Portfolio Performance Evaluation Methods

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
Lecture 17
Evaluation of Portfolio Performance

Size of professionally managed portfolios can be astonishingly large. For example, Fidelity family of mutual funds
has portfolios exceeding 100 billion dollar in market value of their securities. It is not unusual for mutual funds
having assets under management exceeding one billion dollar. In Pakistan asset management companies (AMC) are
formed; and a single AMC may launch and then manage multiple mutual funds with varying investment strategies
such as growth funds, equity funds, balanced funds, income funds, money market funds, etc to cater to the
investment needs of different investors among general public. Even in Pakistan NIT, an open ended mutual fund,
has market value that is more than one billion dollars. Also NAFA funds launched and managed by an AMC that is
subsidiary of NBP (National Bank of Pakistan) has assets under management exceeding a billion US dollar. As a
comparison, there are a few Pakistani industrial companies whose market value of equity is more than a billion US
dollar. With such huge amounts of financial assets under their control of AMCs, it is important that their
performance must be monitored closely. It is also logical that based on the performance of portfolios (mutual funds)
under their management, the managers of AMCs should be rewarded or penalized. In this lecture issues pertaining
to measuring the performance of a portfolio, or more accurately performance of a portfolio manager, are discussed
in some detail.
How to evaluate performance of a portfolio? Or more correctly, how to evaluate performance of a portfolio manager
? This is an unsettled issue. If we compare realized Rp of your portfolio with the realized Rp of all other professionally
managed portfolios taken together, then question arises: which portfolio to be used as the benchmark portfolio
against which your portfolios returns should be compared. Moreover, comparing only the percentage returns of
your portfolio with some other portfolio is only half the story because the risk has been ignored. In fairness, the
benchmark portfolio against which your portfolio returns are compared should have the same risk as your portfolio;
and only then it is fair to compare your portfolios returns with the Rp of the benchmark portfolio. Another problem
is that returns of portfolio can be affected by cash inflows and outflows experienced by a portfolio during the
evaluation period, and that issue is relevant to open-ended mutual funds. Realized returns for any holding period
on a portfolio which does not experience cash inflows and outflows, such as a closed end mutual funds (or the 4
portfolios that you constructed for your class project) are:
Realized Rp= [(End Value - Beg Value)/Beg Value] + [ Dividend/Beg Value]
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While end value or beginning value of a portfolio is market value of shares in the portfolio. If cash dividends are
received during a period then these are included in the wealth at the end of period (W1 ); and then realized rate of
return earned by a portfolio can be written as:
Realized Rp for a closed end portfolio = [(W1 - W0) /W0 ]
But all portfolios are not like closed- end mutual funds where funds are given to portfolio manager once and then
no further funds are given or taken away from her during the period under evaluation. A lot of portfolios, such as
pension funds, provident funds, open ended mutual funds, etc, do receive regular inflows and experiences frequent
outflows during one year or any other period of interest. Due to inflows and outflows during the investment horizon,
end value may be affected . For example open-end mutual funds , such as NIT, experience daily inflow and out flow
of cash as investors every day buy units of NIT and also some investors surrender (sell back) the units to NIT.
Therefore difference in ending values of any 2 open ended portfolios do not give a clear proof that one portfolio
manager was better than the other manager if portfolios were open ended. Example:
YEARS
Manager A Year 0 Year 1 Year 2 Year 3
Value before in and outflows 100 240 126 138.6
In(out) flows 100 (100) 0
Invested amount 200 140 126
Ending Value 240 126 138.6
Rp= (End Value - Beg Value)/Beg Value 20% -10% 10%
Holding Period Rp = [(1 + ROR 1) (1 + ROR2)(1 + ROR3)] -1
=[(1+ 0.2)(1+ -0.1)(1+ 0.1)] - 1 = 18.8% per 3 years holding period
Please note; The above Rp for 3-yar holding period is time-weighted Rp. That means growth in wealth is 18.8% in 3
years. And some one can incorrectly calculate 3-year holding period returns as : (138.6 100 )/100 = 38.6% per 3
years; and may conclude that 38.6/3 = 12.86% per year on average was earned as Rp by this portfolio over a three
year period. Please note also that in this case arithmetic mean Rp per year is: (20 + -10 + 10)/3 = 6.66% per year,
