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Chapter 19

Performance Evaluation
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And with that they clapped him into irons and hauled
him off to the barracks. There he was taught
right turn, left turn, and quick march,
slope arms, and order arms, how to aim and
how to fire, and was given thirty strokes of the
cat. Next day his performance on parade was a
little better, and he was given only twenty strokes.
The following day he received a mere ten and was
thought a prodigy by his comrades.

- From Candide by Voltaire
3
Outline
Introduction
Importance of measuring portfolio risk
Traditional performance measures
Performance evaluation with cash deposits
and withdrawals
Performance evaluation when options are
used
4
Introduction
Performance evaluation is a critical aspect
of portfolio management

Proper performance evaluation should
involve a recognition of both the return and
the riskiness of the investment
5
Importance of
Measuring Portfolio Risk
Introduction
A lesson from history: the 1968 Bank
Administration Institute report
A lesson from a few mutual funds
Why the arithmetic mean is often
misleading: a review
Why dollars are more important than
percentages
6
Introduction
When two investments returns are
compared, their relative risk must also be
considered
People maximize expected utility:
A positive function of expected return
A negative function of the return variance


2
( ) ( ), E U f E R o
(
=

7
A Lesson from History
The 1968 Bank Administration Institutes
Measuring the Investment Performance of
Pension Funds concluded:
1) Performance of a fund should be measured by
computing the actual rates of return on a
funds assets
2) These rates of return should be based on the
market value of the funds assets
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A Lesson from History (contd)
3) Complete evaluation of the managers
performance must include examining a
measure of the degree of risk taken in the
fund
4) Circumstances under which fund managers
must operate vary so great that indiscriminate
comparisons among funds might reflect
differences in these circumstances rather than
in the ability of managers
9
A Lesson from
A Few Mutual Funds
The two key points with performance
evaluation:
The arithmetic mean is not a useful statistic in
evaluating growth
Dollars are more important than percentages

Consider the historical returns of two
mutual funds on the following slide
10
A Lesson from
A Few Mutual Funds (contd)

Year
44 Wall
Street
Mutual
Shares

Year
44 Wall
Street
Mutual
Shares
1975 184.1% 24.6% 1982 6.9 12.0
1976 46.5 63.1 1983 9.2 37.8
1977 16.5 13.2 1984 -58.7 14.3
1978 32.9 16.1 1985 -20.1 26.3
1979 71.4 39.3 1986 -16.3 16.9
1980 36.1 19.0 1987 -34.6 6.5
1981 -23.6 8.7 1988 19.3 30.7
Mean 19.3% 23.5%
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A Lesson from
A Few Mutual Funds (contd)
Mutual Fund Performance
$-
$20,000.00
$40,000.00
$60,000.00
$80,000.00
$100,000.00
$120,000.00
$140,000.00
$160,000.00
$180,000.00
$200,000.00
1
9
7
7
1
9
8
0
1
9
8
3
1
9
8
6
Year
E
n
d
i
n
g

V
a
l
u
e

(
$
)
44 Wall
Street
Mutual
Shares
12
A Lesson from
A Few Mutual Funds (contd)
44 Wall Street and Mutual Shares both had
good returns over the 1975 to 1988 period

Mutual Shares clearly outperforms 44 Wall
Street in terms of dollar returns at the end of
1988
13
Why the Arithmetic Mean
Is Often Misleading
The arithmetic mean may give misleading
information
E.g., a 50% decline in one period followed by a
50% increase in the next period does not return
0%, on average


14
Why the Arithmetic Mean
Is Often Misleading (contd)
The proper measure of average investment
return over time is the geometric mean:

1/
1
1
where the return relative in period
n
n
i
i
i
GM R
R i
=
(
=
(

=
[
15
Why the Arithmetic Mean
Is Often Misleading (contd)
The geometric means in the preceding
example are:
44 Wall Street: 7.9%
Mutual Shares: 22.7%

The geometric mean correctly identifies
Mutual Shares as the better investment over
the 1975 to 1988 period


16
Why the Arithmetic Mean
Is Often Misleading (contd)
Example

A stock returns 40% in the first period, +50% in the
second period, and 0% in the third period.

What is the geometric mean over the three periods?




