Lecture 8

Performance measures

Introduction
We may need to evaluate the performances in
many different scenarios
Which portfolio (fund) should you choose to
invest all your money?
Which asset should you pick to add to your
existing portfolio?
Where does the outperformance (or
underperformance) of a money manager come
from?
Introduction

The problem of performance evaluation

Lets take CAPM (or some other factor models) as our benchmark
asset pricing model, then returns of any asset could be written as:

rit rft = i + i [rMt rft ] + it

So returns of your investment portfolio or any asset are expected to

be high if

It loads high on the systematic risks

It has a high alpha (which normally comes with additional idiosyncratic
risk)

When evaluating investment performance, we need to take that

risk into account

If we were to simply compare the returns of, say, two competing

mutual funds, the fund manager taking the most risk would (more
often than not) look more skilled
Making very risky investments is not the skill were interested in
However, the specific meaning and measure of risks depends on the
context and objective of performance measurement.
Introduction

Evaluating entire portfolio: The Sharpe ratio

We have already encountered the Sharpe ratio:
Si =

E ( ri ) rf

The numerator is the excess return (return in excess of risk-free rate),

i.e. the return that could be attributable to risk taking
The denominator is the standard deviation of returns (i.e., total risk of
an investment or asset)
You can interpret it as an assets price of total risk measure.
M

E(r)

rf

Y
X

Sharpe ratio

Evaluating entire portfolio: The Sharpe ratio

When evaluating the performance of your entire investment
portfolio, what you care about is your utility generated out of
that performance

=
U E ( r ) 12 A 2
Whether systematic or idiosyncratic risk, if you end up holding it, they
are equally undesirable

The Sharpe ratio is appropriate for evaluating our entire

investment portfolio
The higher the Sharpe ratio of an investment, the higher utility you
will get, the more desirable it will be.

Sharpe ratio

Evaluating entire portfolio: The M2

We can interpret the difference between two Sharpe ratios as
the difference in the slope of their respective CALs or prices of
risk
However, it involves both expected return and standard deviation in
the comparison, and does not look intuitive sometime
For example, asset A with an excess return of 2% and a standard
deviation of 2%, versus asset B with an excess return of 10% and a
standard deviation of 11%
A measure that gives a clear difference in expected returns (but
controlling for difference in standard deviations) might be more
intuitive
M

E(r)

rf

Y
X

M2

Evaluating entire portfolio: The M2

The M2 measure works by forming a hypothetical portfolio, P,
on with the same risk (standard deviation) as the market
portfolio on the CAL of the evaluated asset
The M2 measure is the difference between the expected
return on the hypothetical portfolio, E(rP), and that of the
market portfolio, E(rM)
Its essentially a standardized Sharpe ratio
Similarly, it is appropriate for evaluating the performance of the entire
investment portfolio
M

E(r)

M2Y

M2X

rf

M2

Evaluating entire portfolio: The M2

Step 1: Form P by combining the evaluated portfolio with the risk-free
asset
rP ' =
(1 w ) rf + wrP

Step 2: Choose the weight in the evaluated portfolio to set the resulting
standard deviation equal to the standard deviation of the market
=
P ' w=
P M
w=

M
P

Step 3: Calculate the implied expected return and compare it to that of

the market
E ( rP ' ) =rf + w E ( rP ) rf =rf +
M 2 =E ( rP ' ) E ( rM ) =rf +

M
E ( r ) rf
P P

E ( rP ) rf E ( rM ) = M E ( rP ) rf E ( rM ) rf
P
P

We can interpret the measure as the difference between the scaled excess
return of our portfolio P and that of the market, where the scaled
portfolio has the same volatility as the market.
M2

Asset
E(r)

Sharpe ratio

M2: numerical example

X-fund
12%
25%
0.4

Y-fund
5%
5%
0.6

Market portfolio
10%
10%

Risk-free asset
2%

0.8

Forming the hypothetical portfolios for both funds to have same

as the market portfolio.
Wx = M / x = 40%, so 40% in X-fund and 60% in risk-free asset
WY = M / Y = 200%, so 200% in Y-fund and -100% in risk-free asset
Both hypothetical portfolios have a of 10%, same as the market.

