Lecture 9 Portfolio Performance Evaluation

Equity Investments

The CAPM provides the framework for the evaluation of the performance of Funds
which invest in equities.

The three main measures are:

- the Jensen measure
- the Treynor measure
- the Sharpe measure

Finally, we consider Fama’s critique of the Jensen measure.

The Jensen measure

The Jensen α is the excess return generated by the fund over a benchmark portfolio
with the same β.

Ie if Rb = Rf + βa (Rm-Rf) ; and the fund’s actual return is

Ra = α + Rf + βa (Rm-Rf)

then α = Ra - Rb .

If α is positive it shows a superior performance.

In practical terms:

(i) An expost security market line (SML) is drawn based on the average riskfree rate
and the market return. α is the amount by which actual return is above the SML.
(ii) An expost characteristic line can be drawn for the fund by regressing (Ra-Rf)
against (Rm-Rf). α is the intercept on the y-axis, β is the slope of the line.

The performance of a fund is evaluated with respect to the SML on this basis.

Ri Ex post SML Ra-Rf Characteristic Line

Ra α Slope βa
Rm
Rf
α
βa 1
β Rm-Rf

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The Treynor measure

Within the framework as above, the Treynor measure calculates: = Ra - Rf

As shown below: βa

Ri Ex post SML Ra-Rf Characteristic Line

Ra α Slope βa
Rm
Rf
α
βa 1
β Rm-Rf

The Treynor measure is also known as a reward- to- volatility ratio.

A fund shows superior performance if its Treynor measure exceeds that of the market
portfolio.

Treynor measure of market portfolio = Rm-Rf ( since its β = 1)

The Sharpe measure

In contrast, the Sharpe measure takes into account total risk = Ra -Rf
σa
It is also called the reward-to-variability ratio (or reward to total risk ratio)

An ex-post CML is drawn by obtaining average rate of risk free return and the
standard deviation of the market portfolio.

The average returns and standard deviation of the portfolio are then located on this
plot.

Ri Ex post CML
Ra
Rm

Rf

σa σm
σ

The fund shows superior performance if

Ra -Rf > Rm-Rf

σa σm

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