PORTFOLIO PERFORMANCE EVALUATION
Portfolio managers and investment analysts have to continuously
evaluate their performance to identify the source of strengths and
weaknesses. Investors entrust the effective management of their
portfolios to the portfolio manager and they have every right to
question whether their portfolios are managed properly or not.
Performance evaluation forms the basis of portfolio revision
“Portfolio performance evaluation can be defined as a feedback
and control mechanism which is used by the portfolio manager
and investment analysts to make the process of portfolio or
investment management more effective “. performance evaluation
is necessary to find out whether the portfolio manager is heading
towards their objective of achieving an optimum risk-return
adjustment.
Method of Assessing Performance
The portfolio performance is evaluated by measuring and
comparing the portfolio return and associated risk and hence risk-
adjusted-performance. For this purpose, there are essentially
three major methods of assessing performance.
• Return per unit of risk
• Differential return
• Components of performance
Return per unit of risk
The first measure of risk-adjusted performance assesses the
performance of a fund in terms of return per unit of risk both in
absolute terms and relative terms. According to these measures,
funds that provide the highest return per unit of risk would be
adjusted as the best performers, and the funds that provide the
lowest return per unit of risk would be the poorest performers.
There are two methods of determining the return per unit of risk:
• Reward to Volatility ratio developed by William Sharpe
• Reward to Volatility ratio developed by Jeck Treynor
2) DIFFERENTIAL RETURN
Another method to measure risk-adjusted performance is the
differential return measure. This measure was developed by
Michael Jensen. The basic objective of this technique is to
calculate the return that should be expected for the fund given the
realized risk of the fund and then compare the calculated return
, with the realized return. In making this comparison, it is assumed
that the investors play a very passive role.
4) Components of performance
The first two measures stated above are primarily concerned with
the overall performance of a fund. however, the most useful
measure would be to assess the sources and components of
performance by developing a more refined breakdown.
F.Fama has provided an analytical framework to have a more
detailed breakdown of the performance of the fund. this
breakdown is done in the following three ways
1) Stock selection
Overall performance can be examined in terms of superior or
inferior stock selection and the normal return associated with the
given level of risk. thus,
TOTAL EXPENSES = SELECTING + RISK
2) Market timing
If investors want to maximize their returns, they must only
purchase the right security but must also know the right time to
purchase and sell. To generate superior performance better than
the market average, the market has to be timed correctly.
3) Cash maangement Analysis
Cash management analysis was used by Farrel to assess the
degree to which variation in the cash percentage around the long-
term average has benefited or detracted from fund performance.
SHARPE’S REWARD TO VARIABILITY MODEL
Initially, the performance evaluation of portfolios was done entirely by a
manager who was aware of the risk associated with the return, but they did
not know how to quantity risk, so they could not consider it explicitly.
Portfolio evaluation has evolved dramatically since the early 1960s. The
developments enabled the investors to quantify risk in terms of variability
of returns, but there was still no composite measure and both the factors
were considered separately. Sharpe, Treynor, Jensen, and others have
developed models for portfolio evaluation that take into consideration both
risk and return of the portfolio.
This article deals with evaluating portfolio performance based on Sharpe's
reward to Variability Model.
Sharpe’s Model follows closely from the author’s earlier work on CAPM.
This model yields a single value that can be used for investment
performance rankings. It assigns the highest rank portfolio that has the best
risk-adjusted rate of return; His measures measure the risk of portfolios.
Portfolio managers and investment analysts have to continuously
evaluate their performance to identify the source of strengths and
weaknesses. Investors entrust the effective management of their
portfolios to the portfolio manager and they have every right to
question whether their portfolios are managed properly or not.
Performance evaluation forms the basis of portfolio revision
“Portfolio performance evaluation can be defined as a feedback
and control mechanism which is used by the portfolio manager
and investment analysts to make the process of portfolio or
investment management more effective “. performance evaluation
is necessary to find out whether the portfolio manager is heading
towards their objective of achieving an optimum risk-return
adjustment.
Method of Assessing Performance
The portfolio performance is evaluated by measuring and
comparing the portfolio return and associated risk and hence risk-
adjusted-performance. For this purpose, there are essentially
three major methods of assessing performance.
• Return per unit of risk
• Differential return
• Components of performance
Return per unit of risk
The first measure of risk-adjusted performance assesses the
performance of a fund in terms of return per unit of risk both in
absolute terms and relative terms. According to these measures,
funds that provide the highest return per unit of risk would be
adjusted as the best performers, and the funds that provide the
lowest return per unit of risk would be the poorest performers.
There are two methods of determining the return per unit of risk:
• Reward to Volatility ratio developed by William Sharpe
• Reward to Volatility ratio developed by Jeck Treynor
2) DIFFERENTIAL RETURN
Another method to measure risk-adjusted performance is the
differential return measure. This measure was developed by
Michael Jensen. The basic objective of this technique is to
calculate the return that should be expected for the fund given the
realized risk of the fund and then compare the calculated return
, with the realized return. In making this comparison, it is assumed
that the investors play a very passive role.
4) Components of performance
The first two measures stated above are primarily concerned with
the overall performance of a fund. however, the most useful
measure would be to assess the sources and components of
performance by developing a more refined breakdown.
F.Fama has provided an analytical framework to have a more
detailed breakdown of the performance of the fund. this
breakdown is done in the following three ways
1) Stock selection
Overall performance can be examined in terms of superior or
inferior stock selection and the normal return associated with the
given level of risk. thus,
TOTAL EXPENSES = SELECTING + RISK
2) Market timing
If investors want to maximize their returns, they must only
purchase the right security but must also know the right time to
purchase and sell. To generate superior performance better than
the market average, the market has to be timed correctly.
3) Cash maangement Analysis
Cash management analysis was used by Farrel to assess the
degree to which variation in the cash percentage around the long-
term average has benefited or detracted from fund performance.
SHARPE’S REWARD TO VARIABILITY MODEL
Initially, the performance evaluation of portfolios was done entirely by a
manager who was aware of the risk associated with the return, but they did
not know how to quantity risk, so they could not consider it explicitly.
Portfolio evaluation has evolved dramatically since the early 1960s. The
developments enabled the investors to quantify risk in terms of variability
of returns, but there was still no composite measure and both the factors
were considered separately. Sharpe, Treynor, Jensen, and others have
developed models for portfolio evaluation that take into consideration both
risk and return of the portfolio.
This article deals with evaluating portfolio performance based on Sharpe's
reward to Variability Model.
Sharpe’s Model follows closely from the author’s earlier work on CAPM.
This model yields a single value that can be used for investment
performance rankings. It assigns the highest rank portfolio that has the best
risk-adjusted rate of return; His measures measure the risk of portfolios.
