Investment Analysis - PowerPoint

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              to accompany

  Investment Analysis and
    Portfolio Management
              Eighth Edition
    Frank K. Reilly & Keith C. Brown

 Chapter 25
  Chapter 25 - Evaluation of
   Portfolio Performance
Questions to be answered:
• What major requirements do clients expect from
  their portfolio managers?
• What can a portfolio manager do to attain
  superior performance?
• What is the peer group comparison method of
  evaluating an investor’s performance?
     Chapter 25 - Evaluation of
      Portfolio Performance
• What is the Treynor portfolio performance
• What is the Sharpe portfolio performance measure
  and how can it be adapted to include multifactor
  models of risk and expected return?
• What is information ratio and how it related to
  the other performance measures?
     Chapter 25 - Evaluation of
      Portfolio Performance
• When evaluating a sample of portfolios, how do
  you determine how well diversified they are?
    Chapter 25 - Evaluation of
     Portfolio Performance
• What is the Fama portfolio performance measure
  and what information does it provide beyond
  other measures?
• What is attribution analysis and how can it be
  used to distinguish between a portfolio
  manager’s market timing and security selection
     Chapter 25 - Evaluation of
      Portfolio Performance
• What is the benchmark error problem, and what
  are the two factors that are affected when
  computing portfolio performance measures?
• What are customized benchmarks and What are
  the important characteristics that any benchmark
  should possess?
     Chapter 26 - Evaluation of
      Portfolio Performance
• How do bond portfolio performance measures
  differ from equity portfolio performance
    Chapter 25 - Evaluation of
     Portfolio Performance
• What are the time-weighted and dollar-weighted
  returns and which should be reported under
  CFA’s Performance Presentation Standards?
• How can investment performance be measured
  by analyzing the security holdings of a portfolio?
          What is Required of
         a Portfolio Manager?
1.The ability to derive above-average returns for a
   given risk class
 Superior risk-adjusted returns can be derived from
    – superior timing or
    – superior security selection
2. The ability to diversify the portfolio completely to
   eliminate unsystematic risk relative to the
   portfolio’s benchmark
    Early Performance Measures
• Portfolio evaluation before 1960
  – rate of return within risk classes
• Peer group comparisons
  – no explicit adjustment for risk
  – difficult to form comparable peer group
             Treynor Portfolio
           Performance Measure
• Treynor portfolio performance measure
   – market risk
   – individual security risk
   – introduced characteristic line
• Treynor recognized two components of risk
   – Risk from general market fluctuations
   – Risk from unique fluctuations in the securities in the portfolio
• His measure of risk-adjusted performance focuses on
  the portfolio’s undiversifiable risk: market or
  systematic risk
     Treynor ‘s Composite
     Performance Measure
        R    i    RFR 
• The numerator is the risk premium
• The denominator is a measure of risk
• The expression is the risk premium return per unit of
• Risk averse investors prefer to maximize this value
• This assumes a completely diversified portfolio
  leaving systematic risk as the relevant risk
          Treynor ‘s Composite
          Performance Measure
• Comparing a portfolio’s T value to a similar measure for
  the market portfolio indicates whether the portfolio would
  plot above the SML
• Calculate the T value for the aggregate market as follows:

         Tm    
                 R    m    RFR       
  Demonstration of Comparative
       Treynor Measure

• Comparison to see whether actual return of
  portfolio G was above or below expectations
  can be made using:

   ER G   RFR   i R m  RFR 
        Sharpe Portfolio
      Performance Measure

• Risk premium earned per unit of risk

               R i  RFR
     Si 
   Demonstration of Comparative
        Sharpe Measure
                                    Average Annual Rate of          Standard Deviation of
                                            Return                         Return
              D                              0.13                              0.18
              E                              0.17                              0.22
              F                              0.16                              0.23

              0.14  0.08                                     0.13  0.08
       SM                 0.300                      SD                 0.278
                 0.20                                            0.18

              0.17  0.08                                      0.16  0.08
       SE                 0.409                      SF                  0.348
                 0.22                                             0.23
•The D portfolio had the lowest risk premium return per unit of total risk, failing
even to perform as well as the aggregate market portfolio. In contrast, Portfolio E
and F performed better than the aggregate market: Portfolio E did better than
Portfolio F.
    Treynor versus Sharpe Measure
• Sharpe uses standard deviation of returns as the
  measure of risk
• Treynor measure uses beta (systematic risk)
• Sharpe therefore evaluates the portfolio manager
  on the basis of both rate of return performance
  and diversification
• The methods agree on rankings of completely
  diversified portfolios
• Produce relative not absolute rankings of
            Jensen Portfolio
         Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