Calculating the expected returns of two hypothetical portfolios

E(rpx) = 40%*12% + 60%*2% = 6%
E(rpY) = 200%*5% - 100%*2% = 8%

Calculating M2 measures of two hypothetical portfolios

M2x = 6% - 10% = -4%
M2Y = 8% - 10% = -2%

Evaluation conclusion

Y-fund is a better investment option than X-fund, though both funds are
worse than the market portfolio
Same conclusion as inferred from the Sharpe ratios
M2

Ethical considerations for the M2

The M2 will inflate when the risk of the market portfolio increases
Positive M2 will be larger and negative M2 will be smaller (more
negative)
This is because we need to scale the evaluated portfolio P by M/P
when calculating M2

As discussed earlier in the course, the correct proxy for the market
portfolio is not obvious. And when reporting the M2 measure, fund
managers will have incentives to
Choose a market proxy that they beat
Choose a market proxy with high risk

Many performance measures can be affected in similar ways

As investors we should be aware that there is some room to game
with performance measures without actually lying
As fund managers we should resist the urge to do so
We will come back to the market proxy selection issue when talking
about practical issues in performance evaluation
M2

10

Evaluating individual assets in a diversified portfolio:

The Treynor measure
If we are evaluating an asset that we will add to a well
diversified portfolio (and thus account for a trivial fraction of
our investment), we are only concerned with the systematic
risk
The idiosyncratic risk of the new asset should be offset by
those of other assets.
The Treynor measure is an appropriate performance measure
in these cases
E ( ri ) rf
Ti =
i
Similarly as the Sharpe ratio, it is the excess return scaled
by some risk measure, but the relevant risk measure is
You can think of it as an assets price of systematic risk
Treynor measure

11

Evaluating individual assets in a diversified portfolio:

The Treynor measure
In the Sharpe ratio, we are comparing the slopes of CALs of
various assets in the expected return standard deviation
space
Similarly, we can draw lines linking the risk free rate and
assets in the expected return beta space
For the line linking risk-free rate and the market portfolio, we know it
is called as Security Market Line (SML) in lecture 6
For other assets, lets call them as T-lines; and all T-lines will collapse
to SML if all assets are correctly priced based on CAPM
E(r)

rf

Treynor measure

12

Evaluating individual assets in a diversified portfolio:

The Treynor measure
If CAPM is the correct asset pricing model and all assets are
fairly priced, then all assets should have the same Treynor
measure, the market excess return (or the market risk
premium)

E ( ri ) =
rf + i E ( rM ) rf
E ( ri ) rf
= E ( rM ) rf

An asset could beat the market portfolio by Treynor measure

only if its Treynor measure is higher than the market excess
return
E ( ri ) rf

E ( rM ) rf > 0

Market portfolio has a beta of 1, and thus its Treynor measure is its
excess return
Treynor measurev

13

Evaluating individual assets in a diversified portfolio:

The Treynor measure
The M2 scales the excess return with M/P (to have the same
standard deviation as the market portfolio), which is then
used to compare with the excess return of the market
portfolio
The Treynor measure scales the excess return by M/P = 1/P
(to have the same beta as the market portfolio), which is then
used to compare with the excess return of the market
portfolio
Y
SML
E(r)

TY>1
TX<1

rf

M=1
Treynor measure

14

Evaluating individual assets in an active portfolio

We learnt in lecture 7 that Jensens alpha measures over/underperformance relative to systematic risk benchmark

rit rft = i + i [rMt rft ] + it

E ( ri ) rf = i + i E ( rM ) rf

E(r)

TX line = TY line

rf

Information ratio

15

Evaluating individual assets in an active portfolio

Optimally combining such assets with non-zero alphas (called
as active assets in lecture 7) with a diversified benchmark
portfolio (like market portfolio) will increase expected return
without similar increase in volatility for the resulting total
portfolio
We typically form a portfolio of active assets (active portfolio) first,
and then combine this active portfolio with the diversified benchmark
portfolio

