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  1. 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K. Reilly & Keith C. Brown Chapter 25
  2. 2. Chapter 25 - Evaluation of Portfolio Performance <ul><li>Questions to be answered: </li></ul><ul><li>What major requirements do clients expect from their portfolio managers? </li></ul><ul><li>What can a portfolio manager do to attain superior performance? </li></ul><ul><li>What is the peer group comparison method of evaluating an investor’s performance? </li></ul>
  3. 3. Chapter 25 - Evaluation of Portfolio Performance <ul><li>What is the Treynor portfolio performance measure? </li></ul><ul><li>What is the Sharpe portfolio performance measure and how can it be adapted to include multifactor models of risk and expected return? </li></ul><ul><li>What is information ratio and how it related to the other performance measures? </li></ul>
  4. 4. Chapter 25 - Evaluation of Portfolio Performance <ul><li>When evaluating a sample of portfolios, how do you determine how well diversified they are? </li></ul>
  5. 5. Chapter 25 - Evaluation of Portfolio Performance <ul><li>What is the Fama portfolio performance measure and what information does it provide beyond other measures? </li></ul><ul><li>What is attribution analysis and how can it be used to distinguish between a portfolio manager’s market timing and security selection skills? </li></ul>
  6. 6. Chapter 25 - Evaluation of Portfolio Performance <ul><li>What is the benchmark error problem, and what are the two factors that are affected when computing portfolio performance measures? </li></ul><ul><li>What are customized benchmarks and What are the important characteristics that any benchmark should possess? </li></ul>
  7. 7. Chapter 26 - Evaluation of Portfolio Performance <ul><li>How do bond portfolio performance measures differ from equity portfolio performance measures? </li></ul>
  8. 8. Chapter 25 - Evaluation of Portfolio Performance <ul><li>What are the time-weighted and dollar-weighted returns and which should be reported under CFA’s Performance Presentation Standards? </li></ul><ul><li>How can investment performance be measured by analyzing the security holdings of a portfolio? </li></ul>
  9. 9. What is Required of a Portfolio Manager? <ul><li>1.The ability to derive above-average returns for a given risk class </li></ul><ul><li>Superior risk-adjusted returns can be derived from either </li></ul><ul><ul><li>superior timing or </li></ul></ul><ul><ul><li>superior security selection </li></ul></ul><ul><li>2. The ability to diversify the portfolio completely to eliminate unsystematic risk relative to the portfolio’s benchmark </li></ul>
  10. 10. Early Performance Measures Techniques <ul><li>Portfolio evaluation before 1960 </li></ul><ul><ul><li>rate of return within risk classes </li></ul></ul><ul><li>Peer group comparisons </li></ul><ul><ul><li>no explicit adjustment for risk </li></ul></ul><ul><ul><li>difficult to form comparable peer group </li></ul></ul>
  11. 11. Treynor Portfolio Performance Measure <ul><li>Treynor portfolio performance measure </li></ul><ul><ul><li>market risk </li></ul></ul><ul><ul><li>individual security risk </li></ul></ul><ul><ul><li>introduced characteristic line </li></ul></ul><ul><li>Treynor recognized two components of risk </li></ul><ul><ul><li>Risk from general market fluctuations </li></ul></ul><ul><ul><li>Risk from unique fluctuations in the securities in the portfolio </li></ul></ul><ul><li>His measure of risk-adjusted performance focuses on the portfolio’s undiversifiable risk: market or systematic risk </li></ul>
  12. 12. Treynor ‘s Composite Performance Measure <ul><li>The numerator is the risk premium </li></ul><ul><li>The denominator is a measure of risk </li></ul><ul><li>The expression is the risk premium return per unit of risk </li></ul><ul><li>Risk averse investors prefer to maximize this value </li></ul><ul><li>This assumes a completely diversified portfolio leaving systematic risk as the relevant risk </li></ul>
  13. 13. Treynor ‘s Composite Performance Measure <ul><li>Comparing a portfolio’s T value to a similar measure for the market portfolio indicates whether the portfolio would plot above the SML </li></ul><ul><li>Calculate the T value for the aggregate market as follows: </li></ul>
  14. 14. Demonstration of Comparative Treynor Measure <ul><li>Comparison to see whether actual return of portfolio G was above or below expectations can be made using: </li></ul>
  15. 15. Sharpe Portfolio Performance Measure <ul><li>Risk premium earned per unit of risk </li></ul>
  16. 16. Demonstration of Comparative Sharpe Measure <ul><li>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. </li></ul>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. 17. Treynor versus Sharpe Measure <ul><li>Sharpe uses standard deviation of returns as the measure of risk </li></ul><ul><li>Treynor measure uses beta (systematic risk) </li></ul><ul><li>Sharpe therefore evaluates the portfolio manager on the basis of both rate of return performance and diversification </li></ul><ul><li>The methods agree on rankings of completely diversified portfolios </li></ul><ul><li>Produce relative not absolute rankings of performance </li></ul>
