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Portfolio Performance Evaluation

Portfolio Performance Evaluation. Recent Mutual Fund Data. Mutual Funds in Morningstar Database: 17,212 # of funds that have existed over 10 yrs: 2,073 In 10 yrs, 16.69% beat SP500 in avg return and 71% in Sharpe Ratio

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Portfolio Performance Evaluation

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  1. Portfolio PerformanceEvaluation 24-1

  2. Recent Mutual Fund Data • Mutual Funds in Morningstar Database: 17,212 • # of funds that have existed over 10 yrs: 2,073 • In 10 yrs, 16.69% beat SP500 in avg return and 71% in Sharpe Ratio • 10.6% beat the Value-Weighted NYSE index in avg return and 56.73% in Sharpe Ratio. Composite 24-2

  3. Mutual Funds • 22% beat the SP 500 in any 5 of the past years. • 13.2% beat the Value-Weighted NYSE index in any 5 of the past 10 years 24-3

  4. Hedge Funds? • Hedge Funds in TASS database: 1512 • 93 have existed over 10 years • 41% and 31% beat the respective indices in avg return • 75% and 69% beat the indices in Sharpe ratio • 51% and 41% beat the indices in 5 or more of the past 10 years. 24-4

  5. 24-5

  6. Abnormal or Exceptional Performance What is abnormal? Abnormal performance is measured relative to: • Benchmark portfolio • Market adjusted • Market model / index model adjusted • Reward to risk measures such as the Sharpe Measure: E (rp-rf) / p 24-6

  7. Factors That Lead to Abnormal Performance • Market timing • Superior selection • Sectors or industries • Individual stocks 24-7

  8. rp = Average return on the portfolio • rf = Average risk free rate = Standard deviation of portfolio return p Risk Adjusted Performance: Sharpe 1) Sharpe Index rp - rf  p  24-8

  9. M2 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 24-9

  10. M2 Measure: Example Managed Portfolio: return = 35% standard deviation = 42% Market Portfolio: return = 28% standard deviation = 30% T-bill return = 6% Hypothetical Portfolio: 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 24-10

  11. rp = Average return on the portfolio • rf = Average risk free rate • ßp = Weighted average for portfolio Risk Adjusted Performance: Treynor rp - rf ßp 2) Treynor Measure 24-11

  12. Risk Adjusted Performance: Jensen Jensen’s alpha = rp - [ rf + ßp ( rm - rf) ]  p  = Alpha for the portfolio p rp= Average return on the portfolio ßp = Weighted average Beta rf = Average risk free rate rm = Avg. return on market index port. 24-12

  13. Appraisal Ratio Appraisal Ratio = ap / s(ep) Appraisal Ratio divides the alpha of the portfolio by the nonsystematic risk Nonsystematic risk could, in theory, be eliminated by diversification 24-13

  14. Which Measure is Appropriate? It depends on investment assumptions 1) If the portfolio represents the entire investment for an individual, the Sharpe ratio should be compared to the Sharpe ratio 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 systematic risk 24-14

  15. 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 24-15

  16. Performance Attribution • Decomposing overall performance into components • Components are related to specific elements of performance • Example components • Broad Allocation • Industries • Up and Down Markets 24-16

  17. Process of Attributing Performance to Components Set up a ‘Benchmark’ or ‘Bogey’ portfolio • Use indexes for each component • Use target weight structure 24-17

  18. Process of Attributing Performance to Components • Calculate the return on the ‘Bogey’ and on the managed portfolio • Explain the difference in return based on component weights • Summarize the performance differences into appropriate categories 24-18

  19. Complications to Measuring Performance • Two major problems • Need many observations even when portfolio mean and variance are constant • Active management leads to shifts in parameters making measurement more difficult • To measure well • You need a lot of short intervals • For each period you need to specify the makeup of the portfolio 24-19

  20. Managing funds against benchmark: Market Timing Example Adjusting portfolio for up and down movements in the market • In Low Market: adopt low ßeta strategy • In a High Return Market: load on ßeta! 24-20

  21. rp - rf * * * * * * * * * * * * * * * * * * * * rm - rf * * * Steadily Increasing the Beta Example of Market Timing 24-21

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