Chapter 20 EVALUATION OF PORTFOLIO MANAGEMENT

Chapter 20 Questions What are some methods used to evaluate portfolio performance? What are the differences and similarities between the various portfolio performance measures? When we evaluate a sample of portfolios, how do we determine how well diversified they are? How do the various performance measures relate to each other in terms of rankings?

Chapter 20 Questions What are clients’ major requirements of their portfolio managers? What important characteristics should any benchmark possess? What is the benchmark error problem, and how does it affect portfolio performance measures? What impact has global investing had on the significance of the benchmark error problem?

Chapter 20 Questions What two methods can be used to determine a portfolio’s style exposure over time? What is portfolio performance attribution analysis? How does it assist the process of analyzing a manager’s performance? How do bond-portfolio performance measures differ from equity-portfolio performance measures?

Chapter 20 Questions What measure of risk is used in the Wagner and Tito bond-portfolio performance measure? What are the components of the Dietz, Fogler, and Hardy bond-portfolio performance measure?

Judging Portfolio Performance Regardless of the style of management, it is important to evaluate whether portfolio results match the goals of the portfolio managers.

Composite Portfolio Performance Measures How can we evaluate portfolio performance? Calculate excess returns as the difference between portfolio returns and a returns from a return-generating model like the CAPM. Relative return ratios, which measure return per unit of risk Scaled return methods, which adjusts the portfolio return for risk so that it can be directly compared to the benchmark return

Composite Portfolio Performance Measures Excess Returns Methods Jensen Measure Calculates excess returns based on the CAPM Jensen’s alpha represents how much the manager contributes to portfolio (j) returns a j = R jt –(RFR t +  j (R mt -RFR t )) Superior managers will generate a significantly positive alpha; inferior managers will generate a significantly negative alpha Could use APT as the return-generating model

Composite Portfolio Performance Measures Relative Return Ratios Sharpe Portfolio Performance Measure Based on the Capital Market Line, considers the total risk of the portfolio being evaluated S=(R portfolio -RFR)/  portfolio Shows the risk premium earned over the risk free rate per unit of total risk Sharpe ratios greater than the ratio for the market portfolio indicate superior performance (plot above the CML)

Composite Portfolio Performance Measures Relative Return Ratios Treynor Portfolio Performance Measure Based on the CAPM, considers the risk that cannot be diversified, systematic risk T=(R portfolio -RFR)/  portfolio Shows the risk premium earned over the risk free rate per unit of systematic risk Treynor ratios greater than the market risk premium indicate superior performance (plot above the SML)

Information Ratios Let R pt = the return on a portfolio in period t R Bt = the return on the benchmark portfolio in period t D t = the differential return in period t D t = R pt - R Bt D = the average value of D t over the period examined  D = the standard deviation of the differential return during the period The historic (ex post) Sharpe Ratio (S) is:

Composite Portfolio Performance Measures Scaled Returns Risk-Adjusted Performance Measure (RAP) Adjust the risk of the portfolio to equalize the risk of the market or benchmark portfolio Compare the returns after risk adjustment to the benchmark portfolio returns For instance, using the Sharpe index (S): RAP portfolio = RFR+(  market )xS Resulting values larger than the market return (or other benchmark used) would indicate superior performance

Composite Portfolio Performance Measures Comparing Measures Sharpe and RAP both use the portfolio standard deviation as the risk measure, so use total risk to evaluate performance Treynor and Jensen use only systematic risk (beta) to evaluate performance

Composite Portfolio Performance Measures Comparing Measures All measures will give consistent results for completely diversified portfolios When reviewing both diversified and undiversified portfolios, a poorly diversified portfolio could have high beta-adjusted performance but lower  -adjusted performance Statistical analysis indicates high correlations across performance measures when evaluating mutual fund performance They tend to rate and rank performance consistently Still may make sense to use different measures at times

What is Required of a Portfolio Manager? 1. Follow the client’s policy statement 2. Earn above-average returns for a given risk class 3. Diversify the portfolio to eliminate unsystematic risk