Exploiting active assets will give you the benefit of extra

expected return (i.e., alpha), but also comes with the cost of
extra idiosyncratic risk
The extra expected return (alpha here) must be evaluated against the
extra risk (idiosyncratic risk)

Information ratio

16

Evaluating individual assets in an active portfolio:

Information ratio
The appropriate measure was the (absolute value of the)
information ratio
IRi =

The information ratio is appropriate if you are looking for

mispriced assets and trying to combine them with a passive
diversified benchmark portfolio (like market portfolio)

Information ratio

17

Evaluating individual assets in an active portfolio:

Information ratio
The higher the absolute value of the information ratio of an
asset, the higher its contribution to the Sharpe ratio of the
final optimal risky portfolio
We use Sharpe ratio for our evaluation of our entire investment
portfolio
Recall what we learnt in lecture 7, the squared Sharpe ratio of the
optimal risky portfolio is the squared Sharpe ratio of the benchmark
portfolio plus the squared information ratio of the active portfolio;
and the squared information ratio of the active portfolio is the sum of
squared information ratios of individual active assets
The information ratio is also related to the weight of an asset in the
active portfolio, but not directly (please check lecture 7)

Information ratio

18

Sources of performance
Not being silly
That means, at a minimum, not taking on unsystematic risk unless
motivated by some mispricing

Security selection
Finding mispriced assets, i.e. non-zero alphas, and tilting the portfolio
accordingly
This was the focus of our analysis in lecture 7

Asset allocation
This is related to market timing, e.g. investing in equities when
expected equity return is high and investing in the bonds when
expected bond return is high

Performance attribution

19

Performance attribution
We can attribute performance to either security selection or
asset allocation by comparing a fund to a benchmark (or
bogey) portfolio
The bogey portfolio would have some appropriate weights in
each asset class (such as the funds average or stated weights)
The benchmark portfolio is typically chosen based on the claimed
investment strategy/style of the fund

If there are N asset classes, the return of the bogey would be

a weighted average of the returns of each asset class
N

rB = wB ,i rB ,i
i =1

Performance attribution

20

Performance attribution
The managed portfolios returns would depend on its weights
and returns in each asset class
N

rP = wP ,i rP ,i
i =1

The return difference can be written as

r=
P rB

r w=
r

(w

P ,i P ,i
B ,i B ,i
=i 1 =i 1 =i 1

rP rB
=
rP rB
=

(w

r wB ,i rB ,i )

P ,i P ,i

r w r + r w r=
w )

r ( w

P ,i P ,i
B ,i B ,i
B ,i P ,i
B ,i P ,i
i 1 =i 1
N

r (w

) + w (r

B ,i
P ,i
B ,i
i 1 =i 1

P ,i

P ,i

B ,i

P ,i

wB ,i ) + wP ,i ( rP ,i rB ,i )

rB ,i )

Performance attribution

21

Performance attribution
The two sums can be interpreted as returns attributable to
asset allocation and security selection respectively
Asset allocation (AA): return difference due to deviation from
benchmark weights across various asset sectors, but not due to
difference in returns of asset sectors between evaluated targets and
benchmark
Security selection (SS): return difference due to selecting securities
different from benchmark within each asset sectors (so returns of
asset sectors differ btw evaluated targets and benchmark), but not
due to difference in allocation across various asset sectors
=
r r

r (w

) + w (r

P
B
B ,i
P ,i
B ,i
=i 1 =i 1

Security selection

P ,i

rB ,i )

Cross term (attributed to selection)

Asset allocation

Bogey performance

P ,i

Performance attribution

22

Practical issues in performance evaluations

We will discuss various practical issues in performance
evaluation in the remaining slides

