investment Performance
    • Performance Presentation Standards
      • Fundamental principles
        • Total return must be used
        • Time-weighted rates of return must be used
        • Portfolios must be valued at least monthly and periodic returns must be geometrically linked
        • Composite return performance (if presented) must contain all actual fee-paying accounts
        • Performance must be calculated after deduction of trading expenses
        • Taxes must be recognized when incurred
        • Annual returns for all years must be presented
        • Disclosure requirements must be met
  • 52. The Internet Investments Online
    • http://www.nelsons.com
    • http://www.styleadvisor.com
    • http://www.morningstar.com
    • http://www.cfainstitute.org
  • 53.
    • End of Chapter 25
      • Evaluation of Portfolio Performance