CHAPTER TWENTY-FOUR

PORTFOLIO PERFORMANCE EVALUATION

CHAPTER OVERVIEW
This chapter discusses and calculates various return measures and risk-adjusted return measures that are
used for evaluation of portfolio managers. The process of decomposing portfolio returns into the various
components of the portfolio-building process is presented.

LEARNING OBJECTIVES
After studying this chapter, the student should be able to: calculate various risk-adjusted return measures,
and use these measures to evaluate investment performance; and decompose excess returns into
components attributable to asset allocation choices.

PRESENTATION OF CHAPTER MATERIAL

1. The Conventional Theory of Performance Evaluation
Obtaining an accurate estimate of risk-adjusted performance for a portfolio manager is very difficult. Most
of the sound measures of risk adjusted returns require stability for the portfolio. Most portfolios are
actively managed and the stability assumptions are not met. Many industry measures of performance are
based on comparisons to some benchmark portfolio. The comparison to the benchmark is only appropriate
if the risk is similar.

PPT 24-2 Introduction

2. Calculating and Averaging Returns

Discussion of dollar-weighted and time-weighted returns is presented in PPT 24-3 through PPT 24-6. The
example that is used in the text is created and sample calculations are provided. For an investor that has
control over contributions to the investment portfolio, the dollar-weighted return is more comprehensive
measure. Time-weighted returns are more likely appropriate to judge the performance of an investor that
does not control the timing of contributions.

PPT 24-3 Dollar- and Time-Weighted Returns

PPT 24-4 Text Example of Multiperiod Returns
PPT 24-5 Dollar -Weighted Returns
PPT 24-6 Time-Weighted Returns
The concept of abnormal performance is critical to the process performance evaluation. As indicated
above, it is more common to benchmark or market adjusted returns reported in industry. The measure of
abnormal return using this risk-adjusted technique assumes the managed and the benchmark or market
portfolio have the same level of risk. The market model or indexed model approaches are theoretically

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superior since they explicitly adjust for different levels of systematic risk. Factors that lead to superior
performance include selection of undervalued stock and the ability to time general movements in the market

PPT 24-7 Abnormal Performance

PPT 24-8 Factors Leading to Abnormal Performance
The Sharpe Measure is also widely accepted in industry. The slope measure is based on the portfolio risk
premium and the total risk of the portfolio as measured by standard deviation.

PPT 24-9 Risk Adjusted Performance: Sharpe

The M2 measure facilitates interpretation of the reward-to-variability measure. The measure is being used
in industry as is discussed in the text boxed-item entitled New Gauge Measures Mutual-Fund Risk.

PPT 24-10 M2 Measure

PPT 24-11 M2 Measure: Example
The Treynor measure also looks at a measure of reward to variability with the difference being the measure
of risk. The measure of risk used in the Treynor measure is the beta coefficient of the portfolio. The Sharpe
and the Treynor measures should result in similar rankings for most widely diversified portfolios. With
portfolios that are widely diversified, most of the risk will be systematic.

PPT 24-12 Risk Adjusted Performance: Treynor

The Jensen alpha is a measure of the percentage abnormal return using the adjustment of the market model.
The Jensen measure does not scale returns for risk and is therefore not as complete as the Treynor measure.

PPT 24-13 Risk Adjusted Performance: Jensen

The information ratio measures the alpha relative to the unsystematic or diversifiable risk. The appraisal
ratio is used in active portfolio management and is thoroughly described in Chapter 27.

PPT 24-14 Information Ratio

The question of which measure is most appropriate depends on additional investment assumptions. If the
investment is limited to a single managed portfolio, the Sharpe measure is the most appropriate. If there
are many alternative investments under consideration, the Treynor or Jensen measures are most
appropriate. The Jensen measure does not adjust the alpha for the level of systematic risk. If the levels of
systematic risk are quite different for the portfolios that you are measuring, differences in rankings can
occur. For most cases, the Treynor measure will be more complete.

PPT 24-15 Which Measure is Appropriate?

Chapter 24 contains several examples and figures that demonstrate the performance measures. A
comparison ranking using market and the M-sqr measure Figures 24.1 and 24.2.

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 PPT 24-16 Figure 24.1 Universe Comparison
PPT 24-17 Figure 24.2 M2 of Portfolio P
Application of performance analysis is displayed in PPT 24-18 through 24-20.