not 12.86%.
186
YEARS
Manager B Year 0 Year 1 Year 2 Year 3
Value before in and outflows 100 120 198 107.8
In(out) flows 0 100 -100
Invested amount (Beg Value) 100 220 98
Ending Value 120 198 107.8
Rp= (End Value - Beg Value)/Beg Value 20% -10% 10%
Holding Period Rp = [(1 + ROR 1) (1 + ROR2)(1 + ROR3)] -1
= ((1+0.2)(1+ -0.1)(1+0.1)) - 1= 18.8/ per 3-Year holding period. It is time-weighted Rp.
And some one can incorrectly calculate 3-year holding period returns as : (107.8 100 )/100 = 7.8% per 3 years;
and may conclude that 7.8/3 = 2.6% per year on average was earned as Rp by this portfolio over a three year period.
Please note also that in this case also the arithmetic mean Rp per year is: (20 + -10 + 10)/3 = 6.66% per year, not
2.6%.
Both managers began 3-year period with 100 million, both managers experienced during three years inflows of 100
and out flows of 100 million; though the timings of inflows and out flows were different for two managers. And two
managers ended with very different ending value of their respective portfolios. Can we say that manager A has
performed better than manager B because ending value was greater after 3 years for manager A ? The Answer is a
resounding NO.
So for the open ended portfolios which experience cash inflows and outflows during the evaluation (holding) period,
the performance cannot be judged by comparing beginning value with the ending value; rather the holding period
returns for the periods under evaluation must be calculated to decide which portfolio gave better returns. In the
previous example Manager A started with 100 and ended after 3 years with 138 while during 3 years she experienced
inflows of 100 and outflows of 100. Manager B also started with 100 but ended after 3 years with 107.8 and
experienced inflows of 100 and outflows of 100 during this period. Though 2 managers ended with very different
ending value for their portfolios, yet their performance was exactly same when compared on the basis of holding
period returns (calculated as time weighted returns) over the three year period. Otherwise if you had calculated 3-
year holding period Rp as:
(End value - Beginning value) / Beginning value
187
3-year Rp for portfolio manager A = (138.6 - 100) / 100 = 38.6%; and per year Rp = 38.6/3 = 12.86%
3-year Rp for portfolio manager B = (107.8 - 100) / 100 = 7.8%; and per year Rp = 7.8/3 = 2.6%
And therefore you would have concluded that manager A has performed better; but actually that would be an
incorrect conclusion. Using beginning value and ending value of portfolio is valid method only for portfolios which
experience no interim cash inflows and outflows, such as closed ended mutual funds. Please note that for
your class projects also, all the 4 portfolios were closed-ended.
But in the example given above, both portfolios experienced cash inflows and outflows, though timing of inflows
and out flows were different; these were open-ended portfolios. Therefore correct method was comparing their
holding period returns of 3 year holding period; which were exactly the same for both portfolios (18.8% for the
three- year holding period). Therefore you would conclude that both managers performed exactly the same. This
hypothetical example serves to highlight the complexity involved in making sensible comparison of portfolio returns,
let alone doing comparison of portfolio performance by using both risk and returns
How to Include Portfolio Risk in Portfolio Performance Evaluation
As indicated already, the comparison of only the returns earned by portfolios is a complex issue; but more
importantly such a comparison of returns alone is not sufficient to make reasonable judgment about the
performance of a portfolio: risk must also be considered. By comparing realized Rp of a mutual fund with Rp of a
randomly built portfolio whose risk was same as the risk of that mutual fund it was found, in a study by Blume, that
average Rp of mutual funds was less than the Average Rp of randomly built portfolios of similar risk. This finding
implies that when general public gives money to professional portfolio managers of mutual funds then general public
does not earn better returns on a risk adjusted basis compared to a randomly build portfolio which is built by
choosing stocks blindly without any professional expertise. This finding raises question about the ability of
professional money managers to offer superior money management services to the general public; because general
public entrusted their money to professional money managers in the hope of earning higher rate of return. These
findings also raise question about the justification for the fees charged by professional money managers from their
clients, such as fee charged by mutual funds from the general public as front end load or back end load when
investors buy and sell respectively shares of mutual funds (usually such shares are called units). And these fees can
