Lecture Presentation Software   to accompany Investment Analysis and  Portfolio Management Seventh Edition by  Frank K. Re...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>Questions to be answered: </li></ul><ul><li>What major requiremen...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>What is the Treynor portfolio performance measure? </li></ul><ul>...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>What is the Jensen portfolio performance measure, and how does it...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>What is the bias found regarding the composite performance measur...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>What is the Roll “benchmark error” problem, and what are the two ...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>How do bond portfolio performance measures differ from equity por...
Chapter 26 - Evaluation of Portfolio Performance <ul><li>What are the sources of return in the Fong, Pearson, and Vasicek ...
What is Required of  a Portfolio Manager? <ul><li>1.The ability to derive above-average returns for a given risk class </l...
Composite Portfolio  Performance Measures <ul><li>Portfolio evaluation before 1960 </li></ul><ul><ul><li>rate of return wi...
Treynor Portfolio  Performance Measure <ul><li>Treynor recognized two components of risk </li></ul><ul><ul><li>Risk from g...
Treynor Portfolio  Performance Measure <ul><li>The numerator is the risk premium </li></ul><ul><li>The denominator is a me...
Treynor Portfolio  Performance Measure <ul><li>Comparing a portfolio’s T value to a similar measure for the market portfol...
Treynor Portfolio  Performance Measure <ul><li>Comparison to see whether actual return of portfolio G was above or below e...
Sharpe Portfolio  Performance Measure <ul><li>Risk premium earned per unit of risk </li></ul>
Treynor versus Sharpe Measure <ul><li>Sharpe uses standard deviation of returns as the measure of risk </li></ul><ul><li>T...
Jensen Portfolio  Performance Measure <ul><li>Also based on CAPM </li></ul><ul><li>Expected return on any security or port...
Jensen Portfolio  Performance Measure <ul><li>Also based on CAPM </li></ul><ul><li>Expected return on any security or port...
The Information Ratio Performance Measure <ul><li>Appraisal ratio </li></ul><ul><li>measures average return in excess of b...
Application of Portfolio Performance Measures
Potential Bias of One-Parameter Measures <ul><li>positive relationship between the composite performance measures and the ...
Components of Investment Performance <ul><li>Fama suggested overall performance, which is its return in excess of the risk...
Components of Investment Performance <ul><li>The selectivity measure is used to assess the manager’s investment prowess </...
Components of Investment Performance <ul><li>The market line then becomes a benchmark for the manager’s performance </li><...
Components of Investment Performance <ul><li>The selectivity component can be broken into two parts </li></ul><ul><ul><li>...
Components of Investment Performance <ul><li>Assuming the investor has a target level of risk for the portfolio equal to  ...
Relationship Among Performance Measures <ul><li>Treynor </li></ul><ul><li>Sharpe </li></ul><ul><li>Jensen </li></ul><ul><l...
Performance Attribution Analysis <ul><li>Allocation effect </li></ul><ul><li>Selection effect </li></ul>
Measuring Market Timing Skills <ul><li>Tactical asset allocation (TAA) </li></ul><ul><li>Attribution analysis is inappropr...
Measuring Market Timing Skills
Factors That Affect Use of Performance Measures <ul><li>Market portfolio difficult to approximate </li></ul><ul><li>Benchm...
Benchmark Portfolios <ul><li>Performance evaluation standard </li></ul><ul><li>Usually a passive index or portfolio </li><...
Characteristics of Benchmarks <ul><li>Unambiguous </li></ul><ul><li>Investable </li></ul><ul><li>Measurable </li></ul><ul>...
Building a Benchmark <ul><li>Specialize as appropriate </li></ul><ul><li>Provide value weightings </li></ul><ul><li>Provid...
Evaluation of  Bond Portfolio Performance <ul><li>How did performance compare among portfolio managers relative to the ove...
A Bond Market Line <ul><li>Need a measure of risk such as beta coefficient for equities </li></ul><ul><li>Difficult to ach...
Bond Market Line Evaluation <ul><li>Policy effect </li></ul><ul><ul><li>Difference in expected return due to portfolio dur...
Decomposing Portfolio Returns <ul><li>Into maturity, sector, and quality effects </li></ul><ul><li>Total return during a p...
Decomposing Portfolio Returns <ul><li>The sector/quality effect measures expected impact on returns because of changing yi...
Analyzing Sources of Return <ul><li>Total return (R) made up of the effect of the interest rate environment (I) and the co...
Analyzing Sources of Return <ul><li>C is composed of </li></ul><ul><li>M = return from maturity management </li></ul><ul><...
Consistency of Performance <ul><li>A study by Kritzman revealed  no relationship  between performance in the two periods e...
Computing Portfolio Returns <ul><li>To evaluate portfolio performance, we have to measure it </li></ul><ul><li>From Chapte...
