1. Chapter 18 Portfolio Performance Evaluation

2. Types of management revisited Passive management 1.Capital allocation between cash and the risky portfolio 2.Asset allocation within the risky portfolio. –How passive the management actually is varies “Set it and forget it” Change allocations in 1 or 2 according to perceptions of risk to keep current with portfolio goals. Active management –Forecasting future rates of return on either/both asset classes and individual securities 18-2

3. Performance evaluation Purpose: –Are the returns worth the risk and the fees? Measures –Average return by itself is an insufficient measure. Why? Average return may not = expected return Risk return relationship Major component of returns is the market performance –Need a measure of abnormal (excess) performance 18-3

4. Abnormal Performance How is abnormal performance measured? Comparisons to peer groups Rank fund performance within a given category Benchmark portfolio such as an index – choose the right index is important USE reward to risk measures such as the alpha, Sharpe Measure (or variations) 18-4

5. Factors That Lead to Abnormal Performance Successful across asset allocations (the most important step) Superior allocation within each asset class – Sectors or industries Overweight better performing sectors, underweight poorer performers Individual security selection Pick the right stocks, those with performance better than expected 18-5

6. Risk Adjusted Performance: Jensen 3) Jensen’s Alpha Measure 18-6

7. Measuring Risk Adjusted Performance: Sharpe Ratios 1) Historical Sharpe Ratios Use: When choosing among competing portfolios that will not be mixed. In practice: Used when one manager handles the (entire) portfolio. 18-7

8. Risk Adjusted Performance: Treynor 2) Historical Treynor Ratios Use: Evaluate a portfolio when portfolio is a piece of a larger portfolio that has different managers. 18-8

9. Summary of measures and usage Performance Measure DefinitionApplication Sharpe p R/  as the When choosing among portfolios competing optimal risky portfolio Treynor RpRp /  When ranking many portfolios that will be mixed to form the optimal risky portfolio Information ratio p  /  e When evaluating a portfolio to be mixed with a position in the passive benchmark portfolio 18-9

10. Alpha Capture & Transport If an analyst finds an undervalued security and invests in it, market moves may wipe out any gains. –Can hedge out market risk via shorting stock index or stock index futures to establish a market neutral position. –Process is called alpha capture or alpha transport. –When short positions and leverage are allowed a significant non-zero alpha is a sufficient condition for an improvement in the Sharpe and information ratio. 18-10

11. Evaluation with a multi-index model Evidence indicates we should use a multi- index model such as the Fama-French model to establish the expected return: This allows an estimation of alpha: 18-11

12. Style Analysis Complex method of performance evaluation introduced by William Sharpe Recent studies of mutual fund performance show that > 90% of variation in returns can be explained by the funds’ allocations to bills, bonds and stocks. 18-12

13. Morning Star’s Risk Adjusted Rating Companies are put into peer groups based on Morningstar style definitions Risk adjusted fund performance is ranked and then Stars are assigned according to the following table (5 stars is the highest rating) Star ratings are highly correlated to Sharpe measure rankings PercentileStars 0-101 10-32.52 32.5-67.53 67.5-904 90-1005 18-13

14. Problems with performance measures In a large universe of funds, some funds will have abnormal performance in every period just by chance. –Requires statistical work Volatility is quite high and creates large errors in estimation 18-14

15. Performance Attribution Decomposing overall performance into components Performance is determined by specific portfolio choices, Major performance determinants: –Broad asset allocation among types of securities, –Industry weighting in equity portfolio, –Security choice, –Timing of purchases and sales. 18-15

16. Market Timing Adjust the asset allocation for movements in the market –Shift between stocks and money market instruments or bonds –With perfect ability to forecast behaves like an option –Little evidence of market timing ability 18-16

17. Value of Market Timing Invest $1 on December 1, 1926 *Perfect Timing: Every month 100% of the funds are placed in either stocks or cash based on which would have the higher return. StrategyValuein 2008 GeomAvg. Return Money Markets$203.71% Stocks$1,6269.44% Perfect Timing*$36,699,302,47334.54% 18-17