ER j   RFR   j ER m   RFR 
              Jensen Portfolio
           Performance Measure
• Also based on CAPM
• Expected return on any security or portfolio is

ER j   RFR   j ER m   RFR 
Where: E(Rj) = the expected return on security
RFR = the one-period risk-free interest rate
j= the systematic risk for security or portfolio j
E(Rm) = the expected return on the market portfolio of
  risky assets
 Applying the Jensen Measure
• Jensen Measure of performance requires
  using a different RFR for each time interval
  during the sample period
• It does not directly consider the portfolio
  manager’s ability to diversify because it
  calculates risk premiums in term of
  systematic risk
 Jensen Measure and Multifactor
• Advantages:
  – It is easier to interpret
  – Because it is estimated from a regression equation, it is possible to
    make statements about the statistical significance of the manger’s
    skill level
  – It is flexible enough to allow for alternative models of risk and
    expected return than the CAPAM. Risk-adjusted performance can
    be computed relative to any of the multifactor models:

 R jt  RFRt   j  [b j1F1t  b j 2 F2t                 b jk Fkt ]  e jt
      The Information Ratio
      Performance Measure
• Appraisal ratio
• measures average return in excess of
  benchmark portfolio divided by the standard
  deviation of this excess return

               R j  Rb       ER j     j
      IR j                         
                 ER           ER     U
      Application of Portfolio
      Performance Measures

      EPit  Divit   BPit
Rit 
       Potential Bias of One-
       Parameter Measures
• positive relationship between the composite
  performance measures and the risk involved
• alpha can be biased downward for those
  portfolios designed to limit downside risk
        Measuring Performance with
          Multiple Risk Factors
  • Form of the estimation equation

R jt  RFRt   j  [b j1 ( RMt  RFRt )  b j 2 SMBt  b j 3 HMLt ]  e jt
        Relationship between
       Performance Measures
• Although the measures provide a generally
  consistent assessment of portfolio
  performance when taken as a whole, they
  remain distinct at an individual level.
• Therefore it is best to consider these
  composites collectively
• The user must understand what each means
   Components of Investment
• Fama suggested overall performance, which
  is its return in excess of the risk-free rate
  Overall Performance=Excess return=Portfolio
   Risk + Selectivity
      Components of Investment
 • The selectivity measure is used to assess the
   manager’s investment prowess
 • The relationship between expected return
   and risk for the portfolio is:

E R  RFR  
                  ˆ           ˆ ˆ    
             E m R  RFR  Cov R j , R m          
               Rm     Rm 
                         
      Evaluating Selectivity
• The market line then becomes a benchmark
  for the manager’s performance
               Rm  RFR 
  R x  RFR             x
                 Rm  

   Selectivit y  Ra  Rx  a 
        Evaluating Diversification
   • The selectivity component can be broken
     into two parts
       – gross selectivity is made up of net selectivity
         plus diversification

Selectivit y                              Diversific ation
Ra  R x  a   Net Selectivit y  R x  Ra   R x  a 
  Holding Based Performance
• There are two distinct advantages to
  assessing performance based on investment
  – Return are usually easy for the investor to
    observe on a frequent basis
  – Represent the bottom line that the investor
    actually takes away from the portfolio
    manager’s investing prowess
    Holding Based Performance
• Returns-based measures of performance are
  indirect indications of the decision-making
  ability of a manager
• Holdings-based approach can provide
  additional insight about the quality of the
  portfolio manager
       Grinblatt -Titman (GT)
       Performance Measure
• Among the first to assess the quality of the
  services provided by money managers by
  looking at adjustments they made to the
  contents of their portfolios

    GTt      (w
                    jt    w jt 1 )R jt

                              GT      t
      Average GT              t
   Characteristic Selectivity (CS)
      Performance Measure
• CS performance measure compares the returns of
  each stock held in an actively managed portfolio
  to the return of a benchmark portfolio that has the
  same aggregate investment characteristics as the
  security in question
     CSt      wj
                     jt ( R jt    RBjt )

                                  CS    t
       Average CS               t
Performance Attribution Analysis

                                       
• Allocation effect   i Wai  W pi  R pi  R p
• Selection effect     W   R  R 
                        i   ai     ai    pi
      Performance Attribution
• Attribution methodology can be used to
  distinguish security selection skills from
  any of several other decisions that investor
  might make
 Measuring Market Timing Skills

