MONASH

BUSINESS
SCHOOL

Investment and Portfolio Management

Lecture 7 - Chapter: 24

Portfolio Performance Evaluation

Topic Overview:
-Measurement of portfolio return
-Risk-adjusted performance measures
-Style analysis and market timing
-Performance attribution
Overview
• Most financial assets are managed by professional investors
(Assets/Fund managers)
• They allocate a lion share of capital across various firms.
• Investors must be able to measure the performance of these
managers
• In this lecture we concentrate on;
Ø Measurement of portfolio return
Ø Risk-adjusted performance measures
Ø Style analysis and market timing
Ø Performance attribution
• Note: The content of this lecture is very useful in analyzing the
performance of your own portfolio.

MONASH
2 BUSINESS
SCHOOL
Calculating Average Return of a Portfolio
• One important measure of performance of a portfolio is the
average rate of return realized over a period of n years.
• In week 3, we learned how to calculate HPR, Arithmetic average
and Geometric average.
• Let’s revise them.

;! <;" =>!
VWX = ;"
B
1
Z[\]ℎ_`]\a `bc[`dc = [̅ = h [(i)
g
?@A

jck_`][\a `bc[`dc = [C
= 1 + [A × 1 + [D ×. . .× 1 + [B A/B −1

MONASH
3 BUSINESS
SCHOOL
Dollar-Weighted Returns
• Time-weighted returns such as arithmetic average and geometric
average assign equal weights to each period’s return.

• In a multi period investment, return calculation is difficult

because investors may add cash flows to or withdraw cash flows
from the portfolio.
• In such a scenario, DCF approach is used to calculate average
return

• This approach derives the Internal rate of return (IRR).

• This equation should be solved for r.

MONASH
4 BUSINESS
SCHOOL
Dollar-Weighted Returns Cont.
• Under DCF approach, returns are weighted by the amount
invested in each period
• Therefore, IRR is called the dollar-weighted return.
• Following equation is solved for r:

C1 C2 Cn
PV = + + ...
(1 + r ) (1 + r )
1 2
(1 + r )n

MONASH
5 BUSINESS
SCHOOL
Dollar-Weighted Returns Cont.: Example

MONASH
6 BUSINESS
SCHOOL
Dollar-Weighted Returns Cont.: Example

$2 $4+$108

-$50 -$53

Dollar-weighted Return (IRR):

- 51 112
- 50 = +
(1 + r ) (1 + r )
1 2

r = 7.117 %
MONASH
7 BUSINESS
SCHOOL
What is the Geometric Return for the Above Investment?

First, calculate HPR for each period.

53 − 50 + 2 54 − 53 + 2
[A = = 10% ; [D = = 5.66%
50 53

Then calculate geometric return.

[C = (1.10)×(1.0566) A/D −1
[C = 7.81%

The dollar-weighted average is less than the time-weighted average

in this example because more money is invested in year two, when
the return was lower.

MONASH
8 BUSINESS
SCHOOL
Adjusting Returns for Risk
• Evaluating performance based on average return alone is not
very useful.
• Return must be adjusted for risk
• The simplest and most popular way to adjust returns for risk is
to compare the portfolio’s return with the returns on other
portfolios with similar characteristics.
• The benchmark composed of a group of funds/portfolios with
similar characteristics is called comparison universe.
• Each portfolio manager receives a percentile rank within the
comparison group
• Let’s consider the graph in the next slide.

MONASH
9 BUSINESS
SCHOOL
Universe Comparison

Top and bottom lines represent

95th and 5th percentile managers

Dashed lines correspond to 75th,

50th and 25th percentile
managers

Even though Markowill’s

performance in the recent
quarter is closer to that of the top
quarter and better than S&P500;
In the long run, they have
underperformed S&P500 and
their performance is closer to the
median performance of the
universe.

MONASH
10 BUSINESS
SCHOOL
Risk-Adjusted Performance Measures

• Ranking managers’ performance within the universe can be

misleading.
• Within a particular universe, some managers may concentrate on
a particular subgroup
• E.g. Within equity universe, a manager may concentrate on
high beta stocks.
• Therefore, measuring risk-adjusted performance using mean-
variance criteria is important.
• A number of risk-adjusted performance measures have been
developed by academics.
• They are widely used in practice to measure the performance of
fund managers.

MONASH
11 BUSINESS
SCHOOL
 Risk-Adjusted Performance: Sharpe Measure

• Sharpe’s ratio: divides average portfolio excess return over the

sample period by the standard deviation of returns over that
period
• Measures reward to (total) volatility trade-off

[;̅ − [F̅
y; =
z;

MONASH
12 BUSINESS
SCHOOL
Risk-Adjusted Performance: Treynor Measure

• Treynor’s Measure: divides average portfolio excess return over

the sample period by the beta of the portfolio over that period
• Measures reward to market risk

[;̅ − [F̅
{; =
|;

MONASH
13 BUSINESS
SCHOOL
Risk-Adjusted Performance: Jensen’s Alpha

• Jensen’s alpha: the average return on the portfolio over and

above that predicted by the CAPM

• Note: This is the ~ obtained by estimating the index model.

