Portfolio Performance

Portfolios contain groups of securities that are selected to achieve the highest return for a given level of risk. How well this is achieved depends on how well the portfolio manager or investor is able to forecast economic conditions and the future prospects of companies, and to accurately assess the risk of each security under consideration. Many investors and some portfolio managers adopt a passive portfolio management strategy by simply holding a basket of securities that is weighted to reflect a market index, or by buying securities based on a market index, such as most exchange-traded funds. Some investors and portfolio managers think they can do better than the market, and so engage in active portfolio management, buying and selling securities as conditions change. Most active portfolio managers use sophisticated financial models to base their investment decisions. However, most studies have shown that few portfolio managers outperform the market, especially over a long time, and because there are thousands of portfolio managers selling their services, the fact that some outperform the market over an extended period may be due to luck. For instance, if thousands of portfolios were constructed by choosing securities at random, and buying and selling them at random, some would do much better than all of the restsimply by chance. Another factor weighing on the performance of active portfolios are the fees charged by their managers, and the trading costs of frequently buying and selling. There are some managers who seem to outperform the market consistently, such as Warren Buffett of Berkshire Hathaway; however, Warren Buffet uses a buy-and-hold strategy rather than active trading. Another factor that individual investors doing their own active portfolio management should consider is whether any gains are worth the amount of time necessary to actively manage their portfolio.

Measuring Portfolio Returns

Portfolio returns come in the form of current income and capital gains. Current income includes dividends on stocks and interest payments on bonds. A capital gain or capital loss results when a security is sold, and is equal to the amount of the sale price minus the purchase price. The return of the portfolio is equal to the net of the capital gains or losses plus the current income for the holding period. Unrealized capital gains or losses on securities still held are also added to the return to evaluate the holding period return of the portfolio. The portfolio return is adjusted for the addition of funds and the withdrawal of funds to the portfolio, and is time-weighted according to the number of months that the funds were in the portfolio. Below is the formula for calculating the portfolio return for 1 year:

Portfolio Return Formula

Dividends + Interest + Realized Gains or Losses + Unrealized Gains or Losses
Portfolio Return =

Initial Investment + (Added Funds x Number of Months in Portfolio / 12) - (Withdrawn Funds x Number of Months Withdrawn from Portfolio / 12)

Realized gains (or losses) are gains or losses actualized by the selling of the securities, whereas unrealized gains or losses are securities that are still owned but are marked to market to determine the portfolio's return.

Comparing Portfolio Returns

There are several ways of comparing portfolio returns with each other and with the market in general. A simple comparison is to simply compare their returns. However, returns by themselves do not account for the risk taken. If 2 portfolios have the same return, but one has lower risk, then that would be the preferable, more efficient portfolio. There are 3 common ratios that measure a portfolios risk-return tradeoff: Sharpes ratio, Treynors ratio, and Jensens Alpha.

Sharpe ratio
The Sharpe ratio (aka Sharpes measure), developed by William F. Sharpe, is the ratio of a portfolios total return minus the risk-free rate divided by the standard deviation of the portfolio, which is a measure of its risk. The Sharpe ratio is simply the risk premium per unit of risk, which is quantified by the standard deviation of the portfolio. Risk Premium = Total Portfolio Return Risk-free Rate Sharpe Ratio = Risk Premium / Standard Deviation of Portfolio The risk-free rate is subtracted from the portfolio return because a risk-free asset, often exemplified by the T-bill, has no risk premium since the return of a risk-free asset is certain. Therefore, if a portfolios return is equal to or less than the risk-free rate, then it makes no sense to invest in the risky assets. Hence, the Sharpe ratio is a measure of the performance of the portfolio compared to the risk takenthe higher the Sharpe ratio, the better the performance and the greater the profits for taking on additional risk. ExampleCalculating the Sharpe Ratio If a fund has a return of 12% and a standard deviation of 15%, and if the risk-free rate is 2%, then what is its Sharpe ratio? Solution: Sharpe Ratio = (12% 2%) / 15% = 10% / 15% = 66.7% (rounded)

Treynor Ratio
While the Sharpe ratio measures the risk premium of the portfolio over the portfolio risk, or its standard deviation, Treynors ratio, popularized by Jack L. Treynor, compares the portfolio risk premium to the diversifiable risk of the portfolio as measured by its beta.
Treynor Ratio Formula
Total Portfolio Return Risk-Free Rate Treynor Ratio = Portfolio Beta

Note that since the beta of the general market is defined to be 1, the Treynor Ratio of the market would be equal to its return minus the risk-free rate. ExampleCalculating the Treynor Ratio If a portfolio has a return of 12% and a beta of 1.4, and if the risk-free rate is 2%, then what is its Treynor ratio? Solution: Treynor Ratio = (12 2) / 1.4 = 10 / 1.4 = 7.14 (rounded) Note that here we used whole numbers for the return and risk-free rate because it simplifies the math and because it makes no difference when comparing portfolios if the same method is used consistently.

Jensen's Alpha (aka Jensen Index)

Alpha is a coefficient that is proportional to the excess return of a portfolio over its required return, or its expected return, for its expected risk as measured by its beta. Hence, alpha is determined by the fundamental values of the company in contrast to beta, which measures the return due to its volatility. Jensens alpha (aka Jensen index), developed by Michael C. Jensen, uses the capital asset pricing model (CAPM) to determine the amount of the return that is firm-specific over that which is due to market risk, which causes market volatility as measured by the firms beta. Jensens Alpha = Total Portfolio Return Risk-Free Rate [Portfolio Beta x (Market Return Risk-Free Rate)] Jensens alpha can be positive, negative, or zero. Note that, by definition, Jensens alpha of the market is zero. If the alpha is negative, then the portfolio is underperforming the market.