Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edit

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Lecture Presentation Software to
accompanyInvestment Analysis and Portfolio
ManagementSeventh Editionby Frank K. Reilly
Keith C. Brown
Chapter 26
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Judging Portfolio Performance

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

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What is Required of a Portfolio Manager?

• 1.The ability to derive above-average returns for
  a given risk class
• Superior risk-adjusted returns can be derived
  from either
• superior timing or
• superior security selection
• 2. The ability to diversify the portfolio
  completely to eliminate unsystematic risk.
  relative to the portfolios benchmark
• 3. Follow the clients investment policy
  statement?

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Example of Market Timing
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Composite Portfolio Performance Measures

• Portfolio evaluation before 1960
• rate of return within risk classes
• Peer group comparisons
• no explicit adjustment for risk
• difficult to form comparable peer group
• Treynor portfolio performance measure
• market risk
• individual security risk
• introduced characteristic line

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Treynor Portfolio Performance Measure

• Treynor recognized two components of risk
• Risk from general market fluctuations
• Risk from unique fluctuations in the securities
  in the portfolio
• His measure of risk-adjusted performance focuses
  on the portfolios undiversifiable risk market
  or systematic risk

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Treynor Portfolio Performance Measure

• The numerator is the risk premium
• The denominator is a measure of risk
• The expression is the risk premium return per
  unit of risk
• Risk averse investors prefer to maximize this
  value
• This assumes a completely diversified portfolio
  leaving systematic risk as the relevant risk

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Treynor Portfolio Performance Measure

• Comparing a portfolios T value to a similar
  measure for the market portfolio indicates
  whether the portfolio would plot above the SML
• Calculate the T value for the aggregate market as
  follows

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Treynor Portfolio Performance Measure

• Comparison to see whether actual return of
  portfolio G was above or below expectations can
  be made using

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Sharpe Portfolio Performance Measure

• Risk premium earned per unit of risk

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Treynor versus Sharpe Measure

• Sharpe uses standard deviation of returns as the
  measure of risk
• Treynor measure uses beta (systematic risk)
• Sharpe therefore evaluates the portfolio manager
  on the basis of both rate of return performance
  and diversification
• The methods agree on rankings of completely
  diversified portfolios
• Produce relative not absolute rankings of
  performance

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Jensen Portfolio Performance Measure

• Also based on CAPM
• Expected return on any security or portfolio is

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Jensen Portfolio Performance Measure

• Also based on CAPM
• Expected return on any security or portfolio is
• Where E(Rj) the expected return on security
• RFR the one-period risk-free interest rate
• ?j the systematic risk for security or portfolio
  j
• E(Rm) the expected return on the market
  portfolio of risky assets

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The Information Ratio Performance Measure

• Appraisal ratio /Benefit-to-Cost ratio
• measures average return in excess of benchmark
  portfolio divided by the standard deviation of
  this excess return

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Application of Portfolio Performance Measures
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Potential Bias of One-Parameter Measures

• positive relationship between the composite
  performance measures and the risk involved
• alpha can be biased downward for those portfolios
  designed to limit downside risk

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Performance Attribution Analysis

• Allocation effect
• Selection effect

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Components of Investment Performance

• Fama suggested overall performance, which is its
  return in excess of the risk-free rate
• Portfolio Risk Selectivity
• Further, if there is a difference between the
  risk level specified by the investor and the
  actual risk level adopted by the portfolio
  manager, this can be further refined
• Investors Risk Managers Risk Selectivity

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Components of Investment Performance

• The selectivity measure is used to assess the
  managers investment prowess
• The relationship between expected return and risk
  for the portfolio is

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Components of Investment Performance

• The market line then becomes a benchmark for the
  managers performance

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Components of Investment Performance

• The selectivity component can be broken into two
  parts
• gross selectivity is made up of net selectivity
  plus diversification

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Components of Investment Performance

• Assuming the investor has a target level of risk
  for the portfolio equal to bT, the portion of
  overall performance due to risk can be assessed
  as follows

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Relationship Among Performance Measures

• Treynor
• Sharpe
• Jensen
• Information Ratio
• Fama net selectivity measures
• Highly correlated, but not perfectly so