be substantial, ranging from 1% to 5% of investors funds. In Pakistan, mutual funds are managed by an Asset
Management Co (AMC); and mutual funds and the AMC are 2 separate legal entities; with their own income
statements and balance sheets. The Asset Management Co (AMC) charges a management fee from the mutual fund
organization; and this fee is the biggest operating expense of a mutual fund.
188
Please note in Blumes study the benchmark was randomly built portfolios of the same risk level as the risk of a
mutual fund under consideration. Some researchers have proposed to use all other professionally managed
portfolios in that country as benchmark. To perform such comparison, rankings in percentile terms are used. First
see in which percentile fall returns of your portfolio among all other professionally managed portfolios, i.e. mutual
funds. Then see in which percentile falls risk of your portfolio among all other professionally managed portfolios.
For example : last year your portfolios realized Rp was 15% and SDp was 5%. And your portfolio return was in 75th
percentile . So 75% of managers got lower R p than you. Your portfolios SDp (total risk) was in 85th percentile. So
85% managers assumed lower risk than you. Result : in terms of returns you were among the top 25% portfolio
managers; but in term of taking high risk you were among the top 15% portfolio managers. So your risk was higher
than return when compared with all other portfolio managers. If your portfolio risk were also in 75th percentile as
you Rp was, then it was ok. On the other hand if your portfolio risk were in 60th percentile and Rp were in 75Th
percentile then you would be recognized as superior money manager who earned relatively higher returns by taking
relatively lower risk; and relative here means relative to all other professionally managed portfolios.
189
Four Commonly Used Techniques Of Evaluating Portfolio Performance
Though there is no consensus about one acceptable method of evaluating performance of a portfolio, yet certain
methods of portfolio performance evaluation have gained currency and are widely used both by practicing managers
and academicians and researchers. Four such methods are presented below.
Sharpes Excess Return to Variability Ratio (Sharpes Ratio)
(Rp Rf) / SDP
Please note Rp and SDp are respectively realized annual rate of return and total risk of portfolio. This so called the
Sharpe ratio is calculated for each portfolio for a given period such as one year, and portfolios are ranked according
to this ratio: higher the ratio, better is the performance of portfolio, and higher is its rank compared to other
portfolios. You can read this ratio as excess portfolio returns per unit of risk. But a close examination would tell you
that actually the ratio is
(Rp - Rf ) / (SD p - SD Rf)
and SD Rf is not shown because it is zero by definition. It means this ratio is in fact slope of a straight line emerging
from Rf and passing through portfolio P, and extending till infinity. This line is called Capital Allocation Line (CAL) of
a portfolio, in this case it is CAL of portfolio P. Please remember from previous lectures that when you divide your
OE between a risky portfolio (in that case it was portfolio M) and a risk free asset and build multiple portfolios in this
manner, then all such portfolios fall on a straight line called CML. Also remember that the reason for these portfolios
falling on straight line was the perfect positive correlation between a risky portfolio (M) and risk free securities
returns as you saw in notes 14, 15, and 16 , and also in note 8 and 9. Similarly if we use any other risky portfolio
instead of portfolio M then portfolios made up by investing some OE in a risky portfolio P and some in risk free t-
bills would also arrange themselves on a straight line as shown below , and such a straight line is termed CAL.
190
You know that slope of CML is: (Rm - Rf)/ SDm. And it can be called Sharpe ratio of CML. And if portfolio has
Sharpe ratio higher than the Sharpe ratio of CML, then such a portfolio has beaten the market on a risk adjusted
basis.
CAL is straight
line made by
dividing OE in
P
portfolio P and Rf
S M
CML is straight line made by dividing
Rf OE in M and Rf
SD Rf SDp= 5% SDm
In the graph shown above, according to CML a portfolio with SDp = 5% should have Rp shown as S, but actually with
that much risk portfolio P has shown higher Rp, that is the vertical distance between portfolios P and S. Rp shown
as S should have been earned by taking risk (SDp) =5% if portfolio was built as efficient portfolio which required
investing only in 2 securities , namely market portfolio M and risk free asset . But apparently manager of portfolio
P has not built her portfolio in that manner and probably has decided to do stock selection, resulting in a portfolio
of , say, 10 stocks based on her security analysis. Of course this portfolio P is inefficient, of course it has diversifiable
