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[Readings: Ch25]
Sharpe Ratio
Treynor Ratio
Jenson’s Alpha
The Information Ratio
Ri RFR
Sharpe Ratio measure: Si where i represents total risk.
i
Ri RFR
T
i
The numerator is the risk premium (average return on security i over time less the
average risk free rate).
The denominator is a measure of systematic risk
The expression, T, 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.
1
Jensen Alpha
• Based on CAPM
• Expected return on any security or portfolio is:
E ( R j ) RFR j [ E ( RM ) RFR]
Where: E(Rj) = the expected return on security j
RFR = the one-period risk-free interest rate
j= the systematic risk for security or portfolio j
E(Rm) = the expected return on the market portfolio of risky assets
E(Rj) and RFR change over time, hence a time series of rates is employed.The
empirical CAPM includes an error term, and in risk-premium format it is:
Superior portfolio managers earn higher risk premiums than those suggested by
the model. Superior performance may be measured by adding an intercept term
(alpha) to the equation as follows:
easier to interpret ~ the value of alpha indicates how good the manager is
R j Rb ER j
IR j
ER ER
where ER is the residual (unsystematic) risk, also called the tracking error.
The Sharpe ratio may be seen as a special case of the IR where the risk free
asset is assumed to be the benchmark portfolio
If excess portfolio returns are estimated with historical data using the same
single-factor regression equation used to compute Jenson’s alpha, the IR
j
simplifies to: IR j where e is the standard error of the regression.
e
2
Q2 Describe two major factors that a portfolio manager should consider before
designing an investment strategy. What types of decisions can a manager make to
achieve these goals?
The two major factors would be: (1) attempt to derive risk-adjusted returns that
exceed a naive buy-and-hold policy and (2) completely diversify - i.e., eliminate all
unsystematic risk from the portfolio. A portfolio manager can do one or both of two
things to derive superior risk-adjusted returns. The first is to have superior timing
regarding market cycles and adjust your portfolio accordingly. Alternatively, one can
consistently select undervalued stocks. As long as you do not make major mistakes
with the rest of the portfolio, these actions should result in superior risk-adjusted
returns.
(i) Calculate the Treynor and Sharpe measures for both Portfolio X and the
S&P 500. Briefly explain whether Portfolio X under-performed,
equalled, or out-performed the S&P 500 on a risk-adjusted basis using
both Treynor and Sharpe measures.
3
Q4 Consider the following table:
Average Standard
Return % p.a. Deviation % p.a. Beta
Market Index 10.7 19.0 1.00
Fund I 19.4 44.2 1.34
Fund II 13.5 21.8 1.12
Fund III 12.9 17.6 1.30
Fund IV 9.3 5.6 0.71
SP
R Rf
10.7 5.6
0.268
(ii) Sharpe index P
P 19.0
R R f 10.7 5.6
(iii) Treynor index TP P 5.10
P 1
4
Q5
(i) Explain the circumstances in which the Sharpe and Treynor indices can
provide conflicting fund rankings.
The Sharpe and Treynor measures can provide conflicting rankings. The
inconsistency is due to differences in the unit risk measure. The Sharpe Index
uses standard deviation whereas the Treynor Index uses beta risk. However,
if the fund is well diversified then nonsystematic risk will be largely
eliminated and the Sharpe and Treynor Indices will provide very similar
rankings.
(ii) What is the Carhart (1997) model? How does it differ from the Jensen’s alpha
measure?
Carhart’s (1997) empirical model is expressed as:
Carhart’s model has four return generating factors: 1) Rm is the return on the
market index; 2) SMB is the return on the mimicking size portfolio; 3) HML is the
return on the mimicking book-to-market portfolio; and 4) UMD is the return on
the mimicking momentum portfolio. Carhart’s model is supposedly used to control
for market biases.
Now if we assume that Carhart’s model is an accurate one, then the error returns
can be assumed away, allowing the estimation of alpha for any portfolio:
5
(iii) A substantial amount of evidence on the performance of funds has provided
inconsistent results. What are some examples of this inconsistency? What are some
of the explanations for the inconsistency?
Early studies in this area typically found that funds, on average, under-performed the
benchmarks. The conclusion from studies was strong evidence against the ability of fund
managers to out-perform market benchmarks. Subsequent studies, especially in the USA
revealed inconsistent results. Some studies found evidence of positive alphas indicating
superior fund performance. But the results are sensitive to the sample, time-period and
the market index. Specifically, the use a value-weighted market index appears to result in
lower values of Jensen’s alpha than an equal-weighted market index.
Research during the 1980s focussed on more specific performance attributes such as
market timing, consistent with the advancement in the theoretical performance models.
This research has generally shown that fund managers do possess market timing ability
but again the results are mixed. The likely explanation for the conflicting results is in
different samples over different time periods and different performance benchmarks.
Data from different funds and over different time periods indicates sensitivity in the
results. Moreover, depending on the selected performance benchmark, different funds
and indeed funds in aggregate perform differently.
(i) What was the manager’s return in the month? What was her over-
performance or under-performance?
(ii) What was the contribution of security selection to relative performance?
(iii) What was the contribution of asset allocation to relative performance?
Confirm that the sum of selection and allocation contribution equals her
total “excess” return relative to the bogey.
(iv) Which investment decisions would you allow this manager to make?
6
(i) Benchmark: 0.6(2.5%) + 0.3(1.2%) + 0.1(0.5%) = 1.91%
Actual: 0.7(2.0%) + 0.2(1.0%) + 0.1(0.5%) = 1.65%
Underperformance - 0.26%
(iii)
Asset allocation:
(1) (2) (1)x(2) = (3)
Market Excess weight Index return Contribution
(Manager – benchmark) - Index Overall to performance
Equity 0.10 0.59 0.059
Bond -0.10 -0.71 0.071
Cash 0 -1.14 0
Contribution of asset allocation 0.13%
Summary:
Security selection -0.39%
Asset allocation 0.13%
Excess performance -0.26%
(iv) This manager should only be allowed to make equity and bond asset allocation
decisions.