Unit 10: Portfolio Management and Performance Evaluation
Your progress
Learning Objectives
By the end of this unit you will be able to:
Explain how to use asset allocation to construct a portfolio consistent with an investor’s
objectives.
Discuss the data needed to measure and compare investment performance.
Understand the techniques used to measure income, capital gains and total portfolio return.
Use the Sharpe, Treynor and Jensen measures to evaluate performance.
Describe the role of dollar-cost averaging, constant-dollar plans, constant-ratio plans and
variable-ratio plans.
To accomplish these objectives, read carefully through the following pages and complete all of
the activities.
Introduction
Having looked at stocks and mutual funds, you are now ready to think about putting them all
together to create a portfolio. First you need to think about what your objectives are. For
example, how much return will you require to meet your goals, and how much risk are you
willing (and able) to accept? You also need to think about what constraints there might be in
building a portfolio. These can include factors like liquidity (how much money do you need to
access at short notice), time horizon (short, long or a combination), tax concerns, legal and
regulatory factors and circumstances specific to your own situation. From there we generally
follow a top-down process, just like we did with stock analysis. In this case, we would first pick
the asset allocation of the portfolio. This determines how much is invested in Canadian stocks,
foreign stocks, bonds, real estate, cash, and so on. Then within each of those asset classes, you
could think about industries and then individual stocks. While asset allocation can get
complicated, this Unit will show some basic tools that you can use to help meet your
investment objectives and constraints.
When creating your portfolio you thought about what your risk and return goals were, but after
a year or two, you want to know how well you actually met those objectives. That is where
performance measurement and evaluation come in. But how do we measure performance? The
holding period return (HPR) that we have previously seen is a great start for both individual
assets and for portfolios for periods up to about a year. There are a some weaknesses with
using the HPR, though. Just like when we looked at financial statement analysis, knowing the
number by itself does not provide enough context. For example, could we have earned a higher
return by making different choices? What should we compare it with? An obvious comparison
is the return objective, but we might also look at a benchmark which we could have invested in
as a passive portfolio. For a stock portfolio, a stock market index such as the TSX composite
might be appropriate. This benchmark will vary depending on the asset class and strategy
followed. If you are only buying large dividend paying shares, then your benchmark should only
include large dividend paying shares. The second weakness is that the return alone does not
account for risk. You could buy the exact same assets on margin, for example, and earn extra
return, but you are certainly taking on more risk. We look at three measures which account for
risk and benchmark return differently: Sharpe’s measure (often called the Sharpe ratio),
Treynor’s measure (or Treynor’s ratio) and Jensen’s measure (or Jensen’s alpha).
While it would be nice to always ‘buy low and sell high’, it isn’t possible to time things quite
that precisely. There is always uncertainty. Many individuals actually do the opposite—when
markets have been going up for quite a while they are worried about missing out, so they buy
more. After things have been going badly for a while, they tend to sell. So it is good to have a
plan to let us know when to buy and sell assets. There are several different plans you could
think of, but which you choose will depend on your own individual situation. Several different
formula plans are presented in this Unit.