Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Re

1. Lecture Presentation Softwareto accompanyInvestment Analysis and Portfolio ManagementSeventh Editionby Frank K. Reilly & Keith C. Brown Chapter 26

2. Chapter 26 - Evaluation of Portfolio Performance Questions to be answered: • What major requirements do clients expect from their portfolio managers? • What can a portfolio manager do to attain superior performance? • What is the peer group comparison method of evaluating an investor’s performance?

3. Chapter 26 - Evaluation of Portfolio Performance • What is the Treynor portfolio performance measure? • What is the Sharpe portfolio performance measure? • What is the critical difference between the Treynor and Sharpe portfolio performance measures?

4. Chapter 26 - Evaluation of Portfolio Performance • What is the Jensen portfolio performance measure, and how does it relate to the Treynor measure? • What is the information ratio and how is it related to the other performance measures? • When evaluating a sample of portfolios, how do you determine how well diversified they are?

5. Chapter 26 - Evaluation of Portfolio Performance • What is the bias found regarding the composite performance measures? • What is the Fama portfolio performance measure and what information does it provide beyond other measures? • What is attribution analysis and how can it be used to distinguish between a portfolio manager’s market timing and security selection skills?

6. Chapter 26 - Evaluation of Portfolio Performance • What is the Roll “benchmark error” problem, and what are the two factors that are affected when computing portfolio performance measures? • What is the impact of global investing on the benchmark error problem? • What are customized benchmarks? • What are the important characteristics that any benchmark should possess?

7. Chapter 26 - Evaluation of Portfolio Performance • How do bond portfolio performance measures differ from equity portfolio performance measures? • In the Wagner and Tito bond portfolio performance measure, what is the measure of risk used? • What are the components of the Dietz, Fogler, and Hardy bond portfolio performance measure?

8. Chapter 26 - Evaluation of Portfolio Performance • What are the sources of return in the Fong, Pearson, and Vasicek bond portfolio performance measure? • What are the time-weighted and dollar-weighted returns and which should be reported under AIMR’s Performance Presentation Standards?

9. 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 portfolio’s benchmark

10. 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

11. 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 portfolio’s undiversifiable risk: market or systematic risk

12. 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

13. Treynor Portfolio Performance Measure • Comparing a portfolio’s 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:

14. Treynor Portfolio Performance Measure • Comparison to see whether actual return of portfolio G was above or below expectations can be made using:

15. Sharpe Portfolio Performance Measure • Risk premium earned per unit of risk

16. 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

17. Jensen Portfolio Performance Measure • Also based on CAPM • Expected return on any security or portfolio is

18. 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

19. The Information Ratio Performance Measure • Appraisal ratio • measures average return in excess of benchmark portfolio divided by the standard deviation of this excess return

20. Application of Portfolio Performance Measures

21. 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

22. 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 Investor’s Risk + Manager’s Risk + Selectivity

23. Components of Investment Performance • The selectivity measure is used to assess the manager’s investment prowess • The relationship between expected return and risk for the portfolio is:

24. Components of Investment Performance • The market line then becomes a benchmark for the manager’s performance

25. Components of Investment Performance • The selectivity component can be broken into two parts • gross selectivity is made up of net selectivity plus diversification

26. 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:

27. Relationship Among Performance Measures • Treynor • Sharpe • Jensen • Information Ratio • Fama net selectivity measures Highly correlated, but not perfectly so

28. Performance Attribution Analysis • Allocation effect • Selection effect

29. 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

30. Measuring Market Timing Skills

31. 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

32. 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

33. Characteristics of Benchmarks • Unambiguous • Investable • Measurable • Appropriate • Reflective of current investment opinions • Specified in advance

34. Building a Benchmark • Specialize as appropriate • Provide value weightings • Provide constraints to portfolio manager

35. 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?

36. 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 bond’s duration • Duration replaces beta as risk measure in a bond market line

37. 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

38. 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

39. 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

40. 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

41. 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)

42. 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

43. 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:

44. Computing Portfolio Returns • Dollar-weighted rate of return (DWRR) • Internal rate of return on the portfolio’s 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

45. 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

46. 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

47. www.nelnet.com www.styleadvisor.com www.valueline.com www.morningstar.com www.valueline.com www.aimr.org The InternetInvestments Online

48. End of Chapter 26 • Evaluation of Portfolio Performance