Chapter 20 EVALUATION OF PORTFOLIO MANAGEMENT. Chapter 20 Questions What are some methods used to evaluate portfolio performance? What are the differences

Chapter 20

EVALUATION OF PORTFOLIO MANAGEMENT

Chapter 20 Questions

What are some methods used to evaluate portfolio performance?What are the differences and similarities between the various portfolio performance measures?When we evaluate a sample of portfolios, how do we determine how well diversified they are?How do the various performance measures relate to each other in terms of rankings?


What are clients’ major requirements of their portfolio managers?What important characteristics should any benchmark possess?What is the benchmark error problem, and how does it affect portfolio performance measures?What impact has global investing had on the significance of the benchmark error problem?


What two methods can be used to determine a portfolio’s style exposure over time?

What is portfolio performance attribution analysis? How does it assist the process of analyzing a manager’s performance?

How do bond-portfolio performance measures differ from equity-portfolio performance measures?


What measure of risk is used in the Wagner and Tito bond-portfolio performance measure?

What are the components of the Dietz, Fogler, and Hardy bond-portfolio performance measure?

Judging Portfolio Performance

Regardless of the style of management, it is important to evaluate whether portfolio results match the goals of the portfolio managers.

Composite Portfolio Performance Measures

How can we evaluate portfolio performance? Calculate excess returns as the difference

between portfolio returns and a returns from a return-generating model like the CAPM.

Relative return ratios, which measure return per unit of risk

Scaled return methods, which adjusts the portfolio return for risk so that it can be directly compared to the benchmark return


Excess Returns Methods Jensen Measure

Calculates excess returns based on the CAPM Jensen’s alpha represents how much the manager

contributes to portfolio (j) returns

aj = Rjt –(RFRt + j(Rmt-RFRt)) Superior managers will generate a significantly positive

alpha; inferior managers will generate a significantly negative alpha

Could use APT as the return-generating model


Relative Return RatiosSharpe Portfolio Performance Measure

Based on the Capital Market Line, considers the total risk of the portfolio being evaluated

S=(Rportfolio-RFR)/portfolio

Shows the risk premium earned over the risk free rate per unit of total risk

Sharpe ratios greater than the ratio for the market portfolio indicate superior performance (plot above the CML)


Relative Return RatiosTreynor Portfolio Performance Measure

Based on the CAPM, considers the risk that cannot be diversified, systematic risk

T=(Rportfolio-RFR)/portfolio

Shows the risk premium earned over the risk free rate per unit of systematic risk

Treynor ratios greater than the market risk premium indicate superior performance (plot above the SML)

Information RatiosLet Rpt = the return on a portfolio in period t

RBt = the return on the benchmark portfolio in period t

Dt = the differential return in period t

Dt = Rpt - RBt

D = the average value of Dt over the period examined

N

DD

T

tt

1

D = the standard deviation of the differential return during the period

D

DS

The historic (ex post) Sharpe Ratio (S) is:


Scaled Returns Risk-Adjusted Performance Measure (RAP)

Adjust the risk of the portfolio to equalize the risk of the market or benchmark portfolio

Compare the returns after risk adjustment to the benchmark portfolio returns

For instance, using the Sharpe index (S):

RAPportfolio = RFR+(market)xS Resulting values larger than the market return (or other

benchmark used) would indicate superior performance


Comparing MeasuresSharpe and RAP both use the portfolio

standard deviation as the risk measure, so use total risk to evaluate performance

Treynor and Jensen use only systematic risk (beta) to evaluate performance


Comparing Measures All measures will give consistent results for

completely diversified portfolios When reviewing both diversified and undiversified

portfolios, a poorly diversified portfolio could have high beta-adjusted performance but lower -adjusted performance

Statistical analysis indicates high correlations across performance measures when evaluating mutual fund performance

They tend to rate and rank performance consistently Still may make sense to use different measures at times

What is Required of a Portfolio Manager?

