A Simple Approach to Risk-Adjusted Performance

Kartono Liano

Mississippi State University

Department of Finance and Economics
Box 9580
Mississippi State, MS 39762
(662) 325-1981
(662) 325-1977 (fax)
e-mail: [email protected]

Spring 2000
 A Simple Approach to Risk-Adjusted Performance

Abstract

This note shows that the risk-adjusted performance measure developed by

Modigliani and Modigliani [1997] can be derived by using a simple concept
from geometry.

INTRODUCTION

Modigliani and Modigliani [1997] derived a risk-adjusted performance (RAP)

measure by adjusting the risk of a particular portfolio so that it matches the risk of a

market portfolio and then calculate the appropriate return for that portfolio. Unlike

Sharpe measure [1966], Treynor measure [1965], and Jensen measure [1968], the unique

feature of RAP is that it measures the performance of a portfolio in basis points, the

traditional unit to measure return, and hence allow investors to compare the RAP of a

portfolio directly with the return of a market portfolio. A high (low) RAP indicates that

the portfolio has outperformed (underperformed) the market portfolio. Although Tam

[1999] refers to the risk-adjusted performance by Modigliani and Modigliani [1997] as

"M-squared," this note deliberately avoids the use of "M-squared" in order not to confuse

readers with "M-squared" in Fong and Vasicek [1984] for a risk measurement of an

immunized portfolio.

The objective of this note is to simplify the derivation of risk-adjusted performance

measure (Equation (4) in Modigliani and Modigliani [1997]). The risk-adjusted

performance measure can be derived by using a simple concept from geometry. This

simplification will provide readers and investors with an additional insight to the risk-

adjusted performance measure.

METHODOLOGY

This note uses the concept of similar triangles from geometry to show the

derivation of RAP. From Nowlan and Washburn [1975, p. 266]:

 2

A
B C

AB BE
ABE ACD. Therefore, =
AC CD

RESULTS

In order to avoid crowding out the graph, Figure 1 is a replica of Exhibit 1 in

Modigliani and Modigliani [1997] but only for Portfolio 1, P1, where the risk of this

portfolio (1) is greater than the risk of the market portfolio (M). Although P1 offers a

higher return than the market portfolio, it also has a higher risk and thus r1 is not

compatible with rM. RAP(1) is the risk-adjusted performance of P1 after adjusting its risk

to match the risk of market portfolio. The concept of similar triangles in geometry is

applied to calculate RAP(1). Note that Figure 1 contains two triangles, both triangles are

marked by heavy solid lines. Consequently,

================================================================
(Place Figure 1 about here)
================================================================

M x
= (1)
1 r1 rf

M ( r1 rf ) M
x= = (r r )
1 1 1 f

RAP(1) = x + rf (2)

Equation (2) is the same as Equation (4) in Modigliani and Modigliani [1997].
 3

As long as a portfolio has 1 that is greater than M and r1 that is higher than rf,

Equation (1) can be used to calculate the risk-adjusted performance of this portfolio.

Applying the information in Table 1 to Equation (1), the RAP for Fidelity Magellan, for

example, is:

================================================================
(Place Table 1 about here)
================================================================

7.2 x
= x = 8.29
8.6 15.4 55
.

Substituting x into Equation (2), the RAP for Fidelity Magellan is 8.29 + 5.5 = 13.79

13.8, a result similar to the RAP for Fidelity Magellan in Modigliani and Modigliani

[1997]. If Fidelity Magellan had the same level of risk as the market portfolio, it would

had a 13.8% risk-adjusted return, a return that is lower than the return of the market

portfolio (14.1%). For this reason, Fidelity Magellan had underperformed the market

portfolio.

Figure 2 is also a replica of Exhibit 1 in Modigliani and Modigliani [1997] and

contains the analysis for Portfolio 2, P2, where the risk of this portfolio (2) is less than the

risk of the market portfolio (M). Even tough P2 offers a lower return than the market

portfolio, it also has a lower risk and hence r2 is not compatible with rM. RAP(2) is the

risk-adjusted performance of P2 after adjusting its risk to match the risk of market

portfolio. The same geometry approach is used to solve for RAP(2). Also note that

Figure 2 contains two triangles, both triangles are marked by heavy solid lines.

