Portfolio Performance Evaluation, Methods of Assessing Performance

Portfolio Performance Evaluation
Unit 4 SAPM Notes 
Methods of Assessing Performance 

Portfolio performance evaluation and methods of its assessment

Portfolio performance evaluation can be defined as a feedback and control mechanism which is used by the portfolio managers and investment analysts to make the process of portfolio/investment management more effective. Expert Portfolio managers have to show superior performance over the market; for that they have to evaluate their performance in comparison with other portfolio managers. Portfolio manager have an objective to achieve an optimum risk return adjustment. Whether they are heading towards this objective or not will be found out only if they evaluate their portfolios periodically. However, in conducting such an evaluation, a means for determining the appropriate standard or benchmark must be established. Two major factors which influence the performance are the rate of return earned and the associated risk over the relevant period. The return is defined to include changes in the value of the fund over the performance period plus any income earned over that period. Risk is the variability surrounding the return. The manager has to diversify completely into different industries, assets and instruments so as to reduce the unsystematic risk to the minimum for a given level of return. The systematic or market related risk has to be managed by a proper selection of beta for the securities.

Methods of assessing performance

The portfolio performance is evaluated by measuring and comparing the portfolio return and associated risk and hence risks adjusted performance. For this purpose there are essentially three major methods of assessing performance:

a)       Return per unit of risk.

b)      Differential return.

c)       Components of performance.

a)       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 (relative to overall market performance). According to this measure, funds that provide the highest return per unit of risk would be adjudged 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.

Ø  Reward to volatility ratio developed by William Sharpe and

Ø  Reward to volatility ration developed by Jack Treynor.

Evaluation has also to take into account whether the portfolio is securing above average returns, average returns or below average returns as compared to the prevailing rate of return in the market. The ability of the fund managers to diversity can reduce and even eliminate all unsystematic risk. They can manage the systematic risk by use of appropriate risk measures, namely Betas. The portfolio managers must have superior timing and superior stock selection to earn above average returns. Diversification can reduce the market related risk and maximize the returns for a given level of risk. As the market returns are positively related to risk, the evaluators must take into consideration (a) The rate of returns, (b) Excess return over risk free rate, (c) Level of systematic, unsystematic and residual risk through proper diversification.

b)      Differential Return: Another method to measure the 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 comparing the calculated return with the actually realized return. In making this comparison, it is assumed that the investor plays a very passive role. He merely buys the market portfolio and adjusts for the appropriate level of risk by borrowing or lending at the risk free rate.

c)       Components of Performance: The first two measures stated above are primarily concerned with the overall performance of a fund. However, the more useful measure would be to assess the sources and components of performance by developing a more refined breakdown. E. Fama has provided an analytical framework to have a more detailed break down of the performance of the fund. This break down is done in the following three ways:

1.       Stock Selection: Overall performance of the fund can be examined in terms of superior or inferior stock selection and the normal return associated with a given level of risk. Thus, Total Excess Return = Selecting + Risk.

To earn average returns, the fund managers have to diversify. The market pays returns only on the basis of systematic risk. The level of diversification can be judged on the basis of the correlation between the portfolio returns and the returns for a market portfolio. A completely diversified portfolio is perfectly correlated with the market portfolio, which is in turn completely diversified.

To earn the above average return, fund managers will generally have to forsake some diversification that will have its cost in terms of additional portfolio risk. Hence some additional return is needed for this additional diversification risk. Capital Market Line (CML) helps in determining the risk commensurate with the incurred risk.

2.       Market Timing: If investors want to maximize their returns, they must not 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, markets, have to be timed correctly. Market timing implies assessing correctly the direction of the market, either bull or bear and positioning the portfolio accordingly. When there is a forecast of declining market, the managers should position the portfolio properly by increasing the cash percentage of the portfolio or by decreasing the beta of the equity portion of the portfolio. When the forecast is of rising market, the managers should decrease the cash position or increase the beta of the equity portion of the portfolio.

3.       Cash Management Analysis: Cash management analysis was used by Farrell to assess the degree to which variations in the cash percentage around the long term average have benefited or detracted from fund performance. Two indexes were constructed for each fund by Farrell:

Ø  The first index is based on the average cash to other asset allocation experienced by the fund over the period of analysis.

Ø  The second index is based on a quarter to quarter changes experienced by the fund over the period.