Presentation on theme: "Performance Evaluation and Active Portfolio Management"— Presentation transcript:
1 Performance Evaluation and Active Portfolio Management Bm410: InvestmentsPerformance Evaluationand Active PortfolioManagementOr figuring out if you or your manager is good or just lucky!
2 ObjectivesA. Understand active portfolio management and performance evaluationB. Understand how to calculate risk adjusted rates of returnC. Decompose returns into components attributable to asset allocation and securities selection
3 A. Active Portfolio Management and Performance Evaluation Why are these two topics so important?Active Portfolio Management and Performance Evaluation are very difficult tasks and are critical to investingVery few have done it wellThey are very complicated subjectsTheoretically correct measures are difficult to constructDifferent statistics or measures are appropriate for different types of investment decisions and portfolios
4 Active Portfolio Management and Performance Evaluation (continued) How are these topics viewed?Academics and industry view them from different areasIndustry and academic measures are different-- sometimes extremely different, with different resultsThe key area is measuring performanceMost performance measurement is for a buy and hold strategy, or at best, a steady stateActive management complicates this process, for it is by definition changing
5 Active Portfolio Management and Performance Evaluation (continued) The nature of active management leads to very challenging measurement problemsRemember, managers may be buying and selling at any point in timeWhat are asset classes?What about risk?Risk is more complex than just variance or standard deviationIs it upside or downside?
6 Active Portfolio Management (continued) What is Active Portfolio Management?The process of using current, historical, and publicly available data to actively manage a portfolio in an effort to:Earn investment returns in excess of the manager’s specified benchmark (or benchmark, bogey, target) after all costs, including transactions costs, taxes, management, and other feesEarn consistent excess returns period after period--and not just from luck
7 Active Portfolio Management (continued) Are markets totally efficient?This is a critical questionSome managers outperform the market for extended periods, but not others. Why?While the abnormal performance in some instances may not be large, it is too large to be attributed solely to noiseEvidence remains that anomalies, such as the turn of the year, existThe evidence suggests that there is a role for active portfolio management in inefficient marketsIt even suggests there is a role in efficient markets2
8 Active Portfolio Management (continued) What are abnormal returns?Abnormal returns are investment returns which, after fees and transactions costs, are in excess of:A specified benchmark portfolioCan be a specified index (S&P 500, sector, or another real or proxy portfolio)A market proxy adjusted for riskA market model / adjusted index modelA reward to risk measure, such as the Sharpe Measure: E (rp-rf) / sp
9 Active Portfolio Management (continued) What major factors lead to abnormal returns?1. Superior Market timing (or asset allocation)Shifting assets between a poor-performing asset class and a better performing asset class to outperform a specified benchmark which includes both asset classes2. Superior selection (or stock or asset selection_Picking sectors, industries, or companies within a specified benchmark which outperform that specified benchmark
10 1. Superior Market Timing Ability What is superior market timing ability?A process where the manager gains abnormal returns from adjusting the portfolio for movements in the marketThe manager shifts among stocks, money market instruments and bonds based on their expectations for returns from each asset classWhat are the results of superior market timing?Higher returns with lower riskWith perfect forecasting abilities, the portfolio behaves like an optionHowever, no one has perfect forecasting abilities
11 Superior Market Timing (continued) With perfect market timing ability (PMTA)What would your actions have been since ?Switch to T-Bills in 73, 74, 77, 78, 81, 90, 00, 01, 02No negative returns or lossesAverage S&P500 Return: % PFA 16.7%Standard Deviation % %Results with perfect timing?You would have had a 54% increase in mean returnYou would have a 37% lower standard deviation of returns6
12 Superior Market Timing (continued) With imperfect forecasting abilityHow would you judge performance?Long horizon necessary to judge the abilityJudge proportions of correct callsJudge both bull markets and bear market callsWhat is the evidence from the real world: “Market Timing Also Stumps Most Pros”By the time there is enough information to judge to value added, most portfolio managers have retired, written books, or gone back to being teachers7
13 2. Superior Selection Ability What is superior selection ability?The ability of a manager to build an investment portfolio which generates abnormal returns through buying undervalued stocks, sectors or industries and selling overvalued stocks, sectors or industriesDoes this require total active management?A portfolio manager might balance funds in both an active portfolio and in a passive portfolioThe goal is to overweight/buy actively managed funds when they outperform the benchmark, and run passively when actively managed funds under-perform8
15 B. Calculate Risk-adjusted Performance How do you determine whether a portfolio manager is generating abnormal returns?Is it just returns?Should you also be concerned about risk?It is not just returns that matters—they must be adjusted for risk.There are a number of recognized performance measures available:Sharp IndexTreynor MeasureJensen’s Measure
16 Risk Adjusted Performance: Sharpe Sharpe IndexA ratio of your “excess return” divided by your portfolio standard deviationrp – rfsprp = Average return on the portfoliosp = Standard deviation of portfolio returnThe Sharpe Index is the portfolio risk premium divided by portfolio risk as measured by standard deviation
17 Risk Adjusted Performance: Treynor Treynor MeasureThis is similar to Sharpe but it uses the portfolio beta instead of the portfolio standard deviationrp – rfßprp = Average return on the portfoliorf = Average risk free rateßp = Weighted average b for portfolioIt is the portfolio risk premium divided by portfolio risk as measured by beta
18 Risk Adjusted Performance: Jensen Jensen’s MeasureThis is the ratio of your portfolio return less CAPM determined portfolio returnap = rp - [ rf + ßp (rm – rf) ]ap = Alpha for the portfoliorp = Average return on the portfolioßp = Weighted average Betarf = Average risk free raterm = Avg. return on market index port.It is portfolio performance less expected portfolio performance from CAPM
19 Risk Adjusted Performance (continued) Which Measure is Appropriate? Are there some general guidelines?Generally, if the portfolio represents the entire investment for an individual, Sharpe Index compared to the Sharpe Index for the market is bestIf many alternatives are possible, or this is only part of the portfolio, use the Jensen a or the Treynor measure.Of these two, the Treynor measure is more complete because it adjusts for risk
20 Risk Adjusted Performance (continued) Are their limitations of risk adjustment measures?Yes, very much so. The assumptions underlying measures limit their usefulnessKnow the key assumptions and be careful!When the portfolio is being actively managed, basic stability requirements are not metBe carefulPractitioners often use benchmark portfolio comparisons and comparisons to other managers to measure performanceThis is largely because they are easier
21 Risk Adjusted Performance Problem Consider the following data for a particular sample period: Portfolio P MarketAverage return % %BetaStandard Deviation % %Calculate the following performance measures for P and the market: Sharpe, Jensen (alpha), and Treynor. The T-bill rate during the period was 6%. By which measures did P outperform the market.