17
Why the Arithmetic Mean
Is Often Misleading (contd)
Example

Solution: The geometric mean is computed as follows:




1/
1
1
(0.60)(1.50)(1.00) 1
0.10 10%
n
n
i
i
GM R
=
(
=
(

=
= =
[
18
Why Dollars Are More
Important than Percentages
Assume two funds:
Fund A has $40 million in investments and
earned 12% last period

Fund B has $250,000 in investments and earned
44% last period
19
Why Dollars Are More
Important than Percentages
The correct way to determine the return of
both funds combined is to weigh the funds
returns by the dollar amounts:

$40, 000, 000 $250, 000
12% 44% 12.10%
$40, 250, 000 $40, 250, 000
| | | |
+ =
| |
\ . \ .
20
Traditional
Performance Measures
Sharpe and Treynor measures
Jensen measure
Performance measurement in practice
21
Sharpe and Treynor Measures
The Sharpe and Treynor measures:

Sharpe measure
Treynor measure
where average return
risk-free rate
standard deviation of returns
beta
f
f
f
R R
R R
R
R
o
|
o
|

=
=
=
=
=
22
Sharpe and
Treynor Measures (contd)
The Treynor measure evaluates the return
relative to beta, a measure of systematic risk
It ignores any unsystematic risk

The Sharpe measure evaluates return
relative to total risk
Appropriate for a well-diversified portfolio, but
not for individual securities
23
Sharpe and
Treynor Measures (contd)
Example

Over the last four months, XYZ Stock had excess returns
of 1.86%, -5.09%, -1.99%, and 1.72%. The standard
deviation of XYZ stock returns is 3.07%. XYZ Stock has
a beta of 1.20.

What are the Sharpe and Treynor measures for XYZ
Stock?




24
Sharpe and
Treynor Measures (contd)
Example (contd)

Solution: First compute the average excess return for
Stock XYZ:





1.86% 5.09% 1.99% 1.72%
4
0.88%
R
+
=
=
25
Sharpe and
Treynor Measures (contd)
Example (contd)

Solution (contd): Next, compute the Sharpe and Treynor
measures:






0.88%
Sharpe measure 0.29
3.07%
0.88%
Treynor measure 0.73
1.20
f
f
R R
R R
o
|


= = =


= = =
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Jensen Measure
The Jensen measure stems directly from the
CAPM:

( )
it ft i mt ft
R R R R o |
(
= +

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Jensen Measure (contd)
The constant term should be zero
Securities with a beta of zero should have an
excess return of zero according to finance
theory

According to the Jensen measure, if a
portfolio manager is better-than-average,
the alpha of the portfolio will be positive


28
Jensen Measure (contd)
The Jensen measure is generally out of
favor because of statistical and theoretical
problems

29
Performance Measurement
in Practice
Academic issues
Industry issues
30
Academic Issues
The use of traditional performance
measures relies on the CAPM

Evidence continues to accumulate that may
ultimately displace the CAPM
APT, multi-factor CAPMs, inflation-adjusted
CAPM
31
Industry Issues
Portfolio managers are hired and fired
largely on the basis of realized investment
returns with little regard to risk taken in
achieving the returns

Practical performance measures typically
involve a comparison of the funds
performance with that of a benchmark
32
Industry Issues (contd)
Famas decomposition can be used to assess
why an investment performed better or
worse than expected:
The return the investor chose to take
The added return the manager chose to seek
The return from the managers good selection
of securities
33
34
Performance Evaluation With
Cash Deposits & Withdrawals
Introduction
Daily valuation method
Modified Bank Administration Institute
(BAI) Method
An example
An approximate method
35
Introduction
The owner of a fund often taken periodic
distributions from the portfolio and may
occasionally add to it

The established way to calculate portfolio
performance in this situation is via a time-
weighted rate of return:
Daily valuation method
Modified BAI method
36
Daily Valuation Method
The daily valuation method:
Calculates the exact time-weighted rate of
return
Is cumbersome because it requires determining
a value for the portfolio each time any cash
flow occurs
Might be interest, dividends, or additions and
withdrawals
37
Daily Valuation
Method (contd)
The daily valuation method solves for R:

daily
1
1
where
n
i
i
i
i
R S
MVE
S
MVB
=
=
=
[
38
Daily Valuation
Method (contd)
MVE
i
= market value of the portfolio at the end of
period i before any cash flows in period i but
including accrued income for the period

MVB
i
= market value of the portfolio at the
beginning of period i including any cash flows at
the end of the previous subperiod and including
accrued income


39
Modified BAI Method
The modified BAI method:
Approximates the internal rate of return for the
investment over the period in question

Can be complicated with a large portfolio that
might conceivably have a cash flow every day

40
Modified BAI Method (contd)
It solves for R:

1
0
(1 )
where the sum of the cash flows during the period
market value at the end of the period,
including accrued income
market value at the start of the period
to
i
n
w
i
i
i
i
MVE F R
F
MVE
F
CD D
w
CD
CD
=
= +
=
=
=