1. Follow the client’s policy statement

2. Earn above-average returns for a given risk class

3. Diversify the portfolio to eliminate unsystematic risk

Benchmark Portfolios

Provides a performance evaluation standard to judge whether the portfolio manager is meeting requirementUsually a passive index or portfolio

May need benchmark for entire portfolio and separate benchmarks for segments to evaluate individual managers


Required Characteristics of Benchmarks

Unambiguous

Investable

Measurable

Appropriate

Reflective of current investment opinions

Specified in advance


Sometimes no appropriate single benchmark exists, so you “build your own”Specialize as appropriateBe sure to consider risk and ensure that performance standards are not met simply through taking on additional risk.

Performance Measures and Benchmark Error

The market portfolio problemThe theoretical market portfolio is an efficient, diversified portfolio that contains all risky assets in the economy, weighted by their market values Typically use the S & P 500 Index

This is not a complete market proxy (this is benchmark error)

Further, betas derived using an incomplete benchmark may also differ from a company’s “true beta”

Performance Measures and Benchmark Error

Benchmark Errors and Global Investing Concern with the benchmark error increases with

global investing The Dow 30 stocks have higher betas against the

S&P 500 than against the Morgan Stanley World Stock Index

The benchmark problem is one of measurement in evaluating portfolio performance

Might want to give greater weight to the standard deviation-based portfolio performance measures (Sharpe measures)

Taxable Performance and Benchmarking

Another difficulty in evaluating performance

No standard way of adjusting pre-tax performance to after-tax performanceNeed to adjust for capital gains and income

flows to be reinvested

A difficult issue to resolve

Benchmarking and Portfolio Style

Two means of determining a portfolio manager’s style Returns-based analysisCharacteristic analysis

Returns-based analysisAlso called effective mix analysisPortfolio’s historical return pattern is compared to various well-specified indexesAnalysis uses sophisticated programming techniques to indicate styles most similar to the portfolio’s actual returns

Characteristic analysisBased on the idea that current make-up will be a good predictor for the next period’s returnsClassifies manager into four styles: Value, growth, market-oriented, small-

capitalization

Decision tree approach to classify a portfolio’s stocksDevelop a “sector deviation measure”Results combined to determine style

Attributions for Portfolio Performance

Possible explanations of superior performance: Insightful asset allocation strategy that

overweighted an asset class that earned high returns

Investing in undervalued sectorsSelecting individual securities that earned

above average returnsSome combination of these reasons

Attributions for Portfolio Performance

Client’s policy statement is the place to start and compare against actual values Effects of asset allocation decision

Compare actual performance against the policy statement allocation strategy earning benchmark returns across all allocations

Look for differences in allocations and returns within allocations to explain performance differences

Impact of sector and security selection Repeat the same exercise as above, looking to explain

either strong or weak performance

Evaluation of Bond-Portfolio Performance

How did performance compare among portfolio managers relative to the overall bond market or specific benchmarks?

What factors explain or contribute to superior or inferior bond-portfolio performance?

A Bond Market Line

Need a measure of risk such as beta coefficient for equitiesDifficult to achieve due to bond maturity

and coupon effect on volatility of prices

Composite risk measure is the bond’s durationDuration replaces beta as risk measure in

a bond market line

Bond Market Line Evaluation

Explains differences from benchmark returns as a function of the following: Policy effect

Difference in expected return due to portfolio duration target

Interest rate anticipation effect Differentiated returns from changing duration of the

portfolio Analysis effect

Acquiring temporarily mispriced bonds Trading effect

Short-run changes

Decomposing Portfolio Returns

Dietz, Fogler, and Hardy decomposition of portfolio returns into income, interest rate, sector/quality, and residual effects

Total return during a period is the income effect if the yield curve remained constant during the period

Interest rate effect measures changes in the caused by changes in the term structure of interest rates during the period

Decomposing Portfolio Returns

The sector/quality effect measures impact on returns because of changing yield spreads between bonds in different sectors/ratingsThe residual effect is what is left after accounting for the first three factors A large positive residual would indicate superior

selection capabilities

Examining these effects over time should help to determine the strengths and weaknesses of a bond portfolio manager

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Chapter 20 EVALUATION OF PORTFOLIO MANAGEMENT. Chapter 20 Questions What are some methods used to evaluate portfolio performance? What are the differences