risk, and of course portfolio manager has done all this deliberately in the hope of attaining a higher Sharpe ratio than
the Sharpe ratio of CML.
Since many portfolio managers in real life do not follow the dictates of modern portfolio theory, and do build their
portfolios by doing stock selection based on their security analysis expertise; therefore it is sensible to compare their
respective Sharpe ratios with each other, and do the ranking of their performance according to their Sharpe ratio.
Please note that Sharpe ratio does give consideration to both the returns and risk of a portfolio. In fact it is measuring
excess returns of portfolio per unit of its total risk.
As shown in graph above, for 5% risk (SDp) the CML is suggesting that an efficient portfolio, built by investing some
of your OE in Rf and some in M, should have a return of S (say its returns are 15% ); but portfolio P, which is tailor
made portfolio, probably composed of a few stocks, has earned higher returns shown as P (say its returns are 18%);
so portfolio P has beaten the market on a risk adjusted basis. For example if Rf is 3%, and based on total risk (SDp)
191
5%, CML tells this portfolio should have a ROR of 15% but actually it earned ROR of 18%; then according to the CML,
Sharpe ratio of portfolio P should be:
(Rp Rf )/ SDp = (15 3) /5 = 12 /5 = 2.4/1 =2.4
but actually portfolio P has Sharpe ratio of
( Rp SDp ) /SDp = (18 - 3) / 5 = 15 /5 = 3 /1 = 3
So if risk were one unit or 1% SDp, the excess returns of portfolio P should be 2.4% according to CML; but actually
excess return of portfolio P are 3%. Therefore portfolio P has earned higher excess returns per unit of risk than was
suggested by CML. You can say:portfolio P has beaten the market on a risk adjusted basis, or in other words
portfolio P falls on a straight line (CAL) which has higher slope than the slope of CML.
Sharpe ratio is used to rank portfolios: higher the ratio better is portfolios risk adjusted returns. For example your
portfolios Sharpe ratio is 10%, and Sharpe ratio of your friends portfolio is 13%; then she has outperformed you on
a risk adjusted basis. In other words if both portfolios have SDp of 1%, then her portfolios excess returns are 3
percentage points better than your portfolios excess returns. Please note that excess returns refer to Rp Rf. For
comparison purposes excess returns of portfolio are more meaningful than the Rp, because everyone can earn Rf,
so the relevant measure for returns is excess returns, i.e., Rp Rf. Therefore question boils down to : which of the
2 portfolios earned more excess returns if total risk of two portfolios was same? The answer is given by Sharpes
ratio. Please calculate Sharpe ratios for all 4 portfolios that you are managing for your project and then
rank them first, second, third, and fourth on the basis of their Sharpe ratio.
Treynors Excess Return to beta Ratio (Treynors Index)
(Rp - Rf) / p
This ratio measures excess returns per unit of relevant risk, only difference from Sharpe ratio is the use of relevant
risk (beta) instead of total risk (SDp) in the denominator of the ratio. Higher the ratio, better is portfolios risk
adjusted returns. Rank the portfolio according to this ratio. Please calculate Treynors ratios for all 4 portfolios
that you are managing for your project and then rank them first, second, third, and fourth on the basis
of their Treynors ratio.
192
Differential Returns Using SML
Risk adjusted required return of a portfolio according to CAPM theory is :
Rp = Rf + (Rm Rf)Bp
Differential return of a portfolio = Actual realized Rp - Rp from CAPM.
If your portfolio beta was 0.8, Rf was 5%, and Rm was 10%, then according to CAPM , your portfolio should have
earned in the previous year risk adjusted return of : Rp = 5 + (10 - 5)0.8 = 9%
If your portfolio actually earned in the previous year Rp of 11% then:
Differential return of your portfolio = Actual Rp Expected Rp
= 11 - 9
= 2%.
As your differential returns are positive, therefore you have beaten the market on a risk adjusted basis. It means
that based on the relevant risk (beta) of your portfolio , your portfolio should have earned 9% Rp but actually it
earned 11% Rp, thus beating the market on a risk adjusted basis. On the graph, you portfolio, as a dot, would appear
above the SML. Rank the portfolios on the basis of differential returns. Higher differential return means better
performance of portfolio manager, and positive differential returns means portfolio has beaten the market on a risk
adjusted basis whereas in this context risk means relevant risk or beta of portfolio. Please calculate differential
returns for all 4 portfolios that you are managing for your project and then rank them first, second, third, and
fourth on the basis of their differential returns from SML. Please note that your Index Portfolio would have zero
differential returns
Differential Returns using CML

