Portfolio Performance Evaluation

Chapter 18

Abnormal Performance
Big Question: What is abnormal?
Abnormal performance is measured:
Benchmark portfolio
Market adjusted
Market model / index model adjusted
Generally, we can gauge abnormal performance with broad measures that
measure reward to risk in some way (e.g. the Sharpe Measure, Treynor
Measure, and the Information Ratio). Which measure is most appropriate
depends on the scenario that applies. Also, these measures presume that
the distribution of returns are constant.
There are also several performance measures that break down abnormal
performance into factors such as market timing and security selection (e.g.
performance attribution).

How do you get abnormal performance?

Market timing
Superior selection
- Sectors or industries
- Individual companies

Basic Approach to Determining Performance

Use the index model from Chps 6-7:

RP P P RM eP
What would the expected risk premium (RP) be on your portfolio?

E ( RP ) E ( P ) E ( P RM ) E (eP )
P is a constant, so this would stay as whatever you have
measured its value as.
P is also a constant.

You need to estimate an expected value for RM

What about the expected value of eP ?

Therefore,

E ( RP ) P P E ( RM )

P becomes the measure of abnormal performance, i.e. what

you receive above and beyond what the CAPM would
suggest.
What about portfolio risk? Recall that we can break up total risk
into systematic and non-systematic parts:
Total risk:

P2 P2 M2 2 (eP )

How do you get expected returns, risk, and other inputs to

determine how well your portfolio did vs some broadly diversified
benchmark? You need the following:
(1)

(2)

(3)

An average risk premium for your portfolio ( RP ) and for

the comparison portfolio ( RM ) over some measurement
period: This is your guesstimate for the portfolios
expected returns.
The standard deviation of the risk premium for your
portfolio ( P ) and for the comparison portfolio ( M ) over
some measurement period. This is your guesstimate of the
portfolios expected risk.
Regress your portfolios risk premium on the markets risk
premium over the measurement period this will give you
the following: P , P , and unique risk of your portfolio
2 (e P )
. Check the significance of your regressions
estimates!

(4)

Recall that E ( RP ) P P E ( RM ) . Your portfolio

generated an alpha based on your expected return ( RP )

relative to your exposure to systematic risk

P E ( RM ) .

Use RM as your guess for E ( RM ) . Therefore,

P RP P RM

2
2 2
2

(eP ) from
P
P
M
(5) Using the relationship

Chapter 6, the unique risk of your portfolio will be equal

2
2 2

M
P
P
to:

Reward to Risk Measures

1) Sharpe Index
where

RP
P

RP = Your portfolios average risk premium over the

measurement period (return minus risk free rate)
(Step 1)

P = Standard deviation of the portfolios risk premium

(Step 2)

Scenario: If your portfolio is the entire risky investment that you are
considering. Essentially, the Sharpe Index involves calculating the
CAL slope of your portfolio, and then comparing it to other funds /
portfolios. Selecting portfolios based on the Sharpe measure is the
same thing as choosing the highest sloped CAL in earlier chapters.
M2 Measure ( S P S M ) M
Puts the Sharpe measure comparison into percentage terms (i.e., it is a variant of
the Sharpe measure)
Equates the volatility of the managed portfolio with the market by creating a
hypothetical portfolio made up of T-bills and the managed portfolio
If the risk is lower than the market, leverage is used and the hypothetical portfolio
is compared to the market

Example:
Your portfolio Portfolio:

average return = 35%

standard deviation = 42%

Market Portfolio:

average return = 28%

standard deviation = 30%

T-bill return = 6%

Hypothetical Portfolio:
30/42 = .714 in P
(1-.714) or .286 in T-bills
(.714) (.35) + (.286) (.06) = 26.7%
Since this return is less than the market reutrn, the managed portfolio underperformed.

(2) Treynor Measure

where

RP
P

RP = Your portfolios average risk premium over the measurement

period (Step 1)
P = Estimate of your portfolios beta (Step 3)

Scenario: Your portfolio is combined with other actively managed

small portfolios that make up a larger investment fund (i.e., a fund of
funds approach). Since the large investment fund is completely
diversified, systematic risk is all that is relevant for your portfolio
i.e., how much risk it adds to the larger fund.