Benchmark Portfolios Provides a performance evaluation standard to judge whether the portfolio manager is meeting requirement Usually a passive index or portfolio May need benchmark for entire portfolio and separate benchmarks for segments to evaluate individual managers

Benchmark Portfolios Required Characteristics of Benchmarks Unambiguous Investable Measurable Appropriate Reflective of current investment opinions Specified in advance

Benchmark Portfolios Sometimes no appropriate single benchmark exists, so you “build your own” Specialize as appropriate Be sure to consider risk and ensure that performance standards are not met simply through taking on additional risk.

Performance Measures and Benchmark Error The market portfolio problem The theoretical market portfolio is an efficient, diversified portfolio that contains all risky assets in the economy, weighted by their market values Typically use the S & P 500 Index This is not a complete market proxy (this is benchmark error) Further, betas derived using an incomplete benchmark may also differ from a company’s “true beta”

Performance Measures and Benchmark Error Benchmark Errors and Global Investing Concern with the benchmark error increases with global investing The Dow 30 stocks have higher betas against the S&P 500 than against the Morgan Stanley World Stock Index The benchmark problem is one of measurement in evaluating portfolio performance Might want to give greater weight to the standard deviation-based portfolio performance measures (Sharpe measures)

Taxable Performance and Benchmarking Another difficulty in evaluating performance No standard way of adjusting pre-tax performance to after-tax performance Need to adjust for capital gains and income flows to be reinvested A difficult issue to resolve

Benchmarking and Portfolio Style Two means of determining a portfolio manager’s style Returns-based analysis Characteristic analysis

Returns-based analysis Also called effective mix analysis Portfolio’s historical return pattern is compared to various well-specified indexes Analysis uses sophisticated programming techniques to indicate styles most similar to the portfolio’s actual returns

Characteristic analysis Based on the idea that current make-up will be a good predictor for the next period’s returns Classifies manager into four styles: Value, growth, market-oriented, small- capitalization Decision tree approach to classify a portfolio’s stocks Develop a “sector deviation measure” Results combined to determine style

Attributions for Portfolio Performance Possible explanations of superior performance: Insightful asset allocation strategy that overweighted an asset class that earned high returns Investing in undervalued sectors Selecting individual securities that earned above average returns Some combination of these reasons

Attributions for Portfolio Performance Client’s policy statement is the place to start and compare against actual values Effects of asset allocation decision Compare actual performance against the policy statement allocation strategy earning benchmark returns across all allocations Look for differences in allocations and returns within allocations to explain performance differences Impact of sector and security selection Repeat the same exercise as above, looking to explain either strong or weak performance

Evaluation of Bond- Portfolio Performance How did performance compare among portfolio managers relative to the overall bond market or specific benchmarks? What factors explain or contribute to superior or inferior bond-portfolio performance?

A Bond Market Line Need a measure of risk such as beta coefficient for equities Difficult to achieve due to bond maturity and coupon effect on volatility of prices Composite risk measure is the bond’s duration Duration replaces beta as risk measure in a bond market line

Bond Market Line Evaluation Explains differences from benchmark returns as a function of the following: Policy effect Difference in expected return due to portfolio duration target Interest rate anticipation effect Differentiated returns from changing duration of the portfolio Analysis effect Acquiring temporarily mispriced bonds Trading effect Short-run changes

Decomposing Portfolio Returns Dietz, Fogler, and Hardy decomposition of portfolio returns into income, interest rate, sector/quality, and residual effects Total return during a period is the income effect if the yield curve remained constant during the period Interest rate effect measures changes in the caused by changes in the term structure of interest rates during the period

Decomposing Portfolio Returns The sector/quality effect measures impact on returns because of changing yield spreads between bonds in different sectors/ratings The residual effect is what is left after accounting for the first three factors A large positive residual would indicate superior selection capabilities Examining these effects over time should help to determine the strengths and weaknesses of a bond portfolio manager