  18. 18. Jensen Portfolio Performance Measure <ul><li>Also based on CAPM </li></ul><ul><li>Expected return on any security or portfolio is </li></ul>
  19. 19. Jensen Portfolio Performance Measure <ul><li>Also based on CAPM </li></ul><ul><li>Expected return on any security or portfolio is </li></ul><ul><li>Where: E(R j ) = the expected return on security </li></ul><ul><li>RFR = the one-period risk-free interest rate </li></ul><ul><li> j = the systematic risk for security or portfolio j </li></ul><ul><li>E(R m ) = the expected return on the market portfolio of risky assets </li></ul>
  20. 20. Applying the Jensen Measure <ul><li>Jensen Measure of performance requires using a different RFR for each time interval during the sample period </li></ul><ul><li>It does not directly consider the portfolio manager’s ability to diversify because it calculates risk premiums in term of systematic risk </li></ul>
  21. 21. Jensen Measure and Multifactor Models <ul><li>Advantages: </li></ul><ul><ul><li>It is easier to interpret </li></ul></ul><ul><ul><li>Because it is estimated from a regression equation, it is possible to make statements about the statistical significance of the manger’s skill level </li></ul></ul><ul><ul><li>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: </li></ul></ul>
  22. 22. The Information Ratio Performance Measure <ul><li>Appraisal ratio </li></ul><ul><li>measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return </li></ul>
  23. 23. Application of Portfolio Performance Measures
  24. 24. Potential Bias of One-Parameter Measures <ul><li>positive relationship between the composite performance measures and the risk involved </li></ul><ul><li>alpha can be biased downward for those portfolios designed to limit downside risk </li></ul>
  25. 25. Measuring Performance with Multiple Risk Factors <ul><li>Form of the estimation equation </li></ul>
  26. 26. Relationship between Performance Measures <ul><li>Although the measures provide a generally consistent assessment of portfolio performance when taken as a whole, they remain distinct at an individual level. </li></ul><ul><li>Therefore it is best to consider these composites collectively </li></ul><ul><li>The user must understand what each means </li></ul>
  27. 27. Components of Investment Performance <ul><li>Fama suggested overall performance, which is its return in excess of the risk-free rate </li></ul><ul><ul><li>Overall Performance=Excess return=Portfolio Risk + Selectivity </li></ul></ul>
  28. 28. Components of Investment Performance <ul><li>The selectivity measure is used to assess the manager’s investment prowess </li></ul><ul><li>The relationship between expected return and risk for the portfolio is: </li></ul>
  29. 29. Evaluating Selectivity <ul><li>The market line then becomes a benchmark for the manager’s performance </li></ul>
  30. 30. Evaluating Diversification <ul><li>The selectivity component can be broken into two parts </li></ul><ul><ul><li>gross selectivity is made up of net selectivity plus diversification </li></ul></ul>
  31. 31. Holding Based Performance Measurement <ul><li>There are two distinct advantages to assessing performance based on investment returns </li></ul><ul><ul><li>Return are usually easy for the investor to observe on a frequent basis </li></ul></ul><ul><ul><li>Represent the bottom line that the investor actually takes away from the portfolio manager’s investing prowess </li></ul></ul>
  32. 32. Holding Based Performance Measurement <ul><li>Returns-based measures of performance are indirect indications of the decision-making ability of a manager </li></ul><ul><li>Holdings-based approach can provide additional insight about the quality of the portfolio manager </li></ul>
  33. 33. Grinblatt -Titman (GT) Performance Measure <ul><li>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 </li></ul>
  34. 34. Characteristic Selectivity (CS) Performance Measure <ul><li>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 </li></ul>
  35. 35. Performance Attribution Analysis <ul><li>Allocation effect </li></ul><ul><li>Selection effect </li></ul>
  36. 36. Performance Attribution Extensions <ul><li>Attribution methodology can be used to distinguish security selection skills from any of several other decisions that investor might make </li></ul>
  37. 37. Measuring Market Timing Skills <ul><li>Tactical asset allocation (TAA) </li></ul><ul><li>Attribution analysis is inappropriate </li></ul><ul><ul><li>indexes make selection effect not relevant </li></ul></ul><ul><ul><li>multiple changes to asset class weightings during an investment period </li></ul></ul><ul><li>Regression-based measurement </li></ul>
  38. 38. Measuring Market Timing Skills
  39. 39. Factors That Affect Use of Performance Measures <ul><li>Market portfolio is difficult to approximate </li></ul><ul><li>Benchmark error </li></ul><ul><ul><li>can effect slope of SML </li></ul></ul><ul><ul><li>can effect calculation of Beta </li></ul></ul><ul><ul><li>greater concern with global investing </li></ul></ul><ul><ul><li>problem is one of measurement </li></ul></ul><ul><li>Sharpe measure not as dependent on market portfolio </li></ul>
  40. 40. Benchmark Portfolios <ul><li>Performance evaluation standard </li></ul><ul><li>Usually a passive index or portfolio </li></ul><ul><li>May need benchmark for entire portfolio and separate benchmarks for segments to evaluate individual managers </li></ul>