Risk adjusted returns according to capital market theory are calculated from CML, which says:
Rp = Rf + {(Rm - Rf) / SDm}*SDp .
Compare: Actual realized Rp with Rp from CML equation. If actual Rp is greater than Rp expected from CML, then
differential returns of portfolio are positive, and you as portfolio manager did better than market for the given level
of total risk, in other words you have beaten the market. On the graph your portfolio, as dot, would fall above the
CML. For example : Last years Rf = 5%, Rm = 10%, SDm = 20%, total risk of your portfolio (SDp) = 15%.
Expected Rp from CML is:
Rp = Rf + {(Rm - Rf) / SDm}*SDp
193
Rp = 5 + [(10 - 5) / 20]*15
Rp = 8.75%
Your portfolios Actual realized Rp last year was 10%
Differential return = Actual Rp - Expected Rp from CML
= 10 - 8.75
= 1.25%
Again you have beaten the market on a risk adjusted basis. According to CML, for the given level of total risk (SDp)
of 15% your portfolio should have earned 8.75% Rp, but actually it earned 10% Rp, thus beating the market. Rank
the portfolios based on their differential returns from CML.
Please calculate differential returns for all 4 portfolios that you are managing for your project and then rank them
first, second, third, and fourth on the basis of their differential returns from CML. Please note that your Index
Portfolio would have zero differential returns
Two Investment Management Strategies
194
Generally there are two approaches to investment strategy, passive and active. The following is brief explanation of
two investment strategies.
It is important to note that the 4 portfolio performance evaluation methods discussed above may not result in the
same ranking for your 4 portfolios; but that should not be a cause of concern for you as it was stated in the beginning
of this lecture that there is no one agreed upon method of evaluating portfolio performance.
Passive strategy:
Invest some of your OE in the market portfolio (M) and some in a risk free asset ( such as t- bills); and the resulting
portfolios expected Rp can fall exactly on SML and your portfolios risk adjusted required return are estimated using
CAPM equation: Rp = Rf +(Rm - Rf)Bp. Also returns of portfolios built in this manner fall exactly on CML. Please
note in practice a market- index- mimicking mutual fund (index fund) is used as a proxy for market portfolio (M). In
the presence of risk free asset in the country, and if risk free lending (by investing in t-bills) and risk free borrowing
( by shorting t- bills) is allowed to the investors then all portfolios built in the above stated manner are efficient, fully
diversified, and have perfect correlation of their returns with the return of market portfolio. Portfolio of any desired
level of risk or target level of returns can be built using this method of portfolio construction.
Active strategy:
When you build a tailor made portfolio which is different in composition then market portfolio, then you do stock
selection on the basis of your security analysis abilities, i.e., based upon your estimates of expected Ri and SDi , VARi,
COV i , j, EPS 1, DPS1, g , P1, and Bi , etc, of different stocks. Stock selection is done in the hope of beating the market
on a risk adjusted basis. Your active investment strategys performance should be evaluated by differential returns
from SML. If you manage to show positive differential return from SML, then you have exceptional stock selection
abilities.
An investor opting for active strategy involves herself in stock selection instead of just dividing her OE between Rf
and M, and makes portfolios which have a few selected stocks; therefore such portfolios in all likelihood are not
fully diversified, and diversifiable risk is present in such portfolios. That means their VAR e P is not zero, while
portfolios made by dividing OE between Rf and M are always fully diversified and have zero VAR e P. So doing stock
selection means deliberately taking diversifiable risk. Common sense tells that it is justified for you to take a risk
only if extra returns are earned by taking such risk. Positive differential returns from SML is a proof of earning such
extra returns; and if differential returns of such tailor made portfolio is positive then it may be considered as reward
for taking diversifiable risk, or in other words, reward for doing superior stock selection.
195
On the other hand CAPM, as a theory, says that the market does not reward diversifiable risk; so no such extra
returns can be earned according to CAPM. According to CAPM only taking the relevant risk (beta) is rewarded by
the market in the form of higher returns. Therefore in CAPM equation it is beta (the relevant risk) which is
independent variable; and returns depend on it: higher relevant risk taking should result in higher returns according
to CAPM. In the jargon of finance: market rewards only the relevant risk; or, market prices only the relevant risk.
Therefore attempt to do stock selection is meaningless according to CAPM framework.
But you can prove you have superior stock selection ability if your tailor made portfolio of a few stocks earns positive
differential returns from SML, that is, its actual returns fall above SML. For example , for the beta of your portfolio,
CAPM was saying returns should be 12% but you earned 15%, so the 3 %age points positive differential returns of
your portfolio can be viewed as reward for taking diversifiable risk, or viewed as proof of your superior stock
selection abilities. This is also termed as beating the market on risk adjusted basis. Active strategists deliberately
build inefficient portfolios (and not fully diversified portfolios) on the basis of their presumed superior stock selection
abilities. Adopting active investment strategy, therefore, means you do not subscribe to the conclusions of portfolio
theory; because portfolio theorys final recommendation is to build efficient portfolios, and in the presence
of risk free lending and borrowing, such efficient portfolios of any desired level of risk or return can be built just by
dividing your OE between M and Rf; and such efficient portfolios always fall on CML as well as on SML; and you can
use CML and SML equations to estimate expected returns or risk of such portfolios. And such portfolios are fully
diversified, have perfect positive correlation of their return with Rm.
In fact according to CAPM all investors should invest only in one Markowitz risky portfolio, i.e., the market portfolio
,M, and in a risk free security (t-bills) ; and by doing so each investor can build her personal optimal portfolio of
any desired level of risk or desired level of returns . For example you can build in this manner an efficient portfolio
with expected Rp of 29%, or 129%; a portfolio whose beta is 0.9 or beta of 1.9 ; and you can do so just by changing
weights of market portfolio (Xm) and weight of risk free t-bills (XRf) in your personal optimal risky portfolio.
Many research studies indicate that no investment manager has shown superior stock selection abilities because
that requires a managers to show a track record of consistently beating the market on a risk adjusted basis for a
number of years. In other words, a portfolio manager has to show that year after year positive differential returns
from SML were earned by the portfolio she managed. Since such evidence has not been given by any professional
portfolio manager, therefore, though much neglected among the practitioners, the portfolio theory still holds; and
regardless of talk about hot stocks, the empirical evidence does not support the claims of superior performance
made by active strategists who can also be called stock selectors or stock pickers.
The Final Conclusions Drawn From Portfolio Theory