Consequently,

================================================================
(Place Figure 2 about here)
================================================================
 4

M 2 x ( r2 rf )
= (3)
M x

M ( r2 rf ) M
x= = (r r )
2 2 2 f

RAP( 2) = x + rf (4)

Equation (4) is also identical to Equation (4) in Modigliani and Modigliani [1997].
For a portfolio with 2 that is smaller than M and r2 that is higher than rf, Equation

(3) can be used to calculate the risk-adjusted performance of this portfolio. Applying the

information in Table 1 to Equation (3), the RAP for Fidelity Puritan, for instance, is:

7.2 4.7 x (12.0 55

. )
= x = 9.96
7.2 x

Substituting x into Equation (4), the RAP for Fidelity Puritan is 9.96 + 5.5 = 15.46 and is

compared favorably to the RAP for Fidelity Puritan in Modigliani and Modigliani [1997].

If Fidelity Puritan had the same level of risk as the S&P 500, it would had a 15.5% risk-

adjusted return, a return that is higher than the return of the S&P 500 (14.1%).

Therefore, Fidelity Puritan had outperformed the S&P 500.

CONCLUSIONS

This note simplifies the derivation of risk-adjusted performance measure developed

by Modigliani and Modigliani [1997]. The risk-adjusted performance measure can be

derived by using a simple concept from geometry.

 5

REFERENCES

Fong, H. G. and Oldrich A. Vasicek. "A Risk Minimizing Strategy for Portfolio
Immunization," Journal of Finance, 34 (December 1984), 1541-1546.

Jensen, M. C. "The Performance of Mutual Funds in the Period 1945-1964," Journal of

Finance, 23 (May 1968), 389-416.

Modigliani, F. and Leah Modigliani. "Risk-Adjusted Performance," Journal of Portfolio

Management, 23 (Winter 1997), 45-54.

Nowlan, R. A. and Robert M. Washburn. Geometry for Teachers (New York, 1975),
Harper & Row, Publishers.

Sharpe, W. F. "Mutual Fund Performance," Journal of Business, 39 (January 1966), 119-

138.

Tam, P. W. "How to Select a Tech Mutual Fund," The Wall Street Journal, (February 26,
1999), C1.

Treynor, J. L. "How to Rate Management of Investment Funds," Harvard Business

Review, 43 (January-February 1965), 63-75.
 6

Figure 1. RAP for 1 > M

r lM, Market Line

l1
r1 P1
rM PM

RAP(1)

rf

M 1

where: r = return;

= standard deviation = risk;

rf = risk-free rate of return;

P1 = Portfolio 1, with r1 = return of Portfolio 1 and 1 = risk of Portfolio 1;

PM = market portfolio, with rM = return of market portfolio and M = risk of

market portfolio; and

RAP(1) = risk-adjusted performance of Portfolio 1.

 7

Figure 2. RAP for 2 < M

r l2 lM, Market Line

RAP(2)

rM PM

r2 P2

rf

2 M

where: P2 = Portfolio 2, with r2 = return of Portfolio 2 and 2 = risk of Portfolio 2; and

RAP(2) = risk-adjusted performance of Portfolio 2.

 8

Table 1. RAP: Analysis of Selected Mutual Funds

Mutual Funds Average Quarterly Total Quarterly Standard Quarterly RAP

(in order of total return) Return (at annual rate) Deviation (at annual rate)

S&P 500 14.1 7.2 14.1

AIM Constellation 19.7 12.3 13.9

20th Century Vista Investors 16.7 14.0 11.3
T. Rowe Price New Horizon 16.0 11.3 12.2
Fidelity Magellan 15.4 8.6 13.8
Vanguard Windsor 13.0 7.5 12.7
Fidelity Puritan 12.0 4.7 15.4
Income Fund of America 11.3 4.0 15.9

T-Bill 5.5

Source: Modigliani and Modigliani [1997], p. 50.