PPT 24-18 Figure 24.3 Treynors Measure

PPT 24-19 Table 24.2 Excess Returns for Portfolios P and Q and the Benchmark M
over 12 Months
PPT 24-20 Table 24.3 Performance Statistics

2. Performance Measurement for Hedge Funds

The chapter develops application of the information ratio that demonstrates how to allocate funds for a
hedge fund. The nature of active management of hedge funds makes it difficult to apply the performance
measures. Table 24.4 shows index model results for hedge funds allowing for market timing using different
betas in up and down markets.

PPT 24-21 Table 24.4 Index Model Results for Hedge Funds,
Allowing Different Up- and Down- Market Betas

3. Performance Measurement with Changing Portfolio Composition

When a manager is changing the portfolio composition, performance measures over longer periods can be
misleading. An example is show in PPT 24-22. The Sharpe measure in this example is inferior to an
indexed approach when measured over 8 quarters but the two four-quarter measures are superior.

PPT 24-22 Figure 24.4 Portfolio Returns

4. Market Timing
If the manager has the ability to time the market, the portfolio manager will increase the beta when the
market has high levels of performance. When the market experiences lower returns or losses, the manager
reduces the beta of the portfolio. Application of market timing with perfect and imperfect ability is shown
in PPT 24-23 through 24-26

PPT 24-23 Figure 24.5 Characteristic Lines: A: No Market Timing B:

Beta Increases with Return C: Two Values of Beta
PPT 24-24 Table 24.5 Performance of Bills, Equities and (Annual) Timers
Perfect and Imperfect
PPT 24-25 Figure 24.6 Rate of Return of a Perfect Market Timer as a Function
of the Rate of Return on the Market Index
PPT 24-26 Figure 24.7 Scatter Diagram of Timer Performance

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5. Styles Analysis
One of the significant findings on performance was done by William Sharpe. He analyzed performance of
mutual funds and concluded that over 90% of the returns could be contributed to asset allocation. Later
studies have concluded that 97% of returns are due to asset allocation. An application of this style analysis
is shown for the Fidelity Magellan Fund. While the performance of Magellan was extraordinary over the
period from 1986 through 1990, examinations of a large universe of funds show lack of abnormal
performance.

PPT 24-27 Style Analysis

PPT 24-28 Table 24.6 Sharpes Style Portfolios for the Magellan Fund
PPT 24-29 Figure 24.8 Fidelity Magellan Fund Cumulative Return Difference:
Fund versus Style Benchmark and Fund versus SML Benchmark
PPT 24-30 Figure 24.9 Average Tracking Error for 636 Mutual Funds

6. Morningstars Risk-Adjusted Rating

Morningstars risk-adjusted rating is widely used in the mutual fund arena. Comparison of the Morningstar
rating and the Sharpe ratio, indicate that they are very similar, although not identical.

PPT 24-31 Figure 24.10 Rankings Based on Morningstars Category RARs

and Excess Return Sharpe Ratios

7. Performance Attribution
The measures used in industry are often based on performance attribution. An overview of the concept
performance attribution is presented in PPT 24-32. The simplest form of attribution breaks the portfolio
into common stock, long-term debt and cash equivalents. The purpose is to compare the components and
returns in the portfolio whose performance is being measured against the standard mix portfolio.
Attribution can also be based on smaller components such as large and small stocks, and government and
corporate debt.

PPT 24-32 Performance Attribution

The process of attributing performance to the components is presented in PPT 24-33 and PPT 24-34. If the
benchmark or bogey portfolio was comprised of 60% stock, 30% debt and 10% money market, the first
step would be to calculate the returns on the benchmark. Indexes are used to calculate the benchmark
return. Performance for the portfolio in question is then compared to the benchmark portfolio. Differences
in return are attributed to return differentials in the categories and to differences in the weight structures

PPT 24-33 Attributing Performance to Components

PPT 24-34 Attributing Performance to Component
The formula for attribution and performance contribution is shown in PPT 24-35.

PPT 24-35 Formula for Attribution

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Application of performance attribution is contained in PPT 25-36 through 25-40.

PPT 24-36 Figure 24.11 Performance Attribution of ith Asset Class

PPT 24-37 Table 24.7 Performance of the Managed Portfolio
PPT 24-38 Table 24.39 Performance Attribution
PPT 24-39 Table 24.9 Sector Selection within the Equity Market
PPT 24-40 Table 24.10 Portfolio Attribution: Summary

Excel Models
Two excel models that cover material in this chapter are available on the Online Learning Center
(www.mhhe.com/bkm). The first model calculates all of the performance measures covered in the chapter
and can be used to rank funds or managed portfolios by each of the ranks. The second model constructs an
attribution analysis.

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