Computing Portfolio Returns <ul><li>Dollar-weighted rate of return (DWRR) </li></ul><ul><ul><li>Internal rate of return on...
Performance Presentation Standards <ul><li>AIMR PPS have the following goals: </li></ul><ul><ul><li>achieve greater unifor...
Performance Presentation Standards <ul><li>Total return must be used </li></ul><ul><li>Time-weighted rates of return must ...
The Internet Investments Online <ul><li>www.nelnet.com </li></ul><ul><li>www.styleadvisor.com </li></ul><ul><li>www.valuel...
<ul><li>End of Chapter 26 </li></ul><ul><ul><li>Evaluation of Portfolio Performance </li></ul></ul>
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26

  1. 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 26
  2. 2. Chapter 26 - 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 26 - Evaluation of Portfolio Performance <ul><li>What is the Treynor portfolio performance measure? </li></ul><ul><li>What is the Sharpe portfolio performance measure? </li></ul><ul><li>What is the critical difference between the Treynor and Sharpe portfolio performance measures? </li></ul>
  4. 4. Chapter 26 - Evaluation of Portfolio Performance <ul><li>What is the Jensen portfolio performance measure, and how does it relate to the Treynor measure? </li></ul><ul><li>What is the information ratio and how is it related to the other performance measures? </li></ul><ul><li>When evaluating a sample of portfolios, how do you determine how well diversified they are? </li></ul>
  5. 5. Chapter 26 - Evaluation of Portfolio Performance <ul><li>What is the bias found regarding the composite performance measures? </li></ul><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 26 - Evaluation of Portfolio Performance <ul><li>What is the Roll “benchmark error” problem, and what are the two factors that are affected when computing portfolio performance measures? </li></ul><ul><li>What is the impact of global investing on the benchmark error problem? </li></ul><ul><li>What are customized benchmarks? </li></ul><ul><li>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><ul><li>In the Wagner and Tito bond portfolio performance measure, what is the measure of risk used? </li></ul><ul><li>What are the components of the Dietz, Fogler, and Hardy bond portfolio performance measure? </li></ul>
  8. 8. Chapter 26 - Evaluation of Portfolio Performance <ul><li>What are the sources of return in the Fong, Pearson, and Vasicek bond portfolio performance measure? </li></ul><ul><li>What are the time-weighted and dollar-weighted returns and which should be reported under AIMR’s Performance Presentation Standards? </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. Composite Portfolio Performance Measures <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><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>
  11. 11. Treynor Portfolio Performance Measure <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 Portfolio 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 Portfolio 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. Treynor Portfolio Performance 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. 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>
  17. 17. Jensen Portfolio Performance Measure <ul><li>Also based on CAPM </li></ul><ul><li>Expected return on any security or portfolio is </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><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>
  19. 19. 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>
  20. 20. Application of Portfolio Performance Measures
  21. 21. 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>
  22. 22. 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>Portfolio Risk + Selectivity </li></ul></ul><ul><li>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 </li></ul><ul><ul><li>Investor’s Risk + Manager’s Risk + Selectivity </li></ul></ul>
  23. 23. 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>
  24. 24. Components of Investment Performance <ul><li>The market line then becomes a benchmark for the manager’s performance </li></ul>
  25. 25. Components of Investment Performance <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>
  26. 26. Components of Investment Performance <ul><li>Assuming the investor has a target level of risk for the portfolio equal to  T , the portion of overall performance due to risk can be assessed as follows: </li></ul>
  27. 27. Relationship Among Performance Measures <ul><li>Treynor </li></ul><ul><li>Sharpe </li></ul><ul><li>Jensen </li></ul><ul><li>Information Ratio </li></ul><ul><li>Fama net selectivity measures </li></ul><ul><li>Highly correlated, but not perfectly so </li></ul>
  28. 28. Performance Attribution Analysis <ul><li>Allocation effect </li></ul><ul><li>Selection effect </li></ul>
  29. 29. 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>
  30. 30. Measuring Market Timing Skills
  31. 31. Factors That Affect Use of Performance Measures <ul><li>Market portfolio 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>
  32. 32. 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>
  33. 33. 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>
  34. 34. Building a Benchmark <ul><li>Specialize as appropriate </li></ul><ul><li>Provide value weightings </li></ul><ul><li>Provide constraints to portfolio manager </li></ul>
