®1999 South-Western College Publishing 1 Chapter 15 Performance Measurement

®1999 South-Western College Publishing 2 How Should Investors Measure Risk? Standard DeviationStandard Deviation –Investors with limited holdings BetaBeta –Investors with a wide array of holding

®1999 South-Western College Publishing 3 How Should Investors Select Funds? Performance Indexes Provide a method of comparing funds with different funds with different risk-return characteristics

®1999 South-Western College Publishing 4 Performance Indexes Sharpe’s Performance Index (PI S )Sharpe’s Performance Index (PI S ) Treynor’s Performance Index (PI T )Treynor’s Performance Index (PI T ) Jensen’s Performance Index (PI J )Jensen’s Performance Index (PI J ) Performance Indexes With APT(PI A )Performance Indexes With APT(PI A )

®1999 South-Western College Publishing 5 Sharpe’s Performance Index Based on the Slope of the CMLBased on the Slope of the CML Uses Standard Deviation to Measure RiskUses Standard Deviation to Measure Risk The Higher the IndexThe Higher the Index –The better the performance Investors Only Hold the Mutual FundInvestors Only Hold the Mutual Fund

®1999 South-Western College Publishing 6 Treynor’s Performance Index Based on SMLBased on SML Uses Beta to measure RiskUses Beta to measure Risk The Higher the IndexThe Higher the Index –The better the performance Investors Hold Many AssetsInvestors Hold Many Assets For Investors Only Interested in Whether They Beat the MarketFor Investors Only Interested in Whether They Beat the Market

®1999 South-Western College Publishing 7 Jensen’s Performance Index Based on CAPMBased on CAPM Uses Beta to Measure RiskUses Beta to Measure Risk Determines How Much One Fund Outperforms or Underperforms Another FundDetermines How Much One Fund Outperforms or Underperforms Another Fund Determines the Significance of ResultsDetermines the Significance of Results Investors Hold Many AssetsInvestors Hold Many Assets

®1999 South-Western College Publishing 8 Performance Indexes With APT One or More Factors Determine RiskOne or More Factors Determine Risk Jensen’s Performance MeasureJensen’s Performance Measure Examine the Difference BetweenExamine the Difference Between –Actual and expected average rate of return Determines the Significance of ResultsDetermines the Significance of Results For Investors Who Want to Compare Their Performance With Other Fund ManagersFor Investors Who Want to Compare Their Performance With Other Fund Managers

®1999 South-Western College Publishing 9 Summary Standard Deviation AppropriateStandard Deviation Appropriate –Sharpe’s index Beta AppropriateBeta Appropriate –Treynor’s index –Jensen’s index One or More Factors Determine RiskOne or More Factors Determine Risk –APT

®1999 South-Western College Publishing 10 Empirical Evidence For MFs MFs performance Fall Behind the MarketMFs performance Fall Behind the Market MFs can not OutperformMFs can not Outperform –Buy-the-market and-hold policy International MFs Tend to do BetterInternational MFs Tend to do Better –Outperform the S&P 500 –Choice of market portfolio critical Bond Funds Underperform the IndexesBond Funds Underperform the Indexes –Relationship underperformance and the expense ratio underperformance and the expense ratio

®1999 South-Western College Publishing 11 Pension Funds Outperformed By The S&P 500

®1999 South-Western College Publishing 12 Can Fund Managers Time The Market? Newsletters FailedNewsletters Failed Performance Attributed ToPerformance Attributed To –Problems with performance indexes

®1999 South-Western College Publishing 13 Caution About Performance Indexes ProblemsProblems –Historical performance is used to infer future performance –Difficult to measure the risk of actively traded accounts –Beta is not stable Depends on the choice of market indexDepends on the choice of market index –Overall performance indexes cannot identify What activities of the portfolio manager resulted in the performanceWhat activities of the portfolio manager resulted in the performance

®1999 South-Western College Publishing 14 Performance Attribution Assessing the performance of the activities that make up the activities that make up portfolio management portfolio management

®1999 South-Western College Publishing 15 Levels Of Decisions Causing Excess Returns Top-Down ApproachTop-Down Approach –Asset allocation –Sector Allocation –Industry allocation –Security selection

®1999 South-Western College Publishing 16 Flow Chart Top -Down Money Management Process