MONASH
14 BUSINESS
SCHOOL
Risk-Adjusted Performance: Information Ratio

• Information ratio: divides the alpha of the portfolio by the

nonsystematic risk of the portfolio
• Measures abnormal return per unit of risk that in principle
could be diversified away by holding a market index portfolio

~;
•; =
z c;

MONASH
15 BUSINESS
SCHOOL
Risk-Adjusted Performance: M2 Measure
• Create an adjusted portfolio (P*) that has the same standard
deviation as the market index.
• To create P*, the active portfolio is mixed with a position in T-bills.
• Note: In week 5 lecture we learned that this is possible.
• Because the market index and P* have the same standard
deviation, their returns are comparable.
• So, the M2 is calculated as follows:

M = rP * - rM
2

MONASH
16 BUSINESS
SCHOOL
 2
M Measure: Example
Managed Portfolio: return = 35%; standard deviation = 42%
Market Portfolio: return = 28%; standard deviation = 30%
T-bill return = 6%
P* Portfolio:
30/42 = 0.714 in P and (1-0.714) or 0.286 in T-bills Therefore, P*
and M are
Note that; z;∗ = 0.714 ∗ 42% = 30% comparable.
The return on P* = (0.714*0.35) + (0.286*0.06) = 26.7%
Therefore; M2 =26.7% - 28% = -1.3%
Since M2 is negative, the managed portfolio underperformed.

MONASH
17 BUSINESS
SCHOOL
 2
M measure: Graphical illustration

P* and M have the same

standard deviation of
30%.

Therefore, returns of P*
and M are comparable.

MONASH
18 BUSINESS
SCHOOL
Class Exercise

• Let’s use the Excel file named ‘Data for class exercise’
to calculate the above performance measures.

MONASH
19 BUSINESS
SCHOOL
Which Measure is Appropriate?

BUT, don’t forget that a positive ~ is necessary to outperform

the passive market index.

MONASH
20 BUSINESS
SCHOOL
Performance Measures: An Example
If P or Q represents the entire
investment, Q is better because
of its higher Sharpe measure
and better M2

If P and Q are competing for a

role as one of a number of sub-
portfolios, Q also dominates
because its Treynor measure is
higher

If we seek an active portfolio to

mix with an index portfolio, P is
better due to its higher
information ratio

MONASH
21 BUSINESS
SCHOOL
Style Analysis

• A tool to systematically measure the exposures of managed

portfolios (introduced by William Sharpe)
• Idea is to regress fund returns on indexes representing a range of
asset classes
• Regression coefficient on each index would then measure
the fund’s implicit allocation to that “style”
• R2 of regression (goodness of fit) would measure
percentage of return variability attributable to style choice
rather than security selection
• Intercept measures average return from security selection
of the fund portfolio
• Next slide has an example.

MONASH
22 BUSINESS
SCHOOL
Style Analysis Cont.

Magellan’s return is regressed on;

T-bill rate
Small cap portfolio return
Medium cap portfolio return
Large cap portfolio return
High P/E portfolio return
Medium P/E portfolio return
and
Low P/E portfolio return

R-square reveals that 97.5% of

fund’s return variability is
attributable to these styles.

MONASH
23 BUSINESS
SCHOOL
Market Timing
• Market timing involves shifting funds between a market-index
portfolio and a safe asset (such as T-bills).
• Treynor and Mazuy:

r P - r f = a + b ( rM - r f ) + c ( rM - r f ) + e P
2

• If c is positive, there is evidence of timing ability because it makes

characteristic line steeper as ([V − [F ) is larger (i.e. when market
does better than the safe asset).

MONASH
24 BUSINESS
SCHOOL
Performance Attribution

• Practitioners often want to know which decision resulted in

superior or inferior performance.
• Performance of their assets allocation and sector/security
selection decisions.
• Performance attribution system decomposes performance into
three components:
1. Allocation choices across broad asset classes.
2. Industry or sector choice within each market.
3. Security choice within each sector.

MONASH
25 BUSINESS
SCHOOL
Attributing Performance to Components

• Attribution method explains the difference in return between

managed portfolio and a ‘Benchmark’ or ‘Bogey’ portfolio.
• Superior performance is achieved by:
• overweighting assets in markets that perform well
• underweighting assets in poorly performing markets

MONASH
26 BUSINESS
SCHOOL
Performance Attribution: Example

• Portfolio performance
Asset Class Weight Return
Equity 70% 7.28%
Fixed income 7% 1.89%
Cash 23% 0.48%

• Benchmark performance
Asset Class Weight Return

Equity 60% 5.81%

Fixed income 30% 1.45%
Cash 10% 0.48%

MONASH
27 BUSINESS
SCHOOL
Performance Attribution: Example Cont.
• Portfolio return:
(7.28 x 0.70) + (1.89 x 0.07) +(0.48 x 0.23) = 5.34%

• Benchmark return:
(5.81 x 0.60) + (1.45 x 0.30) + (0.48 x 0.10) = 3.97%

• Excess return = 5.34 – 3.97 = 1.37%

• Managed portfolio has outperformed the benchmark portfolio by

1.37%.

MONASH
28 BUSINESS
SCHOOL
Performance Attribution: Example Cont.

Note that
return on cash
is the same for
both. So, it is
not considered
in calculating
security
selection
contribution.

MONASH
29 BUSINESS
SCHOOL
 Copyright statement for items made available via Moodle

Copyright © (2023). NOT FOR RESALE. All materials produced

for this course of study are reproduced under Part VB of the
Copyright Act 1968, or with permission of the copyright owner
or under terms of database agreements. These materials are
protected by copyright. Monash students are permitted to use
these materials for personal study and research only. Use of
these materials for any other purposes, including copying or
resale, without express permission of the copyright owner, may
infringe copyright. The copyright owner may take action against
you for infringement.

30

24-30 INVESTMENTS | BODIE, KANE, MONASH

MARCUS
BUSINESS
SCHOOL