Chapter 22

1. Chapter 22 Measuring Risks and Returns of Portfolio Managers

2. Objectives • Appreciate the importance of historical trends • Explain how return is measured against risk for portfolio managers • Discuss the adequacy of performance for professional money managers

3. Objectives continued • Describe the success of portfolio managers in diversifying their portfolios • Explain the process of asset allocation • Show how results can be measured against benchmarks

4. Measuring Risks and Returns of Portfolio Managers • Learning from Historical Trends • Stated Objectives and Risk • Measurement of Return in Relation to Risk • Diversification • Other Assets As Well As Stocks • A Specific Example – Asset Allocation • Appendix 22A: The Makeup of Institutional Investors

5. Basic Summary Statistics of Annual Total Returns from 1926-2005

6. Learning From Historical Trends • Historical trends provide insight • 6 asset classes over 79 years - Figure 22–1 • Small co. stocks highest return 12.6% & largest risk 32.9% • σ is 2.61 times the return σ=

7. Learning From Historical Trends • Large co. stocks return 10.4% & σ= 20.2% • σ is 1.94 times the return • Lower expected return & lower risk to small company stocks • Corporate/government bonds return approx. half of stocks and also much less risk

8. Large Company Stocks, Return Index from 1926-2005

9. Small Company Stocks, Return Index from 1926-2005

10. Stated Objectives and Risk Questions to ask fund managers: • What are the basic objectives of the fund? • Where the objectives met? • How much risk fund manager accepted? • Number of years experience? • Best/worst/average performance? • Economic environment?

11. Maximum and Minimum Values of Returns for 1-, 5-, 10-, and 20-Year Holding Periods (compound annual rates of return in percent)

12. Risk and Fund Objectives for 123 Mutual Funds

13. Stated Objectives and Risk

14. Measurement of Return in Relation to Risk • Sharpe Approach • Treynor Approach • Jensen Approach • Adequacy of Performance

15. Excess Return • Fund managers’ performance is measured by using “excess returns” • Excess returns has many definitions • Most commonly used is: • Excess returns = returns over/above what could be earned on a riskless asset • Treasury bills used as risk-free rate

16. Sharpe Approach View excess return per unit of risk Decision Rule: The higher the Sharpe measure the better

17. Treynor Approach • Shapre uses total risk • Treynor uses only systematic risk, beta, because unsystematic risk can be diversified away in a portfolio • Market beta, by definition, is 1

18. Example of a Portfolio using Treynor Approach 0.044 > Decision Rule: The higher the measure the better

19. Jensen Approach • Use capital asset pricing model • Compare actual excess returns with what should be required in the market, based on portfolio beta • If the beta is 0, investor should expect to earn no more than the risk-free rate of return because there is no systematic risk

20. Please see the next 2 slides for explanations

21. Adequacy of PerformanceUsing Jensen Approach • Performance judged against market line • Did it fall above or below the line? • It appears Y’s return (2.1%) is inferior to Z’s return (3.9%) • Portfolio Y performed above risk-return expectations • Portfolio Z was below risk-adjusted expected level

22. Adequacy of PerformanceUsing Jensen Approach • Vertical difference from a fund’s performance point to the market line measures performance • It indicates the difference between the return on the fund and a point on the market line that corresponds to a beta equal to the fund Alpha or average differential return

23. Adequacy of PerformanceUsing Jensen Approach • Z’s beta of 1.5 indicates excess return 4.5% • The actual excess return was only 3.9% • Negative alpha of 0.6% (= 3.9% - 4.5%) Decision Rule: Positive alpha superior performance Negative alpha inferior performance

24. Empirical Study of Risk-Adjusted Portfolio Returns-Systematic Risk and Return

25. Excess Returns: Based on Six Different Management Styles (1986-1995)

26. Diversification • Money manager’s role: effective diversification of asset holdings • Superior performance on a risk-adjusted basis is difficult achievement • Systematic risk measured by the portfolio’s (or individual stock’s) beta • Unsystematic risk is random or nonmarket related, may be diversified away

27. Diversification • Capital asset pricing model implies • Is fund diversifying away the nonrewarded, unsystematic risk? • Plot a fund’s excess returns against market excess returns - LOOK for correlation between the two? • No market reward for unsystematic risk • Eliminate it through diversification

28. Diversification • Degree of association between the independent and dependent variables is measured by R 2 • R2 = coefficient of determination • 0 ≤ R2 ≤ 1 • High degree of correlation between the independent and dependent variables will produce an R2 of close to 1

29. Relationship of Fund’s Excess Returns to Market Excess Returns

30. Example of Lower Correlation

31. Quarterly Returns Attributable to Market Fluctuations: 100 Mutual Funds

32. Other Assets as Well as Stocks • Funds diversified across asset classes • Brinson, Hood, & Beebower (BHB) examined 91 large corporate pension plans (1974-1983) • Average plan included investments in • Stocks • Bonds • T-bills • Real estate • Combined asset mix makes • Performance evaluation more complex than Sharpe, Treynor, and Jensen measures

33. Other Assets as Well as Stocks • Appropriate asset allocationmix more important than picking winning/losing stocks • Asset managers lose • not because they pick stock A over stock B, but • Because of poor portfolio mix in given market condition

34. Typical Weighted Portfolio for Money Managers

35. Ten Different Sectors Total 100% 100%

36. Portfolio Managers and Bear Markets • Perhaps best time to buy, not to sell • Unusually good buying opportunities • Stocks provide superior returns in comparison with other investments over the long term • May not be true over a short period of time • Use a three- to five-year time horizon

38. The Makeup of Institutional Investors Appendix 22A

39. The Makeup of Institutional Investors • Institutional investorsnot individual investors • Organizations responsible for bringing together large pools of capital for reinvestment • Investment companies such as: • Mutual funds • Pension funds • Life insurance companies • Bank trust departments • Endowments • Foundations

40. Investment Companies (Including Mutual Funds) • Investment companies reinvest funds • Specific objectives • Income/capital gains subject to single tax • See Chapter 18

41. Pension funds Important/growing sector of institutional market • Private • Public • Insured • Uninsured • Public pension funds are run for the benefit of federal, state, or local employees

42. Insurance companies • Life • Property and casualty • Life insurance companies must earn a minimum rate of return assumed in calculating insurance premiums; public policy emphasizes safety of assets • Property and casualty insurance companies enjoy more lenient regulation

43. Bank Trust Departments • Manage other people’s funds for a fee • Administer • Individual trust funds • Commingled (combined) funds • Different common trust fund to serve varying needs and objectives • Small number of trust departments holding the majority of funds

44. Foundations • Nonprofit organizations • Set up to accomplish • Social • Educational • Charitable purposes • Donation of stocks in which the donor was one of the corporate founders e.g. • Ford • Carnegie • Rockefeller • Getty

45. Endowments • Permanent capital funds donated to • Universities • Churches • Civic organizations • Difficult to manage • Pressure for current income • Maintain operations (e.g. Library)

46. Measurement of Performance for Foundations & Endowments Now Total-return basis = Annual income + Capital appreciation Traditional Interest-earned or Dividend-received Basis Moving