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1 Performance Evaluation and Active Portfolio Management CHAPTER 18

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2 Introduction Complicated subject Theoretically correct measures are difficult to construct Different statistics or measures are appropriate for different types of investment decisions or portfolios Many industry and academic measures are different The nature of active managements leads to measurement problems

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3 Abnormal Performance What is abnormal? Abnormal performance is measured: Comparison groups Market adjusted Market model / index model adjusted Reward to risk measures such as the Sharpe Measure: E (r p -r f ) / p

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4 Factors That Lead to Abnormal Performance Market timing Superior selection – Sectors or industries – Individual companies

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5 Comparison Groups Simplest method Most popular Compare returns to other funds with similar investment objectives

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6 Risk Adjusted Performance: Sharpe 1) Sharpe Index r p - r f r p = Average return on the portfolio r f = Average risk free rate p = Standard deviation of portfolio return p

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7 Risk Adjusted Performance: Treynor 2) Treynor Measure r p - r f ß p r p = Average return on the portfolio r f = Average risk free rate ß p = Weighted average for portfolio

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8 = r p - [ r f + ß p ( r m - r f ) ] = r p - [ r f + ß p ( r m - r f ) ] 3) Jensen’s Measure 3) Jensen’s Measure p p r p = Average return on the portfolio ß p = Weighted average Beta r f = Average risk free rate r m = Avg. return on market index port. Risk Adjusted Performance: Jensen = Alpha for the portfolio

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9 M 2 Measure Developed by Modigliani and Modigliani Equates the volatility of the managed portfolio with the market by creating a hypothetical portfolio made up of T-bills and the managed portfolio If the risk is lower than the market, leverage is used and the hypothetical portfolio is compared to the market

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10 M 2 Measure: Example Managed Portfolio Market T-bill Return35% 28% 6% Stan. Dev42% 30% 0% Hypothetical Portfolio: Same Risk as Market 30/42 =.714 in P (1-.714) or.286 in T-bills (.714) (.35) + (.286) (.06) = 26.7% Since this return is less than the market, the managed portfolio underperformed

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11 Figure 17-2 The M 2 of Portfolio P

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12 T 2 (Treynor Square) Measure Used to convert the Treynor Measure into percentage return basis Makes it easier to interpret and compare Equates the beta of the managed portfolio with the market’s beta of 1 by creating a hypothetical portfolio made up of T-bills and the managed portfolio If the beta is lower than one, leverage is used and the hypothetical portfolio is compared to the market

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13 T 2 Example Port. P.Market Risk Prem. (r-r f ) 13% 10% Beta Alpha 5% 0% Treynor Measure Weight to match Market w = M / P = 1.0 / 0.8 Adjusted Return R P * = w (R P ) = 16.25% T 2 P = R P * - R M = 16.25% - 10% = 6.25%

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14 Figure 17-3 Treynor Square Measure

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15 Which Measure is Appropriate? It depends on investment assumptions 1) If the portfolio represents the entire investment for an individual, Sharpe Index compared to the Sharpe Index for the market. 2) If many alternatives are possible, use the Jensen or the Treynor measure The Treynor measure is more complete because it adjusts for risk

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16 Exercise2 1. A managed portfolio has a standard deviation equal to 22% and a beta of 0.9 when the market portfolio's standard deviation is 26%. The adjusted portfolio P* needed to calculate the M2 measure will have _____ invested in the managed portfolio and the rest in T-bills. a. 84.6% b. 118% c. 18% d. 15.4%

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17 Exercise 2 Use the following to answer questions 2-4: The average returns, standard deviations and betas for three funds are given in previous slide along with data for the S&P 500 index. The risk free return during the sample period is 6%. 2. You wish to evaluate the three mutual funds using the Sharpe measure for performance evaluation. The fund with the highest Sharpe measure of performance is __________. a. Fund A b. Fund B c. Fund C d. Indeterminable 3. You wish to evaluate the three mutual funds using the Treynor measure for performance evaluation. The fund with the highest Treynor measure of performance is __________. a. Fund A b. Fund B c. Fund C d. Indeterminable 4. You wish to evaluate the three mutual funds using the Jensen measure for performance evaluation. The fund with the highest Jensen measure of performance is __________. a. Fund A b. Fund B c. Fund C d. S&P500

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18 Limitations Assumptions underlying measures limit their usefulness When the portfolio is being actively managed, basic stability requirements are not met Practitioners often use benchmark portfolio comparisons to measure performance

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19 Performance Attribution Decomposing overall performance into components Components are related to specific elements of performance Example components – Broad Allocation – Industry – Security Choice – Up and Down Markets

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20 Market Timing Adjust the portfolio for movements in the market Shift between stocks and money market instruments or bonds Results: higher returns, lower risk (downside is eliminated) With perfect ability to forecast behaves like an option

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21 rfrfrfrf rfrfrfrf rMrMrMrM Rate of Return of a Perfect Market Timer What if the forecast is not precise?

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22 Market Timing & Performance Measurement Adjusting portfolio for up and down movements in the market Low Market Return - low ßeta High Market Return - high ßeta

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23 Figure 17-6 Characteristic Lines

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24 Style Analysis Introduced by Bill Sharpe Explaining percentage returns by allocation to style Style Analysis has become popular with the industry

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25 Superior Selection Ability Concentrate funds in undervalued stocks or undervalued sectors or industries Balance funds in an active portfolio and in a passive portfolio Active selection will mean some unsystematic risk

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