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Week 13_Portfolio performance evaluation

The document discusses methods for measuring portfolio returns, specifically the Time-Weighted Rate of Return (TWR) and Money-Weighted Rate of Return (MWR), highlighting their differences and applications. It also covers risk-adjusted return metrics such as Sharpe's ratio, Treynor's measure, Jensen's alpha, and the Information ratio, along with the M² measure of performance. Additionally, it emphasizes performance attribution to analyze the impact of investment decisions on overall portfolio performance.

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3 views

Week 13_Portfolio performance evaluation

The document discusses methods for measuring portfolio returns, specifically the Time-Weighted Rate of Return (TWR) and Money-Weighted Rate of Return (MWR), highlighting their differences and applications. It also covers risk-adjusted return metrics such as Sharpe's ratio, Treynor's measure, Jensen's alpha, and the Information ratio, along with the M² measure of performance. Additionally, it emphasizes performance attribution to analyze the impact of investment decisions on overall portfolio performance.

Uploaded by

idk814047
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Portfolio performance

evaluation
Week 13
Measuring portfolio return
When we consider investments over a period during which cash was
added to or with drawn from the portfolio, measuring the rate of return
becomes more difficult.

Two methods can be applied in this case:


• Time-weighted rate of return
• Money-weighted rate of return
The time-weighted rate of
return
The time-weighted rate of return (TWR) the compound growth rate
after removing the effects of deposits and withdrawals.

To calculate TWR:
Step 1: Identify the Sub-Periods. A sub-period is the interval when
each deposit or withdrawal happens.
Step 2: Calculate the Sub-Period Returns. The return is the percentage
change of the value of the portfolio before any new cash flows.
Step 3: Calculate the Geometric Mean of All Sub-Periods.
Example (TWR)
The Mientkiewicz account was initially valued at $1,000,000. One month later it
was worth $1,080,000. Let us assume that the account received two cash flows
during month t: a contribution of $30,000 on day 5 and a contribution of
$20,000 on day 16.Further, assume that we use a daily pricing system that
provides us with values of the account (inclusive of the contributions) of
$1,045,000 and $1,060,000 on days 5 and 16 of the month, respectively.
Example (TWR)
For subperiod 1:

For subperiod 2:
Example (TWR)

The subperiod returns can be combined through a process called chain-linking.


The Money-Weighted Rate of Return
• The money-weighted rate of return (MWR) takes into account the
size and timing of cash flows into your account.
• It is like the IRR of your investment cash flows.
• It takes into account when you invested or withdrew money, and how
much.
Example (MWR)
The Mientkiewicz account was initially valued at $1,000,000. One
month later it was worth $1,080,000. Let us assume that the account
received two cash flows during month t: a contribution of $30,000 on
day 5 and a contribution of $20,000 on day 16.Further, assume that we
use a daily pricing system that provides us with values of the account
(inclusive of the contributions) of $1,045,000 and $1,060,000 on days 5
and 16 of the month, respectively.
MWR vs. TWR
• The MWR represents the average growth rate of all money invested in
an account.
• The TWR represents the growth of a single unit of money invested in
the account.
• Consequently, the MWR is sensitive to the size and timing of external
cash flows (contributions and withdrawals) to and from the account,
while the TWR is unaffected by these flows.
Example (TWR vs. MWR)

Consider the Charlton account, worth $800,000 at the


beginning of the month. On Day 10 it is valued at $1.8
million after receiving a $1 million contribution.
At the end of the month, the account is worth $3 million.
Find TWR and MWR.
Example (TWR vs. MWR)
Consider the Charlton account, worth $800,000 at the beginning of the month. On Day 10 it is
valued at $1.8 million after receiving a $1 million contribution.
At the end of the month, the account is worth $3 million.
TWR:
Linked internal return
Linked Internal Rate of Return (Linked IRR), is kind of a hybrid between Time-Weighted
Return (TWR) and Dollar-Weighted Return (IRR).

Linked IRR is a method that:


• Calculates IRR for multiple sub-periods (usually between each cash flow), and then
• Chains (links) those IRRs together to get a total return.

It’s especially useful when:


• You don’t have exact cash flow timing (like daily values).
• You want a more practical version of IRR that adapts to periodic reporting (like monthly
or quarterly).
Risk-adjusted returns
Sharpe’s ratio divides average portfolio excess return over the sample period by the standard deviation of
returns over that period. It measures the reward to (total) volatility trade-off.

Treynor’s measure gives excess return per unit of risk, but it uses systematic risk instead of total
risk.

Jensen’s alpha measures the abnormal return of a portfolio, i.e., the return it earns above what the CAPM
predicts it should earn based on its risk (Beta).

The information ratio measures how much excess return a portfolio generates per unit of active risk (i.e.,
tracking error vs. the benchmark).
Information ratio
Calculate Information ratio:

Month Portfolio Benchmark


Return Return
Jan 2,00% 1,50%
Feb 1,80% 2,00%
Mar 2,50% 2,30%
Apr -1,00% -0,50%
May 3,00% 2,80%
Jun 0,50% 0,60%
Return 1,47% 1,45%
Example, risk-adjusted returns
M2 measure of performance
"What would the return on a portfolio be if it were adjusted to have the
same level of risk as the market portfolio?"

• The M² measure is a risk-adjusted performance measure that


expresses a portfolio’s return as if it had the same risk as the market.

• In contrast to the Sharpe Ratio, M² converts risk-adjusted


performance into a return percentage, making it easier to interpret
and compare.
M2 measure of performance
You are evaluating the performance of a portfolio over a year compared
to the market. Calculate Sharpe ratio and M2 measure.

Metric Portfolio P Market M


Return 13% 10%

Standard
Deviation 18% 12%

Risk-Free Rate 3% 3%
Performance attribution
Rather than focus on risk-adjusted returns, practitioners often want simply to ascertain
which decisions resulted in superior or inferior performance.

Superior investment performance depends on an ability to be in the “right” securities at


the right time.

Performance attribution attempts to decompose overall performance into discrete


components that may be identified with a particular level of the portfolio selection
process.

For example, decomposing the performance into components:


allocation between asset classes, industry, or security choice.
Contribution due to asset allocation
Contribution due to total
performance
Contribution due to sector allocation

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