196
It should be clear by now that in the absence of risk free security, portfolio theory gives precise answer to question
1 and 2, namely, what to buy and what combination to buy ? It does so by giving exact weights (Xi) of stocks included
in Markowitz efficient risky portfolio selected by an investor as her / his optimal portfolio. In the presence of risk
free security and permission for risk free lending and borrowing, the portfolio theory again gives precise answers to
question 1 and 2 by recommending to invest only in 2 securities, namely market portfolio and risk free t-bills; and
the theory gives precise answers about the weights of efficient portfolio in the form of X m and X Rf for your desired
level of return and risk (Rp or Bp). Therefore the last word of advice based upon the portfolio theory is to adopt a
passive investment strategy, avoid stock selection, build your optimal portfolio for your desired level of risk (beta)
or desired level of return by investing only in 2 securities, namely, market portfolio (M) and risk free security (Rf) ;
and you will have an efficient portfolio, a fully diversified portfolio, and a rightly priced portfolio without worries of
holding an overvalued or undervalued portfolio.
Unfortunately these conclusions of portfolio theory are not stated in such stark and almost astonishing terms in any
text book; nor the advisory research reports prepared by the brokerage houses give this kind of advice. In case of
brokerage houses, one can understand their reluctance to tow this line of argument because their business
compulsion of earning commission revenues arising from frequent trading by the investors may prohibit them from
recommending such passive investment strategy to their clients.
The third and last question raised in the very first lecture was: When to buy ? There are ample research findings
showing that ability to correctly time the buying or the selling of stocks, or ability to time the entry and the exit from
the market, is not demonstrated by the followers of any of the so called systems of technical trading. Therefore
regardless of the claims made by the proponents of various approaches / methods / systems/ rules of technical
trading, none has shown consistently the ability to identify correctly the time to sell or time to buy. It must be
stated that any time is good time to buy, as long your estimate of expected return of market portfolio is reliable
enough. Similarly, the logic of portfolio theory would dictate, that any time is good time to sell.
It is important to emphasize that for the results of portfolio theory to be realized, at least a one year holding period
is necessary; that is why CAPM is called a single period model: inputs of CAPM, namely Rf and Rm, are annual
expected returns, therefore result of CAPM , namely Rp, is also annual expected return. It also makes sense that to
see the results of investment in corporate shares, one should hold shares for at least one year to give the corporate
managers a chance to show their performance in terms of managing the corporations and then investor in shares
should also allow for the time it takes for the corporate performance to translate into outcomes which impact
investors returns, namely, dividends and capital gains. In other words, the idea of frequent trades, or as they say in
industry jargon, frequent rebalancing the portfolio, is also not recommended by the portfolio theory. Buy and hold
at least for one year should be the mind set of investors following the portfolio theory.
197
This explanation still leaves the behavior of stock pickers un-explained; and the next lecture would discuss the logic
underlying the stock selection behavior of the active investors.
198