• Tactical asset allocation (TAA)
• Attribution analysis is inappropriate
  – indexes make selection effect not relevant
  – multiple changes to asset class weightings
    during an investment period
• Regression-based measurement
      Measuring Market Timing Skills
R pt  RFRt  maxRst  RFRt , Rbt  RFRt ,0
R   pt    RFRt      b Rbt  RFRt    s Rst  RFR 
                   maxRst  RFRt , Rbt  RFRt ,0 U t
      Factors That Affect Use of
       Performance Measures
• Market portfolio is difficult to approximate
• Benchmark error
  –   can effect slope of SML
  –   can effect calculation of Beta
  –   greater concern with global investing
  –   problem is one of measurement
• Sharpe measure not as dependent on market
      Benchmark Portfolios
• Performance evaluation standard
• Usually a passive index or portfolio
• May need benchmark for entire portfolio
  and separate benchmarks for segments to
  evaluate individual managers
    Demonstration of the Global
       Benchmark Problem
• Two major differences in the various beta
  – For any particular stock, the beta estimates
    change a great deal over time.
  – There are substantial differences in betas
    estimated for the same stock over the same time
    period when two different definition of the
    benchmark portfolio are employed.
  Implications of the Benchmark
• Benchmark problems do not negate the
  value of the CAPM as a normative model of
  equilibrium pricing
• There is a need to find a better proxy for the
  market portfolio or to adjust measured
  performance for benchmark errors
• Multiple markets index (MMI) is major step
  toward a truly comprehensive world market
      Required Characteristics of
•   Unambiguous
•   Investable
•   Measurable
•   Appropriate
•   Reflective of current investment opinions
•   Specified in advance
      Selecting a Benchmark
Must be selected at two levels:
• A global level that contains the broadest
  mix of risky asset available from around
  the world
• A fairly specific level consistent with the
  management style of an individual money
  manager (i.e., a customized benchmark).
            Evaluation of
      Bond Portfolio Performance
 • Returns-Based Bond Performance
       – Early attempts to analyze fixed-income
         performance involved peer group comparisons
       – Peer group comparisons are potentially flawed
         because they do not account for investment risk
       – Fama and French addressed the flaw
R jt - RFR t = α j +  b j1  R mt - RFR t  + b j2SMBt + b j3HML t  + b j4TERM t + b j4 DEFt  + e jt
                                                                                             
Bond Performance Attribution
• How did the performance levels of portfolio
  managers compare to the overall bond
• What factors lead to superior or inferior
  bond-portfolio performance?
Bond Performance Attribution
• 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 Performance Attribution
 • This technique divides the portfolio return that
   differs from the return on the Lehman Brothers
   Index into four components:
    – Policy effect
       • Difference in expected return due to
         portfolio duration target
    – Rate anticipation effect
       • Differentiated returns from changing
         duration of the portfolio
    – Analysis effect
       • Acquiring temporarily mispriced bonds
    – Trading effect
       • Short-run changes
            Reporting Investment
• Time-Weighted and Dollar-Weight Returns
   – A better way to evaluate performance regardless of the
     size or timing of the investment involved.
   – The dollar-weighted and time-weighted returns are the
     same when there are no interim investment
     contributions within the evaluation period.
                     Ending Value of Investment
            HPY =                                 -1
                    Beginning Value of Investemnt

               Ending Value of Investment - 1 - DW  Contribution 
Adjusted HPY =                                                        1
               Beginning Value of Investemnt +  DW  Contribution 
        Reporting Investment
• Performance Presentation Standards (PPS)
  – The goals of the AIMR-PPS are:
     • achieve greater uniformity and comparability
       among performance presentation
     • improve the service offered to investment
       management clients
     • enhance the professionalism of the industry
     • bolster the notion of self-regulation
          Reporting Investment
• Performance Presentation Standards
  – Fundamental principles
     • Total return must be used
     • Time-weighted rates of return must be used
     • Portfolios must be valued at least monthly and periodic returns must
       be geometrically linked
     • Composite return performance (if presented) must contain all actual
       fee-paying accounts
     • Performance must be calculated after deduction of trading expenses
     • Taxes must be recognized when incurred
     • Annual returns for all years must be presented
     • Disclosure requirements must be met
        The Internet
     Investments Online
End of Chapter 25
 –Evaluation of Portfolio

Description: Investment Analysis document sample