MEASURING AND
EVALUATING PORTFOLIO
PERFORMANCE
INTRODUCTION
Portfolio evaluation is the last step in the process of
portfolio management.
Portfolio analysis, selection and revision are
undertaken with the objective of maximizing returns
and minimizing risk.
Portfolio evaluation is the stage where we examine
to what extent the objective has been achieved.
Through portfolio evaluation the investor tries to find
out how well the portfolio has performed.
Without Portfolio Evaluation, portfolio management
would be incomplete.
NEED FOR PORTFOLIO
EVALUATION
Investment may be carried out by individuals on
their own. The funds available with individual
investor may not be large enough to create a well
diversified portfolio.
The time, skill and other resources at the disposal
of individual may not be sufficient to manage the
portfolio professionally.
Institutional investor such as mutual fund and
investment companies are better equipped to
create and manage well diversified portfolios in a
professional manner.
Whether the investment activity is carried out by
an individual investor themselves or through
mutual fund and investment companies,
different situations arise where evaluation of
performance becomes imperative. These
situations are:
Self Evaluation
Evaluation of Portfolio Managers
Evaluation of Mutual funds
EVALUATION PERSPECTIVE
Transaction View
Security View
Portfolio View
MEASURING PORTFOLIO RETURN
Portfolio Evaluation comprises of two functions,
Performance Measurement and Performance
Evaluation.
Performance Measurement is an accounting
function which measures the return earned on
portfolio during the holding period.
Performance Evaluation on the other hand
addresses issues such as whether performance
was superior or inferior.
RISK ADJUSTED RETURNS
One obvious method of adjusting for risk is to
look at reward per unit of risk.
Return earned over and above the risk free rate
is the risk premium that is the reward for bearing
risk.
Two methods of measuring the reward per unit of
risk have been proposed by William Sharpe and
Jack Treynor respectively in their pioneering work
on portfolio performance.
SHARPE’S RATIO
The performance measure developed by William
Sharpe is referred to as Sharpe’s ratio or Reward
to Variability Ratio.
It is the ratio of the reward or risk premium to
the variability of return or risk measured by the
standard deviation of return.
Sharpe’s Ratio = Rp – Rf
σp
TREYNOR’S RATIO
The performance measure developed by Jack
Treynor is referred to as Treynor’s Ratio or
Reward to Volatility ratio.
It is the ratio of the reward or risk premium to
the volatility of return as measured by the
portfolio beta.
Treynor’s Ratio = Rp – Rf
βp
Q.1. The return and risk figures of two mutual
funds and the stock market index are given
below:
Fund Return(%) Standard Beta
Deviation (%)
A 12 18 0.7
B 19 25 1.3
Market 15 20 1.0
index
Evaluate the performance of the two mutual
funds if risk free rate of return is 7%.
Q.2. An investor owns a portfolio that over the
last five years has produced 16.8% return.
During that time the portfolio produced a 1.10
beta. Further, risk free return and the market
averaged 7.4% and 15.2% per year respectively.
How would you evaluate the performance of the
portfolio?
Q.3. The following results were obtained from
study for a period of six months in 2018:
Portfolio Rp Standard Correlation
Deviation Coefficient
between Market
and Portfolio
A 18 27 0.8
B 14 18 0.6
C 15 8 0.9
Market 13 12 -
Risk-Free 9 - -
Interest
Rate
Rank these portfolios using Sharpe’s Ratio
and Treynor’s Ratio.
DIFFERENTIAL RETURN
Another type of risk adjusted performance
measure has been developed by Michael Jensen
and is referred to as the Jensen’s Measure.
Jensen’s Measure attempt to measure the
differential between the actual return earned on
portfolio and the return expected from the
portfolio given its level of risk.
CAPM model is used to calculate the expected
return on portfolio. It indicates that the return
that a portfolio should earn for its given level of
risk.
The difference between the return actually earned on a
portfolio and the return expected from a portfolio is the
measure of the excess return or differential return that has
been earned over and above what is mandated for its level of
systematic risk.
Using CAPM model, the expected return of the portfolio can be
calculated as follows:
E(Rp) = Rf + βp(Rm – Rf)
The differential return is calculated as follows:
αp = Rp – E(Rp)
Where,
αp = Differential return earned
Rp = Actual Return earned on a portfolio
E(Rp) = Expected return
Q.4. A mutual fund analyst has collected the
following past performance report of 5 funds and
Nifty:
Fund Return(%) Standard Beta
Deviation
A 16.5 25.6 1.25
B 15.3 20.5 0.95
C 9.5 15.8 0.85
D 22.5 16.5 1.15
E 18.5 18.5 1.05
Market 14.0 13.5 1.00
Based on the above information, you are required
to rank the funds on Sharpe ratio, Treynor ratio
and Jensen’s Measure. Assume that the risk free
rate is 7%. Explain behavior of ranking.
DECOMPOSITION OF
PERFORMANCE
Eugene Fama has provided an analytical
framework that allows for detailed breakdown of a
funds performance into the source or components
of performance. This is known as the Fama’s
Decomposition of total return.
The total return on a portfolio can be firstly divided
into two components, namely risk free return and
excess return.
Thus,
Total Return = Risk Free Return + Excess Return
The excess return arises from different factors or
sources, such as risk bearing and stock selection.
Hence the excess return, in turn, may be
decomposed into two components namely Risk
Premium or reward for bearing risk and return
from stock selection known as return from stock
selectivity.
Thus,
Excess Return = Risk Premium + Return from
Stock Selection
The risk of a security is of two types: Systematic
and Unsystematic risk. When a portfolio of
securities is created, most of the unsystematic risk
would disappear. But in practice, no portfolio
would be fully diversified.
Hence portfolio would have both systematic and a
small amount of unsystematic risk, consequently,
the risk premium can be decomposed into two
components, namely return for bearing systematic
risk and return for bearing unsystematic risk.
Thus,
Risk Premium = Return For Bearing Systematic
Risk + Return For Bearing Unsystematic Risk
Thus the total return on a portfolio can be decomposed
into four components.
Return on a portfolio =Risk free Return +
Return from market risk +
Return from diversifiable risk+
Return from pure selectivity
This may be represented as:
= Risk free rate of return
= Return from market risk
= Return from a diversifiable risk =
= Return from pure selectivity can be obtained as a
difference between the actual return and sum of other
three components
The return from pure selectivity is really the
additional return obtained by a portfolio manager
for his superior stock selection ability. It is the
return earned over and above the return
mandated by the total risk of the portfolio as
measured by standard deviation.
Mathematically, this can be calculated as the
difference between the actual return on a portfolio
and the return mandated by its total risk. This is
known as Fama’s net Selectivity measure.
Fama’s net Selectivity measure can be estimated
as follows:
Q.5. Information regarding two mutual funds and
the stock market index are given below:
Fund Return(%) Standard Beta
Deviation
(%)
SBI Fund 7 15 0.72
HDFC Fund 16 35 1.33
Market 10 24 1.0
Riskindex
free rate of return is 5%
Calculate net selectivity measure for the both the
funds and evaluate the performance using Fama’s
framework of performance components.
Q.6. A mutual fund has earned an average
annual return of 24% over a five years period
while the average market return over the same
period was only 18%. The risk free rate prevailing
at the time was 7.5%. The mutual fund had a
beta of 1.45. The standard deviation of returns of
the mutual fund and the market index were 40%
and 30% respectively.
Calculate Fama’s net selectivity for the fund,
showing the decomposition of performance.