Note that a higher portfolio P will make the Treynor measure higher.

P
(eP )

(3)

Information Ratio

where

P = your portfolios alpha coefficient (Step 4), and

(eP ) = standard deviation of the portfolios residuals (i.e. amount of nonsystematic risk) (Step 5)

Scenario: You mix your portfolio with a broad passive index

portfolio. The information ratio tells you how much you enhance

the CAL of the passive portfolio with your actively managed subportfolio.
To calculate the information ratio, you first need to calculate P . This is
known as Jensens alpha and, as in the CAPM and market model chapters,
measures your portfolios return in excess of what would have been expected
(as defined by your portfolios beta.)

Which Measure is Appropriate?

It depends on investment assumptions
1) If the portfolio represents the entire investment for an
individual, Sharpe Index compared to the Sharpe Index for the
market.
2)

If many funds are within the same overall portfolio, relevant

risk is measured as beta. The Treynor measure evaluates
performance based on beta risk and remember that the
manager with the highest alpha will also have the best Treynor
measure.

3)

Big Question: Is alpha well specified if you are only using

the market index as the factor? Should you use more factors?

Limitations
Assumptions underlying measures limit their usefulness

 When the portfolio is being actively managed, basic stability

requirements are not met
Secondary question: Are portfolio returns really based on ability?
Returns will depend on other things besides selection ability!
Practitioners often use benchmark portfolio comparisons to
measure performance

Performance Attribution
Good investment performance depends on being in the right asset (e.g.
stocks vs. bonds etc) and in the right securities at the right time.
Performance attribution separates over / under performance into these two
components (or more), so you can see how much asset allocation added /
subtracted from your portfolios performance, and likewise how much
security picking added / subtracted.
Decomposing overall performance into components
Components are related to specific elements of performance

Example components
Broad Allocation
Industry
Security Choice
Up and Down Markets

Process of Attributing Performance to Components

Set up a Benchmark or Bogey portfolio

 Use indexes for each component

Use target weight structure

Process of Attributing Performance to Components

Calculate the return on the Bogey and on the managed portfolio
Explain the difference in return based on component weights or
selection
Summarize the performance differences into appropriate categories

Formula for Performance Attribution:

n

rB wBi rBi
i 1
n

rp wpi rpi
i 1

i 1

i 1

i 1

rp rB wpi rpi wBi rBi ( wpi rpi wBi rBi )

Bogey return:

Your portfolios return:

Abnormal return:

Contributions for Performance

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+
=

Contribution for asset allocation

(wpi wBi) rBi
Contribution for security selection wpi (rpi rBi)
Total Contribution from asset class wpirpi wBirBi

i is each asset class. If you have 2 asset classes (say stocks and
bonds), then the contribution for asset selection involves calculating
(wpi wBi) rBi for stocks and bonds and then summing them up. The
contribution for security selection is a similar process.

Market Timing
Main idea: Adjusting portfolio for up and down movements in the market.
Changing portfolio composition in response to changes in market
conditions will make the measures discussed above unreliable (since you
are changing the distribution of your portfolios returns!)
Low Market Return - low eta e.g. you anticipate a poor stock
market, and move money into bonds. This results in a lower portfolio
beta. When the stock market does poorly, your portfolio does not
drop by as much.
High Market Return - high eta e.g., you anticipate a better market
and move money back into stocks. This results in a higher beta.
When the market does improve, your portfolio rises up by more.
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Example of Market Timing

rp - rF

rf

* *
* *
*
*
*
* * **
*
* * * *
** *
*
* * *

rm - rf

Steadily Increasing the Beta

Complications to Measuring Performance

Two major problems
- Need many observations even when portfolio mean and variance are
constant
- Active management leads to shifts in parameters making measurement
more difficult

To measure well:
- You need a lot of short intervals
- For each period you need to specify the makeup of the portfolio

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