Practical issues

23

Passive investments: Tracking error and fees

Suppose that you decide (as you reasonably might) that active
portfolio management is a waste of time and money
Buy an index fund whose performance is claimed to be like
a tracked index, like S&P500 index
So you are expected to earn similar returns as S&P500
index
Tracking error
However, the actual returns may differ from those of the
tracked index, i.e., there is tracking error
As such, you are bearing the unsystematic risk due to the
tracking error
Tracking error measures how closely the fund manages to
replicate the index, the smaller, the better.
Practical issues

24

Passive investments: Tracking error and fees

Fees
If a fund is trying to track an index very closely, then it may have to
rebalance its portfolio from time to time, which means lots of
transaction costs and fees charged on you (although the fund can also
do lots of unnecessary transactions to result in high tracking error).
So it is important that a fund could track an index well with reasonably
low costs and fees charged on investors.
In practice, fees are very important for overall investment
performance
You can buy an ETF tracking the US market with fees as low as
0.06%
The average fee for a US equity fund is about 1.44% (in 2010)

For passive investments, you want some funds with low

tracking error and low fees as well.
Practical issues

25

Uncertainty in estimates
Ex-ante performance measures are unobservable
We have to estimate them using past data, for example, to
calculate Sharpe ratio
ri rf
Si =
i

We need returns to be stationary, but fund managers may

change strategy
We need to choose a sample period
Theres always uncertainty in our estimates

Practical issues

26

Choice of asset pricing model

Many risk measures, such as , rely on a particular choice of
asset pricing model, e.g. the CAPM
If that model is wrong the performance measures may be
misleading
This is especially important when evaluating assets for which
we suspect that a particular model, like CAPM, does a poor
job, for example
Hedge funds invest in illiquid assets
Hedge funds also invest in assets with option-type payoffs
Making things worse, even if the model is correct in theory,
the empirical choice could be still wrong
For example, we have to pick a market portfolio proxy for CAPM

Practical issues

27

Tail risk
American Samoa
Unincorporated territory of the US
Lovely place, but not very good at football
Lost every game for 20 years
Lost to Australia by 31-0

Hypothetical hedge fund strategy:

Bet $1 billion against the team every time they play
This would result in a nice track record with steady returns and low zero-beta risk
until November 23, 2011 when finally they won against Tonga after 30 straight losses
(and the hedge fund would have lost everything)

The risk of such improbable but catastrophic events is known as tail risk
Many hedge funds are exposed to it, examples are selling deep out-of-the-money put
options and merger arbitrage; Or think about selling insurance against earthquake in
Australia
so track records and performance measures may be misleading, because such risk may
not be reflected in your risk measures which are likely calculated from historical data

Since tail risk has the potential to mislead investors, funds that are
consciously taking it on have an ethical responsibility to communicate that
to investors
Practical issues

28

Incubation
How to make a successful investment news letter:
1. Prior to Googles earnings announcement, send newsletters to 1000
potential investors. Let half the letters predict that Google will
outperform their expectations and half that they will underperform
2. Observe the outcome and forget about the investors that got the
wrong prediction
3. Prior to the next earnings announcement, send newsletters to the
remaining 500 investors. As before, let half the letters make a positive
prediction and half a negative prediction
4. Rinse and repeat six times. You should now have about 30 investors
that have been sent six accurate predictions in a row.
5. Offer them to keep subscribing to your newsletters for a fee

This is an example of so called survivorship bias or selection

bias
Dont actually do this. Its highly unethical and possibly illegal
Practical issues

29

Incubation
Many mutual funds run a similar scam
They start many incubation funds that are not open for public
trading
By chance, some do well and some do poorly
They open the high performing funds to public trading
Even if the managers have no skill, the funds they offer will have good
track records and appear to be beating the market

A similar (but less unethical) effect is that of fund survival

Suppose that no fund managers have any skills
By chance, some funds would still do well and some poorly
Poorly performing funds are likely to go out of business and funds with
good performance are likely to survive (and grow)
As a result, the average fund would appear to do well
That is no indication of fund manager skill or of future performance
Practical issues

30