23 Answer Treynor = (rp – rf )/ ßp Portfolio P Market Average return % %BetaStandard Deviation % %Treynor = (rp – rf )/ ßpPortfolio (35-6)/1.2 = 24.2Market (28-6)/1.0 = 22.0The portfolio outperformed the market in terms of the Jensen’s alpha and the Treynor measure, but not the Sharpe ratio.
24 QuestionsAny questions on risk-adjusted performance measures?
25 C. Portfolio Attribution and Decomposing Portfolio Returns What is Portfolio Attribution?Portfolio attribution is the process of decomposing portfolio returns into components, generally attributable to asset allocation and securities selection (although other components can be added as well)What is the importance of these components?These components are related to specific elements of portfolio performanceWhat are examples of some of these components?Broad Allocation, security choice, industry, trading, etc.
26 Portfolio Attribution (continued) How do you determine portfolio attribution?1. Set up a ‘Benchmark’ or ‘Bogey’ portfolio which includes all relevant asset classesUse indexes for each componentUse target weight structure2. Compare your portfolio returns in each asset class to the benchmark returns of each index3. Calculate your attribution
27 Portfolio Attribution (continued) Why is it important to attribute performance to the portfolio’s components?It can explain the difference in return based on component weights or selectionIt can summarize the performance differences into appropriate categoriesWhat happens if you don’t perform portfolio attribution?You will not know why you are performing as you are?You will not know how to improve
28 Portfolio Attribution Problem Consider the following information regarding the performance of a money manager during a recent month. The equity index is the S&P500, Bonds the Salomon Brothers Index, and cash is the Lehman Cash.Asset Class Actual Actual Benchmark BenchmarkReturn Weight Weight ReturnEquity Fund 2.0% %Bond Fund % %Cash Fund % %a. What was the managers return in the month? What was the over/underperformance?
29 Answer Asset Class Actual Actual Benchmark Benchmark Return Weight Weight ReturnEquity % %Bonds % %Cash % %a. What was the managers return in the month? What was the over or underperformance?The managers return was (2.0%*.7) + (1.0%*.2) + (.5%*.1) or 1.65%.The index return was (2.5%*.6) + (1.2%*.3) + (.5%*.1) or 1.91%. the total underperformance was .26% for the portfolio or 1.65%-1.91%.
30 Portfolio Attribution Problem Asset Class Actual Actual Benchmark BenchmarkReturn Weight Weight ReturnEquity % %Bonds % %Cash % %b. What was the contribution of security selection to relative performance?c. What was the contribution of asset allocation to relative performance? Confirm that the sum of selection and allocation contributions equals her total excess return relative to the bogey.
31 Answer Part Bb) What was the contribution of security selection to relative performance?(1) (2) (1*2)Market Diff. Ret. Man. Port. Wgt. ContributionEquity % %Bonds % %Cash % %Contribution of Security Selection %(1) Fund return less index return (2.0%-2.5%)(2) Actual weight of the managed portfolio(1*2) Contribution of asset class security selection to the portfolio
32 Problem Part Cc. What was the contribution of asset allocation to relative performance? Confirm that the sum of selection and allocation contributions equals her total excess return relative to the bogey.(3) (4) (3*4)Market Excess Weight Index-BM ContributionEquity % % %Bonds % % %Cash % % %Contribution of Asset Allocation %(3) Weight of actively managed fund less benchmark weight (- is underweight)(4) Asset class return less total portfolio return (equity is or .59%, bond is =-.71)(3*4) Contribution of the asset class to the total portfolio
33 Overall Attribution Results The actively managed portfolio under performed the benchmarks by .26% or 26 basis points (1.65%-1.91%). This underperformance was a combination of a -.39% contribution to security selection and a .13% contribution from asset allocation.While the manager picked the asset classes that performed the best, she didn’t do as well picking the stocks. She needs to work on stock selection or just index that part of the portfolio construction process.
34 Portfolio Attribution Summary Performance Evaluation and Active Portfolio Management are very difficult tasksVery few have done it wellActive management is a difficult topicWhile some active managers have proven their ability to deliver consistent excess returns, the numbers are fewFinding adequate statistics to evaluate performance is criticalUnderstand the assumptions on which the statistics are based
35 QuestionsAny questions on portfolio attribution?
36 Review of ObjectivesA. Do you understand the importance of performance evaluation and active portfolio management?B. Do you understand how to calculate risk adjusted rates of return?C. Do you understand how to decompose returns into components attributable to asset allocation and securities selection?