  35. 35. Evaluation of Bond Portfolio Performance <ul><li>How did performance compare among portfolio managers relative to the overall bond market or specific benchmarks? </li></ul><ul><li>What factors explain or contribute to superior or inferior bond-portfolio performance? </li></ul>
  36. 36. A Bond Market Line <ul><li>Need a measure of risk such as beta coefficient for equities </li></ul><ul><li>Difficult to achieve due to bond maturity and coupon effect on volatility of prices </li></ul><ul><li>Composite risk measure is the bond’s duration </li></ul><ul><li>Duration replaces beta as risk measure in a bond market line </li></ul>
  37. 37. Bond Market Line Evaluation <ul><li>Policy effect </li></ul><ul><ul><li>Difference in expected return due to portfolio duration target </li></ul></ul><ul><li>Interest rate anticipation effect </li></ul><ul><ul><li>Differentiated returns from changing duration of the portfolio </li></ul></ul><ul><li>Analysis effect </li></ul><ul><ul><li>Acquiring temporarily mispriced bonds </li></ul></ul><ul><li>Trading effect </li></ul><ul><ul><li>Short-run changes </li></ul></ul>
  38. 38. Decomposing Portfolio Returns <ul><li>Into maturity, sector, and quality effects </li></ul><ul><li>Total return during a period is the income effect and a price change effect </li></ul><ul><li>The yield-to-maturity (income) effect is the return an investor would receive if nothing had happened to the yield curve during the period </li></ul><ul><li>Interest rate effect measures changes in the term structure of interest rates during the period </li></ul>
  39. 39. Decomposing Portfolio Returns <ul><li>The sector/quality effect measures expected impact on returns because of changing yield spreads between bonds in different sectors and ratings </li></ul><ul><li>The residual effect is what is left after accounting for the first three factors </li></ul><ul><li>A large positive residual would indicate superior selection capabilities </li></ul><ul><li>Time-series plot demonstrates strengths and weaknesses of portfolio manager </li></ul>
  40. 40. Analyzing Sources of Return <ul><li>Total return (R) made up of the effect of the interest rate environment (I) and the contribution of the management process (C) </li></ul><ul><li>R = I + C </li></ul><ul><li>I is the expected rate of return (E) on a portfolio of default-free securities and the unexpected return (U) on the Treasury Index </li></ul><ul><li>I = E + U </li></ul>
  41. 41. Analyzing Sources of Return <ul><li>C is composed of </li></ul><ul><li>M = return from maturity management </li></ul><ul><li>S = return from spread/quality management </li></ul><ul><li>B = return attributable to the selection of specific securities </li></ul><ul><li>R = I + C </li></ul><ul><li>= (E + U) + (M + S + B) </li></ul>
  42. 42. Consistency of Performance <ul><li>A study by Kritzman revealed no relationship between performance in the two periods examined in the study </li></ul><ul><li>A further test also revealed no relationship between past and future performance even among the best and worst performers </li></ul><ul><li>Based on these results, Kritzman concluded that it would be necessary to examine something besides past performance to determine superior bond portfolio managers </li></ul>
  43. 43. Computing Portfolio Returns <ul><li>To evaluate portfolio performance, we have to measure it </li></ul><ul><li>From Chapter 1 we learned how to calculate a holding period yield, which equals the change in portfolio value plus income divided by beginning portfolio value: </li></ul>
  44. 44. Computing Portfolio Returns <ul><li>Dollar-weighted rate of return (DWRR) </li></ul><ul><ul><li>Internal rate of return on the portfolio’s cash flows </li></ul></ul><ul><li>Time-weighted rate of return (TWRR) </li></ul><ul><ul><li>Geometric average return </li></ul></ul><ul><li>TWRR is better </li></ul><ul><ul><li>Considers actual period by period portfolio returns </li></ul></ul><ul><ul><li>No size bias - inflows and outflows could affect results </li></ul></ul>
  45. 45. Performance Presentation Standards <ul><li>AIMR PPS have the following goals: </li></ul><ul><ul><li>achieve greater uniformity and comparability among performance presentation </li></ul></ul><ul><ul><li>improve the service offered to investment management clients </li></ul></ul><ul><ul><li>enhance the professionalism of the industry </li></ul></ul><ul><ul><li>bolster the notion of self-regulation </li></ul></ul>
  46. 46. Performance Presentation Standards <ul><li>Total return must be used </li></ul><ul><li>Time-weighted rates of return must be used </li></ul><ul><li>Portfolios valued quarterly and periodic returns geometrically linked </li></ul><ul><li>Composite return performance (if presented) must contain all actual fee-paying accounts </li></ul><ul><li>Performance calculated after trading expenses </li></ul><ul><li>Taxes must be recognized when incurred </li></ul><ul><li>Annual returns for all years must be presented </li></ul><ul><li>Disclosure requirements </li></ul>
  47. 47. The Internet Investments Online <ul><li>www.nelnet.com </li></ul><ul><li>www.styleadvisor.com </li></ul><ul><li>www.valueline.com </li></ul><ul><li>www.morningstar.com </li></ul><ul><li>www.valueline.com </li></ul><ul><li>www.aimr.org </li></ul>
  48. 48. <ul><li>End of Chapter 26 </li></ul><ul><ul><li>Evaluation of Portfolio Performance </li></ul></ul>
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