  41. 41. Demonstration of the Global Benchmark Problem <ul><li>Two major differences in the various beta statistics: </li></ul><ul><ul><li>For any particular stock, the beta estimates change a great deal over time. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  42. 42. Implications of the Benchmark Problems <ul><li>Benchmark problems do not negate the value of the CAPM as a normative model of equilibrium pricing </li></ul><ul><li>There is a need to find a better proxy for the market portfolio or to adjust measured performance for benchmark errors </li></ul><ul><li>Multiple markets index (MMI) is major step toward a truly comprehensive world market portfolio. </li></ul>
  43. 43. Required Characteristics of Benchmarks <ul><li>Unambiguous </li></ul><ul><li>Investable </li></ul><ul><li>Measurable </li></ul><ul><li>Appropriate </li></ul><ul><li>Reflective of current investment opinions </li></ul><ul><li>Specified in advance </li></ul>
  44. 44. Selecting a Benchmark <ul><li>Must be selected at two levels: </li></ul><ul><li>A global level that contains the broadest mix of risky asset available from around the world </li></ul><ul><li>A fairly specific level consistent with the management style of an individual money manager (i.e., a customized benchmark). </li></ul>
  45. 45. Evaluation of Bond Portfolio Performance <ul><li>Returns-Based Bond Performance Measurement </li></ul><ul><ul><li>Early attempts to analyze fixed-income performance involved peer group comparisons </li></ul></ul><ul><ul><li>Peer group comparisons are potentially flawed because they do not account for investment risk directly. </li></ul></ul><ul><ul><li>Fama and French addressed the flaw </li></ul></ul>
  46. 46. Bond Performance Attribution <ul><li>How did the performance levels of portfolio managers compare to the overall bond market? </li></ul><ul><li>What factors lead to superior or inferior bond-portfolio performance? </li></ul>
  47. 47. Bond Performance Attribution <ul><li>A Bond Market Line </li></ul><ul><ul><li>Need a measure of risk such as beta coefficient for equities </li></ul></ul><ul><ul><li>Difficult to achieve due to bond maturity and coupon effect on volatility of prices </li></ul></ul><ul><ul><li>Composite risk measure is the bond’s duration </li></ul></ul><ul><ul><li>Duration replaces beta as risk measure in a bond market line </li></ul></ul>
  48. 48. Bond Performance Attribution <ul><li>This technique divides the portfolio return that differs from the return on the Lehman Brothers Index into four components: </li></ul><ul><ul><li>Policy effect </li></ul></ul><ul><ul><ul><li>Difference in expected return due to portfolio duration target </li></ul></ul></ul><ul><ul><li>Rate anticipation effect </li></ul></ul><ul><ul><ul><li>Differentiated returns from changing duration of the portfolio </li></ul></ul></ul><ul><ul><li>Analysis effect </li></ul></ul><ul><ul><ul><li>Acquiring temporarily mispriced bonds </li></ul></ul></ul><ul><ul><li>Trading effect </li></ul></ul><ul><ul><ul><li>Short-run changes </li></ul></ul></ul>
  49. 49. Reporting Investment Performance <ul><li>Time-Weighted and Dollar-Weight Returns </li></ul><ul><ul><li>A better way to evaluate performance regardless of the size or timing of the investment involved. </li></ul></ul><ul><ul><li>The dollar-weighted and time-weighted returns are the same when there are no interim investment contributions within the evaluation period. </li></ul></ul>
  50. 50. Reporting Investment Performance <ul><li>Performance Presentation Standards (PPS) </li></ul><ul><ul><li>The goals of the AIMR-PPS are: </li></ul></ul><ul><ul><ul><li>achieve greater uniformity and comparability among performance presentation </li></ul></ul></ul><ul><ul><ul><li>improve the service offered to investment management clients </li></ul></ul></ul><ul><ul><ul><li>enhance the professionalism of the industry </li></ul></ul></ul><ul><ul><ul><li>bolster the notion of self-regulation </li></ul></ul></ul>
  51. 51. Reporting Investment Performance <ul><li>Performance Presentation Standards </li></ul><ul><ul><li>Fundamental principles </li></ul></ul><ul><ul><ul><li>Total return must be used </li></ul></ul></ul><ul><ul><ul><li>Time-weighted rates of return must be used </li></ul></ul></ul><ul><ul><ul><li>Portfolios must be valued at least monthly and periodic returns must be geometrically linked </li></ul></ul></ul><ul><ul><ul><li>Composite return performance (if presented) must contain all actual fee-paying accounts </li></ul></ul></ul><ul><ul><ul><li>Performance must be calculated after deduction of trading expenses </li></ul></ul></ul><ul><ul><ul><li>Taxes must be recognized when incurred </li></ul></ul></ul><ul><ul><ul><li>Annual returns for all years must be presented </li></ul></ul></ul><ul><ul><ul><li>Disclosure requirements must be met </li></ul></ul></ul>
  52. 52. The Internet Investments Online <ul><li>http://www.nelsons.com </li></ul><ul><li>http://www.styleadvisor.com </li></ul><ul><li>http://www.morningstar.com </li></ul><ul><li>http://www.cfainstitute.org </li></ul>
  53. 53. <ul><li>End of Chapter 25 </li></ul><ul><ul><li>Evaluation of Portfolio Performance </li></ul></ul>