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  • 1. Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 26
  • 2. 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?
  • 3. 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?
  • 4. 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?
  • 5. 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?
  • 6. 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?
  • 7. 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?
  • 8. 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?
  • 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. 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
  • 11. 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
  • 12. 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
  • 13. 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:
  • 14. Treynor Portfolio Performance 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. 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
  • 17. Jensen Portfolio Performance Measure
    • Also based on CAPM
    • Expected return on any security or portfolio is
  • 18. 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
  • 19. The Information Ratio Performance Measure
    • Appraisal ratio
    • measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return
  • 20. Application of Portfolio Performance Measures
  • 21. 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
  • 22. 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
  • 23. 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:
  • 24. Components of Investment Performance
    • The market line then becomes a benchmark for the manager’s performance
  • 25. Components of Investment Performance
    • The selectivity component can be broken into two parts
      • gross selectivity is made up of net selectivity plus diversification
  • 26. Components of Investment Performance
    • 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:
  • 27. Relationship Among Performance Measures
    • Treynor
    • Sharpe
    • Jensen
    • Information Ratio
    • Fama net selectivity measures
    • Highly correlated, but not perfectly so
  • 28. Performance Attribution Analysis
    • Allocation effect
    • Selection effect
  • 29. 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
  • 30. Measuring Market Timing Skills
  • 31. 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
  • 32. 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
  • 33. Characteristics of Benchmarks
    • Unambiguous
    • Investable
    • Measurable
    • Appropriate
    • Reflective of current investment opinions
    • Specified in advance
  • 34. Building a Benchmark
    • Specialize as appropriate
    • Provide value weightings
    • Provide constraints to portfolio manager
  • 35. Evaluation of Bond Portfolio Performance
    • How did performance compare among portfolio managers relative to the overall bond market or specific benchmarks?
    • What factors explain or contribute to superior or inferior bond-portfolio performance?
  • 36. 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
  • 37. Bond Market Line Evaluation
    • Policy effect
      • Difference in expected return due to portfolio duration target
    • Interest rate anticipation effect
      • Differentiated returns from changing duration of the portfolio
    • Analysis effect
      • Acquiring temporarily mispriced bonds
    • Trading effect
      • Short-run changes
  • 38. Decomposing Portfolio Returns
    • Into maturity, sector, and quality effects
    • Total return during a period is the income effect and a price change effect
    • The yield-to-maturity (income) effect is the return an investor would receive if nothing had happened to the yield curve during the period
    • Interest rate effect measures changes in the term structure of interest rates during the period
  • 39. Decomposing Portfolio Returns
    • The sector/quality effect measures expected impact on returns because of changing yield spreads between bonds in different sectors and ratings
    • The residual effect is what is left after accounting for the first three factors
    • A large positive residual would indicate superior selection capabilities
    • Time-series plot demonstrates strengths and weaknesses of portfolio manager
  • 40. Analyzing Sources of Return
    • Total return (R) made up of the effect of the interest rate environment (I) and the contribution of the management process (C)
    • R = I + C
    • I is the expected rate of return (E) on a portfolio of default-free securities and the unexpected return (U) on the Treasury Index
    • I = E + U
  • 41. Analyzing Sources of Return
    • C is composed of
    • M = return from maturity management
    • S = return from spread/quality management
    • B = return attributable to the selection of specific securities
    • R = I + C
    • = (E + U) + (M + S + B)
  • 42. Consistency of Performance
    • A study by Kritzman revealed no relationship between performance in the two periods examined in the study
    • A further test also revealed no relationship between past and future performance even among the best and worst performers
    • Based on these results, Kritzman concluded that it would be necessary to examine something besides past performance to determine superior bond portfolio managers
  • 43. Computing Portfolio Returns
    • To evaluate portfolio performance, we have to measure it
    • 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:
  • 44. Computing Portfolio Returns
    • Dollar-weighted rate of return (DWRR)
      • Internal rate of return on the portfolio’s cash flows
    • Time-weighted rate of return (TWRR)
      • Geometric average return
    • TWRR is better
      • Considers actual period by period portfolio returns
      • No size bias - inflows and outflows could affect results
  • 45. Performance Presentation Standards
    • AIMR PPS have the following goals:
      • 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
  • 46. Performance Presentation Standards
    • Total return must be used
    • Time-weighted rates of return must be used
    • Portfolios valued quarterly and periodic returns geometrically linked
    • Composite return performance (if presented) must contain all actual fee-paying accounts
    • Performance calculated after trading expenses
    • Taxes must be recognized when incurred
    • Annual returns for all years must be presented
    • Disclosure requirements
  • 47. The Internet Investments Online
    • www.nelnet.com
    • www.styleadvisor.com
    • www.valueline.com
    • www.morningstar.com
    • www.valueline.com
    • www.aimr.org
  • 48.
    • End of Chapter 26
      • Evaluation of Portfolio Performance

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