Chapter 22

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

22-1
Measuring Portfolio Performance
 “Bottom line” issue in investing
 Important for investors who manage their
own money or have others manage it
 Performance must be evaluated before
intelligent decisions can be made about
portfolios
 Ratings reflect only past performance, not
future performance

22-2
 Three key questions
1. Was the return, after expenses,
satisfactory?

2. How much risk did investor/manager take?

 Evaluate performance on a risk-adjusted basis

3. What should have been earned? That is the

proper benchmark.
 Relative comparisons necessary

22-3
 Change in investor’s total wealth over an
evaluation period
(VE - VB) / VB
VE =ending portfolio value
VB =beginning portfolio value
 Assumes no funds added or withdrawn
during evaluation period
◦ Timing of cash flows is important

22-4
 Money-weighted returns
◦ Equivalent to internal rate of return (IRR)
◦ Measures actual return considering
contributions and withdrawals
◦ Equates initial value with PV of cash flows and
ending value
◦ Cash flow effects make comparisons to
indexes or other portfolios inappropriate

22-5
 Time-weighted returns
◦ Unaffected by portfolio additions/withdrawals
◦ Measures actual rate of return earned by
manager
 Money-weighted vs. Time-weighted returns
◦ Can produce different results
◦ MWR captures rate of return to owner
◦ TWR captures rate of return earned by
portfolio manager

22-6
 Risk differences cause portfolios to respond
differently to market changes
 Total risk measured by the standard
deviation of portfolio returns
 Nondiversifiable risk measured by a
security’s beta
 Coefficient of determination (R2) denotes
degree of diversification

22-7
Performance Benchmarks & Universes
 Good universes/benchmarks are:
◦ Unambiguous
◦ Specified in advance
◦ Appropriate
◦ Investable
◦ Measurable
 It can be difficult to find benchmarks that
meet these criteria

22-8
Performance Benchmarks & Universes
 Universes
◦ Constructed by aggregating market valuations and
income accruals for a large number of portfolios
◦ Generally not investable or specified in advance
◦ Subject to survivorship bias
 Benchmarks
◦ Unmanaged portfolios that reflect investment style
◦ Unambiguous, measurable, investable
◦ May not truly capture manager’s style

22-9
Performance Evaluation

 Straightforward method
◦ Compare each asset class to relevant
benchmark
◦ Calculate weighted average return
◦ Compare return to your portfolio
◦ Money-weighted return will measure
portfolio’s return to owner

22-10
 Sharpe (reward-to-variability) ratio

◦ Based on the ex post capital market line

◦ Equals excess return divided by risk
◦ Higher the ratio → better the performance
◦ Provides a ranking measure for portfolios
 The Treynor ratio
◦ Replaces standard deviation with beta

22-11
 The estimated a coefficient in
Rpt - RFt =ap +bp [RMt - RFt] +ept
is a means to identify superior or inferior portfolio
performance
◦ CAPM implies a is zero
◦ Measures contribution of portfolio manager

 If a >0 (<0,=0), risk-adjusted performance

superior (inferior, equal) to market
◦ Statistical significance rarely achieved

22-12
M2
 Allows returns between portfolios to be
compared
 Measured in percentage terms, easy to
understand
 Equates the volatility of portfolio to market
◦ The resulting measure, M2, is directly
comparable to market return

22-13
Performance Measures Compared

 If portfolio is completely diversified, Sharpe,

Treynor, M2, Jensen agree on ranking
 Sharpe ratio evaluates performance on basis
of both return and diversification
 M2 produces percentage return
 Jensen’s measure must be adjusted to rank
portfolios

22-14
 Information Ratio (IR): relates performance
to a designated benchmark

 Where,
◦ Mean active return often referenced as “alpha”
◦ Standard deviation of active return often
referenced as “tracking risk”
 Sortino ratio (SR) focuses on “excess”
return relative to downside risk

 RMAR = minimum acceptable return

 DDMAR = downside deviation

 Useful measure when return distributions

are not symmetric
Style Analysis
 Seeks to identify portfolio’s investing style
in terms of types of securities targeted
 Two approaches to identify portfolio style
1. Holdings-based: uses the characteristics of
the portfolio’s current holdings
2. Returns-based: compares portfolio’s
returns to returns of market indexes
 Many mutual funds inconsistent in style

22-17
Components: Measurement, Attribution, and
Appraisal
 Measurement – measure the performance
(risk and return) of the portfolio
 Attribution – attribute performance to
manager’s selection or allocation abilities
 Appraisal – assess the manager’s
performance
Performance Attribution

 Decomposes total performance into specific

components
 Typically top-down approach
 Identify benchmark (bogey) to compare to
portfolio
◦ Bogey designed to measure passive results
◦ Difference between portfolio’s results and
bogey must be result of managers’ decisions

22-19
Performance Presentation
 Minimum standards developed to reduce
performance misrepresentations
◦ Global Investment Performance Standards (GIPS)
require:
 Uniformity in calculations and disclosures
 Inclusion of all fee-paying discretionary portfolios
in composites with similar objectives
 Compliance history for at least five years
 Effective evaluation requires long-term results,
fair measures

22-20
Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of

this work beyond that permitted in section 117 of
the 1976 United States Copyright Act without
express permission of the copyright owner is
unlawful. Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the
use of the information herein.

22-21