Evaluating Portfolio Performance

1
Chapter 4

• Evaluating Portfolio Performance

2
Why Evaluating Portfolio Performance Is Not
Simple

• Cash inflows and outflows mean that different,
  legitimate methods of computing returns will
  provide different performance results.
• Time-weighted vs. dollar weighted

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Interim Cash Flows

• Additions of cash to or removals of cash from a
  portfolio
• dividends or interest payments left in
  portfolio are not interim cash flows
• charges in a margin account added to the debit
  balance, or offset against a cash position are
  not interim cash flows

4
Two Tools to Measure Actual Return Over a Period

• Geometric Mean Return
• Time-weighted rate of return measure
• Internal Rate of Return
• Dollar-weighted rate of return measure

5
Which Rate Should Be Used?

• Depends on conditions governing cash flows
• If portfolio manager controls timing of cash
  flows, use IRR
• If he or she does not, use GMR
• Return to an investor is always IRR
• Performance by portfolio manager is usually GMR

6
Two Components to Benchmarking

• Selection of market index
• Selection of comparison method
• Should be risk-adjusted comparison
• Can adjust risk based on
• Beta
• Variance (or standard deviation)

7
Choices for a Market Index

• Dow Jones Industrial Average
• Standard Poors 500
• Other Domestic Indexes
• Foreign Indexes
• Bond Indexes

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Dow Jones Industrial Average

• Oldest, started in 1884
• Most commonly quoted
• Flaws
• Small number of stocks (30)
• Industries not proportionally represented
• Focuses only on large, mature companies
• Ignores dividends
• Price-weighted index

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Price Weighted Index

• Add up all prices and divide by number of
  securities in index
• Unless there have been
• Stock splits
• Stock dividends
• Changes in composition of index
• Adjustments made via denominator
• Stock with highest price has most impact

10
Standard Poors 500

• Advantages
• Large percentage of total market capitalization
• Includes stocks from multiple markets
• Industry representation more typical of economy
• Value weighted (as are most indexes)

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Value Weighted Index

• Capitalizations of all companies in index added
  together
• Capitalization price x number of shares
• Sum divided by sum of capitalizations on start
  date
• Neutral with regard to splits and dividends
• Minor adjustment with regard to changes in
  components

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Other Indexes

• NASDAQ 100
• NYSE Composite
• Russell 3000, 1000, and 2000
• Dow Jones Wilshire 5000
• Closest to a Total Market Index

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Other Indexes (continued)

• Value Line Index
• Only equally weighted index
• Foreign Indexes
• FTSE 100
• MSCI EAFE
• Bond Indexes
• Lehman Brothers Aggregate Bond Index
• Lehman Brothers Corporate Bond Index
• Lehman Brothers Government Bond Index
• Lehman Brothers Mortgage-Backed Securities Index

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Computing Risk Adjusted Performance Using
Standard Deviation

• Sharpe ratio
• also called reward-to-variability ratio
  (RVAR)

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Treynor ratio

• Also called the reward-to-volatility ratio (RVOL)

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Other Beta-Based Measures of Performance
Evaluation

• Jensens alpha

• Information Ratio
• A portfolios alpha divided by the standard
  deviation of the error term from the estimation
  of a portfolios characteristic line
• The larger the value of the ratio, the more
  attractive the performance of the portfolio

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Choosing a Performance Measure

• Use the Sharpe ratio when it is important to
  consider total variability and not just exposure
  to systematic risk
• Use the Information ratio when a portfolio is
  divided into two components and only one is
  actively managed
• Use the Treynor ratio when an overall portfolio
  has been allocated to multiple active managers