Portfolio Performance Evaluation Methods

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.

Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Evaluation of Portfolio Performance

Realized Rp= [(End Value - Beg Value)/Beg Value] + [ Dividend/Beg Value]

Realized Rp for a closed end portfolio = [(W1 - W0) /W0 ]

Holding Period Rp = [(1 + ROR 1) (1 + ROR2)(1 + ROR3)] -1

=[(1+ 0.2)(1+ -0.1)(1+ 0.1)] - 1 = 18.8% per 3 years holding period

Holding Period Rp = [(1 + ROR 1) (1 + ROR2)(1 + ROR3)] -1

= ((1+0.2)(1+ -0.1)(1+0.1)) - 1= 18.8/ per 3-Year holding period. It is time-weighted Rp.

(End value - Beginning value) / Beginning value

How to Include Portfolio Risk in Portfolio Performance Evaluation

Four Commonly Used Techniques Of Evaluating Portfolio Performance

Sharpes Excess Return to Variability Ratio (Sharpes Ratio)

(Rp Rf) / SDP

(Rp - Rf ) / (SD p - SD Rf)

(Rp Rf )/ SDp = (15 3) /5 = 12 /5 = 2.4/1 =2.4

but actually portfolio P has Sharpe ratio of

( Rp SDp ) /SDp = (18 - 3) / 5 = 15 /5 = 3 /1 = 3

Treynors Excess Return to beta Ratio (Treynors Index)

Differential Returns Using SML

Risk adjusted required return of a portfolio according to CAPM theory is :

Differential return of a portfolio = Actual realized Rp - Rp from CAPM.

Differential Returns using CML

Two Investment Management Strategies

The Final Conclusions Drawn From Portfolio Theory

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