=
=

tal number of days in the period


number of days since the beginning of the period
in which the cash flow occurred
i
D =
41
An Example
An investor has an account with a mutual
fund and dollar cost averages by putting
$100 per month into the fund

The following slide shows the activity and
results over a seven-month period
42
43
An Example (contd)
The daily valuation method returns a time-
weighted return of 40.6% over the seven-
months period
See next slide
44
45
An Example (contd)
The BAI method requires use of a computer

The BAI method returns a time-weighted
return of 42.1% over the seven-months
period (see next slide)

46
47
An Approximate Method
Proposed by the American Association of
Individual Investors:

1
0
0.5(Net cash flow)
1
0.5(Net cash flow)
where net cash flow is the sum of inflows and outflows
P
R
P

=
+
48
An Approximate
Method (contd)
Using the approximate method in Table 19-
6:

1
0
0.5(Net cash flow)
1
0.5(Net cash flow)
5, 500.97 0.5( 4, 200)
1
7, 550.08 0.5(-4, 200)
0.395 39.5%
P
R
P

=
+

=
+
= =
49
Performance Evaluation
When Options Are Used
Introduction
Incremental risk-adjusted return from
options
Residual option spread
Final comments on performance evaluation
with options

50
Introduction
Inclusion of options in a portfolio usually
results in a non-normal return distribution

Beta and standard deviation lose their
theoretical value of the return distribution is
nonsymmetrical
51
Introduction (contd)
Consider two alternative methods when
options are included in a portfolio:
Incremental risk-adjusted return (IRAR)

Residual option spread (ROS)
52
Incremental Risk-Adjusted
Return from Options
Definition
An IRAR example
IRAR caveats
53
Definition
The incremental risk-adjusted return
(I RAR) is a single performance measure
indicating the contribution of an options
program to overall portfolio performance
A positive IRAR indicates above-average
performance
A negative IRAR indicates the portfolio would
have performed better without options
54
Definition (contd)
Use the unoptioned portfolio as a
benchmark:
Draw a line from the risk-free rate to its
realized risk/return combination

Points above this benchmark line result from
superior performance
The higher than expected return is the IRAR
55
Definition (contd)
56
Definition (contd)
The IRAR calculation:

( )
where Sharpe measure of the optioned portfolio
Sharpe measure of the unoptioned portfolio
standard deviation of the optioned portfolio
o u o
o
u
o
IRAR SH SH
SH
SH
o
o
=
=
=
=
57
An IRAR Example
A portfolio manager routinely writes index
call options to take advantage of anticipated
market movements
Assume:
The portfolio has an initial value of $200,000
The stock portfolio has a beta of 1.0
The premiums received from option writing are
invested into more shares of stock
58
59
An IRAR Example (contd)
The IRAR calculation (next slide) shows
that:
The optioned portfolio appreciated more than
the unoptioned portfolio

The options program was successful at adding
about 12% per year to the overall performance
of the fund
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61
IRAR Caveats
IRAR can be used inappropriately if there is
a floor on the return of the optioned
portfolio
E.g., a portfolio manager might use puts to
protect against a large fall in stock price
The standard deviation of the optioned
portfolio is probably a poor measure of risk
in these cases
62
Residual Option Spread
The residual option spread (ROS) is an
alternative performance measure for portfolios
containing options
A positive ROS indicates the use of options
resulted in more terminal wealth than only holding
stock
A positive ROS does not necessarily mean that the
incremental return is appropriate given the risk
63
Residual Option
Spread (contd)
The residual option spread (ROS)
calculation:

1 1
1
where /
value of portfolio in Period
n n
ot ut
t t
t t t
t
ROS G G
G V V
V t
= =

=
=
=
[ [
64
Residual Option
Spread (contd)
The worksheet to calculate the ROS for the
previous example is shown on the next slide

The ROS translates into a dollar differential
of $1,452
65
66
The M2
Performance Measure
Developed by Franco and Leah Modigliani
in 1997
Seeks to express relative performance in
risk-adjusted basis points
Ensures that the portfolio being evaluated and
the benchmark have the same standard
deviation
67
The M2 Performance
Measure (contd)
Calculate the risk-adjusted portfolio return
as follows:

benchmark
risk-adjusted portfolio actual portfolio
portfolio
benchmark
portfolio
1
f
R R
R
o
o
o
o
=
| |
+
|
|
\ .
68
Final Comments
IRAR and ROS both focus on whether an
optioned portfolio outperforms an
unoptioned portfolio
Can overlook subjective considerations such as
portfolio insurance

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