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Performance of Mutual Funds

The document discusses various methods for evaluating the performance of mutual funds, including measures of risk-adjusted returns such as the Sharpe ratio and Treynor ratio. It also examines the Jensen measure for determining whether a fund's performance is better than expected based on the capital asset pricing model. Finally, it discusses issues that portfolio managers and the investment industry face in properly assessing fund performance.

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9 views

Performance of Mutual Funds

The document discusses various methods for evaluating the performance of mutual funds, including measures of risk-adjusted returns such as the Sharpe ratio and Treynor ratio. It also examines the Jensen measure for determining whether a fund's performance is better than expected based on the capital asset pricing model. Finally, it discusses issues that portfolio managers and the investment industry face in properly assessing fund performance.

Uploaded by

akpanyap
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 22

Performance of Mutual Funds

Investments

© K. Cuthbertson and D. Nitzsche


Learning Objectives

To explain how we assess risk-adjusted performance


of portfolios/assets using funds alpha
To examine the historic performance of
portfolios/assets
To examine whether it is possible to pick groups of
funds that earn positive abnormal return in the
future
To examine whether investors put money in into
funds that do well and withdraw from funds that do
perform badly

© K. Cuthbertson and D. Nitzsche


A Lesson from
a Few Mutual Funds
3

The two key points with performance evaluation:


 The arithmetic mean is not a useful statistic in evaluating
Consider the historical returns of two mutual funds
on the following slide
A Lesson from
a Few Mutual Funds (cont’d)
4

44 Wall Mutual 44 Wall Mutual


Year Street Shares Year Street Shares
1975 184.1% 24.6% 1982 6.9 12.0
1976 46.5 63.1 1983 9.2 37.8
1977 16.5 13.2 1984 –58.7 14.3
1978 32.9 16.1 1985 –20.1 26.3
1979 71.4 39.3 1986 –16.3 16.9
1980 36.1 19.0 1987 –34.6 6.5
1981 -23.6 8.7 1988 19.3 30.7
Mean 19.3% 23.5%
Change in net asset value, January 1 through December 31.
A Lesson from
a Few Mutual Funds (cont’d)
5

Mutual Fund Performance

$200,000.00
$180,000.00
Ending Value ($)

$160,000.00
$140,000.00 44 Wall
$120,000.00 Street
$100,000.00 Mutual
$80,000.00 Shares
$60,000.00
$40,000.00
$20,000.00
$-

Year
A Lesson from
a Few Mutual Funds (cont’d)
6

44 Wall Street and Mutual Shares both had good


returns over the 1975 to 1988 period

Mutual Shares clearly outperforms 44 Wall Street in


terms of dollar returns at the end of 1988
Why the Arithmetic Mean
Is Often Misleading: A Review
7

The arithmetic mean may give misleading


information
 e.g., a 50 percent decline in one period followed by a 50
percent increase in the next period does not produce an
average return of zero
Why the Arithmetic Mean
Is Often Misleading: A Review (cont’d)
8

The proper measure of average investment return


over time is the geometric mean:

1/ n
 n

GM   Ri   1
 i 1 
where Ri  the return relative in period i
Traditional
Performance Measures
9

Sharpe Measure
Treynor Measures
Jensen Measure
Performance Measurement in Practice
Sharpe and Treynor Measures
10

The Sharpe and Treynor measures:

R  Rf
Sharpe measure 

R  Rf
Treynor measure 

where R  average return
R f  risk-free rate
  standard deviation of returns
  beta
Sharpe and
Treynor Measures (cont’d)
11

Example

Over the last four months, XYZ Stock had excess


returns of 1.86 percent, –5.09 percent, –1.99
percent, and 1.72 percent. The standard deviation of
XYZ stock returns is 3.07 percent. XYZ Stock has a
beta of 1.20.

What are the Sharpe and Treynor measures for XYZ


Stock?
Sharpe and
Treynor Measures (cont’d)
12

Example (cont’d)

Solution: First, compute the average excess return


for Stock XYZ:

1.86%  5.09%  1.99%  1.72%


R
4
 0.88%
Sharpe and
Treynor Measures (cont’d)
13

Example (cont’d)

Solution (cont’d): Next, compute the Sharpe and


Treynor measures:

R  Rf 0.88%
Sharpe measure    0.29
 3.07%
R  Rf 0.88%
Treynor measure    0.73
 1.20
Portfolio Performance Measures:
Treynor’s versus Sharpe’s Measure
Treynor versus Sharpe Measure
 Sharpe uses standard deviation of returns as the measure of
risk
 Treynor measure uses beta (systematic risk)
 Sharpe evaluates the portfolio manager on basis of both rate
of return performance and diversification
 Methods agree on rankings of completely diversified
portfolios
 Produce relative not absolute rankings of performance
Jensen Measure
15

The Jensen measure stems directly from the CAPM:

Rit  R ft      i  Rmt  R ft 


Jensen Measure (cont’d)
16

The constant term should be zero


 Securities with a beta of zero should have an excess return of
zero according to finance theory

According to the Jensen measure, if a portfolio


manager is better-than-average, the alpha of the
portfolio will be positive
Academic Issues
Regarding Performance
17
Measures
The use of Treynor and Jensen performance
measures relies on measuring the market return and
CAPM
 Difficult to identify and measure the return of the market
portfolio
Evidence continues to accumulate that may
ultimately displace the CAPM
 Arbitrage pricing model, multi-factor CAPMs, inflation-
adjusted CAPM
Industry Issues
18

“Portfolio managers are hired and fired largely on


the basis of realized investment returns with little
regard to risk taken in achieving the returns”

Practical performance measures typically involve a


comparison of the fund’s performance with that of a
benchmark
Industry Issues (cont’d)
19

“Fama’s return decomposition” can be used to assess


why an investment performed better or worse than
expected:
 The return the investor chose to take
 The added return the manager chose to seek
 The return from the manager’s good selection of securities
20
Industry Issues (cont’d)
21

Diversification is the difference between the return


corresponding to the beta implied by the total risk of
the portfolio and the return corresponding to its
actual beta
 Diversifiable risk decreases as portfolio size increases, so if the
portfolio is well diversified the “diversification return” should
be near zero
Industry Issues (cont’d)
22

Net selectivity measures the portion of the return


from selectivity in excess of that provided by the
“diversification” component

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