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Measuring Market Timing Skills

• Tactical asset allocation (TAA)
• Attribution analysis is inappropriate
• indexes make selection effect not relevant
• multiple changes to asset class weightings during
  an investment period
• Regression-based measurement

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Measuring Market Timing Skills
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Factors That Affect Use of Performance Measures

• Market portfolio difficult to approximate
• Benchmark error
• can effect slope of SML
• can effect calculation of Beta
• greater concern with global investing
• problem is one of measurement
• Sharpe measure not as dependent on market
  portfolio

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Benchmark Portfolios

• Performance evaluation standard
• Usually a passive index or portfolio
• May need benchmark for entire portfolio and
  separate benchmarks for segments to evaluate
  individual managers

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Characteristics of Benchmarks

• Unambiguous
• Investable
• Measurable
• Appropriate
• Reflective of current investment opinions
• Specified in advance

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Building a Benchmark

• Specialize as appropriate
• Provide value weightings
• Provide constraints to portfolio manager

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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?

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A Bond Market Line

• Need a measure of risk such as beta coefficient
  for equities
• Difficult to achieve due to bond maturity and
  coupon effect on volatility of prices
• Composite risk measure is the bonds duration
• Duration replaces beta as risk measure in a bond
  market line

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Bond Market Line Evaluation

• 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

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Decomposing Portfolio Returns

• Into maturity, sector, and quality effects
• Total return during a period is the income effect
  and a price change effect
• The yield-to-maturity (income) effect is the
  return an investor would receive if nothing had
  happened to the yield curve during the period
• Interest rate effect measures changes in the term
  structure of interest rates during the period

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Decomposing Portfolio Returns

• The sector/quality effect measures expected
  impact on returns because of changing yield
  spreads between bonds in different sectors and
  ratings
• The residual effect is what is left after
  accounting for the first three factors
• A large positive residual would indicate superior
  selection capabilities
• Time-series plot demonstrates strengths and
  weaknesses of portfolio manager

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Analyzing Sources of Return

• Total return (R) made up of the effect of the
  interest rate environment (I) and the
  contribution of the management process (C)
• R I C
• I is the expected rate of return (E) on a
  portfolio of default-free securities and the
  unexpected return (U) on the Treasury Index
• I E U

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Analyzing Sources of Return

• C is composed of
• M return from maturity management
• S return from spread/quality management
• B return attributable to the selection of
  specific securities
• R I C
• (E U) (M S B)

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Consistency of Performance

• A study by Kritzman revealed no relationship
  between performance in the two periods examined
  in the study
• A further test also revealed no relationship
  between past and future performance even among
  the best and worst performers
• Based on these results, Kritzman concluded that
  it would be necessary to examine something
  besides past performance to determine superior
  bond portfolio managers

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Computing Portfolio Returns

• To evaluate portfolio performance, we have to
  measure it
• From Chapter 1 we learned how to calculate a
  holding period yield, which equals the change in
  portfolio value plus income divided by beginning
  portfolio value

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Computing Portfolio Returns

• Dollar-weighted rate of return (DWRR)
• Internal rate of return on the portfolios cash
  flows
• Time-weighted rate of return (TWRR)
• Geometric average return
• TWRR is better
• Considers actual period by period portfolio
  returns
• No size bias - inflows and outflows could affect
  results

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Performance Presentation Standards

• AIMR PPS have the following goals
• achieve greater uniformity and comparability
  among performance presentation
• improve the service offered to investment
  management clients
• enhance the professionalism of the industry
• bolster the notion of self-regulation

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Performance Presentation Standards

• Total return must be used
• Time-weighted rates of return must be used
• Portfolios valued quarterly and periodic returns
  geometrically linked
• Composite return performance (if presented) must
  contain all actual fee-paying accounts
• Performance calculated after trading expenses
• Taxes must be recognized when incurred
• Annual returns for all years must be presented
• Disclosure requirements

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The InternetInvestments Online

• www.nelnet.com
• www.styleadvisor.com
• www.valueline.com
• www.morningstar.com
• www.valueline.com
• www.aimr.org

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• End of Chapter 26
• Evaluation of Portfolio Performance