Performance Evaluation

Evaluation of the historic performance of a portfolio is the last step in the process of portfolio management. Investors seek maximum returns with a minimum risk in their portfolio. To begin with, the rate of return provides a useful perspective on portfolio performance. In assessing portfolio performance it is necessary to consider both risk and return i.e., the return should be adjusted for risk exposure. One simple method of adjusting for risk is to locate the absolute level of return per unit of risk. The risk may be measured in terms of standard deviation or beta of the portfolio. Alternatively methods developed by William Sharpe and Jack Treynor use risk premium instead of absolute return in the numerator.

Sharpe Ratio
Sharpe Ratio This ratio measures the return earned in excess of the risk free rate on a portfolio to the portfolios total risk as measure by the standard deviation in its returns over the measurement period. William Sharpe used standard deviation as a measure of risk and Treynor uses beta of the portfolio. Sharpe Ratio= Risk premium/ Total risk or Return on Portfolio-Return of Risk free investment Standard Deviation of Portfolio or ( p- f) p

r r

Where

rp = average return from a portfolio

rf = average risk-free rate of interest
p= standard deviation of return for portfolio

Treynor Ratio
Treynor Ratio This ratio is similar to the above except it uses beta instead of standard deviation. Its also known as the reward to Volatility Ratio, it is the ratio of a funds average excess return to the funds beta. It measures the returns earned in excess of those that could have been earned on a riskless investment per unit of market risk assumed. Treynor Ratio = risk premium systematic risk or Return on Portfolio-Return of Risk free investment Beta of Portfolio (rp-rf) Where rp = average return from a portfolio rf = average risk-free rate of interest = portfolio beta or systematic risk index of portfolio.

Michael Jensens measure of portfolios alphas

Jensens Alpha: This is the difference between a funds actual return and those that could have been made on a benchmark portfolio with the same risk i.e. Beta. It measures the ability of active management to increase returns above those that are purely a reward for bearing market risk. The Expected Return = Risk Free Return + Beta Portfolio (Return of MarketRisk Free Return) Alpha = Return of Portfolio- Expected Return Jensens measure(p)= rp- E(rp) Where E(rp)= rf + p(rm-rf) (p)= differential return earned Rp= average return on portfolio, E(rp)= expected return predicted by the SML Rf= average risk free rate of interest, Rm= average return on market portfolio = systematic risk of the portfolio, (rm-rf) = risk premium for market index

It may be noted that the conclusion is based on the sign of alpha. If the value is identical for two portfolios, it does not mean that they have performed equally well. This implies that ranking of the assets based on their alpha is unsuitable. Alpha divided by portfolio beta yields risk-adjusted alpha, which is the appropriate measure for ranking of assets. Eugene Fama has provided the procedure for decomposition within the analytical framework provided by Sharpe, Treynor and Jensen evaluation measures. Famas measure of net or pure selectivity of portfolios is overall selectivity minus additional return needed to compensate for diversifiable or unsystematic risk of the portfolio. This represents the extra return earned over and above the return required for the total risk of the total portfolio. Net Selectivity = Average return on portfolio Return predicted by CML

Problems
1. Following information is available regarding four mutual funds: Evaluate performance of these mutual funds using Sharpes ratio and Treynors ratio. Comment on the evaluation after ranking the funds.
Mutual Fund P Q R S Return (%) 13 17 23 15 Risk (%) 16 23 39 25 Beta .90 .86 1.20 1.38 Risk Free rate (%) 9 9 9 9

Problems
2. A Ltd has an expected return of 22% and standard deviation of 40%. B Ltd. Has an expected return of 24% and standard deviation of 24%. The correlation coefficient between the return of A Ltd and B Ltd. Is 0.72. the standard deviation of the market return is 20%. Suggest: i. Is investing in B Ltd is better than investing in A Ltd. ii. If you invest 30% in B Ltd and 70% in A Ltd what is your expected rate of return and portfolio standard deviation? iii. What is the market portfolios expected rate of return and how much is the risk free rate? iv. What is the beta of portfolio if A Ltd weights is 70% and B Ltd weight is 30%?

 Michael C Jensens measure or portfolios alphas value is the second type of risk adjusted performance measure. Jensen's measure is the average return on the portfolio, over and above that predicted by SML of the CAPM. In other words, it is the differential or the extra return earned for the realized (systematic) risk of the portfolio. Positive value of the alpha shows the superior ability of the portfolio manager in selecting undervalued assets.