Portfolio Evaluation & Revision SAIM (UNIT IV)

Presented by:Dr. Mini Jain

It is Not the Return On My Investment ...

It is not the return on my investment that I am concerned about. It is the return of my investment!
Will Rogers

Introduction
Portfolio evaluating refers to the evaluation of the performance of the portfolio. It is essentially the process of comparing the return earned on a portfolio with the return earned on one or more other portfolio or on a benchmark portfolio. Portfolio evaluation essentially comprises of two functions, performance measurement and performance evaluation. Performance measurement is an accounting function which measures the return earned on a portfolio during the holding period or investment period. Performance evaluation , on the other hand, address such issues as whether the performance was superior or inferior, whether the performance was due to skill or luck etc. The ability of the investor depends upon the absorption of latest developments which occurred in the market. The ability of expectations if any, we must able to cope up with the wind immediately. Investment analysts continuously monitor and evaluate the result of the portfolio performance. The expert portfolio constructer shall show superior performance over the market and other factors. The performance also depends upon the timing of investments and superior investment analysts capabilities for selection. The evolution of portfolio always followed by revision and reconstruction. The investor will have to assess the extent to which the objectives are achieved. For evaluation of portfolio, the investor shall keep in mind the secured average returns, average or below average as compared to the market situation. Selection of proper securities is the first requirement.

Need for portfolio evaluation

To build an optimum portfolio & to ensure that the portfolio continues to remain an optimum one. Performance evaluation of the portfolio is required to be done at periodic intervals to check up whether the objectives of the portfolio are being met To revise the portfolio if required

Performance Evaluation Measures

For evaluation the performance of the portfolio(s), it is necessary to consider both risk & return. Various methods to do so: Sharpe measure. Treynor measure. Jenson measure.

Sharpe Measures
- William Sharpe
The objective of modern portfolio theory is maximization of return or minimization of risk. In this context the research studies have tried to evolve a composite index to measure risk based return. The credit for evaluating the systematic, unsystematic and residual risk goes to sharpe, Treynor and Jensen. Sharpe measure total risk by calculating standard deviation. The method adopted by Sharpe is to rank all portfolios on the basis of evaluation measure. Reward is in the numerator as risk premium. Total risk is in the denominator as standard deviation of its return. We will get a measure of portfolios total risk and variability of return in relation to the risk premium. The Sharpe ratio is a reward-to-risk ratio that focuses on total risk. One simple way to investigate the funds performance is to consider risk-adjusted returns. Thus, the Sharpe measure gives us a measure of return per unit of total risk.

Sharpe Measures
Sharpe ratio Rp R f p

Rp Average rate of return on portfolio p. Rf Average rate of return on a risk-free investment.

p S.D. of return of portfolio p.

Hence, the Sharpe measure reflects the excess return earned on a portfolio per unit of its total risk (standard deviation). The higher the Sharpe measure, the better the performance.

Treynor Measures - Jack Treynor

The Treynor ratio is a reward-to-risk ratio that looks at systematic risk only. It basically gives us a measure of return per unit of market risk (or systematic risk) that our investment earns. This measure substitutes standard deviation for Beta. However, unlike the Sharpe Ratio, it uses the systematic risk instead of total risk.

Treynor Measures
Treynor ratio Rp R f
p

Rp Average rate of return on portfolio p. Rf Average rate of return on a risk-free investment. p Beta[systematic risk] of portfolio p. Hence this measure reflects the excess return on a portfolio to the portfolio beta. As systematic risk is the measure of risk, the Treynor measure implicitly assumes that the portfolio is well diversified.

Jensens Measure: - Michael Jensen

Jensen attempts to construct a measure of absolute performance on a risk adjusted basis. This measure is based on CAPM model. It measures the portfolio managers predictive ability to achieve higher return than expected for the accepted riskiness. The ability to earn returns through successful prediction of security prices on a standard measurement.

Jensens Measure
E(Rp) = Rf+ p (Rm Rf) Where, Rp = Return on portfolio RM = Return on market index Rf = Risk free rate of return p = Beta coefficient of the portfolio

Application of Portfolio Performance Measures

Calculated Sharpe, Treynor and Jenson measures for 20 mutual funds. Using the Jenson measure, only 3 managers had superior performance (Fidelity Magellan, Templeton Growth Funds, and Value Line Special Situations Fund) while 2 managers had inferior performance (Oppenheimer Fund and T. Rowe Price Growth Stock Fund).

Relationship among Portfolio Performance Measures

For all three methods, if we are examining a welldiversified portfolio, the rankings should be similar. A rank correlation measure finds that there is about a 90% correlation among all three measures. Reilly recommends that all three measures. [In my opinion the Jensen measure is the most stringent. It is testing for statistical significance, whereas the other methods are not. The other methods are also examining average returns, whereas the Jensen measure uses actual returns during each observation period.]

Thank You!!!