Chapter
17
Portfolio Monitoring and
Performance Evaluation
© CSI GLOBAL EDUCATION INC. (2012)
17•1
17
Portfolio Monitoring and
Performance Evaluation
CHAPTER OUTLINE
Portfolio Monitoring
Portfolio Performance Evaluation
• Performance Measurement
• Performance Appraisal
• Other Issues in Performance Evaluation
17•2
© CSI GLOBAL EDUCATION INC. (2012)
LEARNING OBJECTIVES
By the end of this chapter, you should be able to:
1. Describe the portfolio monitoring process.
2. Describe the steps in an effective monitoring system.
3. Define portfolio performance evaluation.
4. Calculate portfolio returns.
5. Discuss the use of pre-tax and post-tax returns and pre-fee and post-fee returns in
portfolio assessment.
6. Explain the proper use of benchmarks in assessing portfolio performance.
7. Explain and calculate any type of risk-adjusted return measure.
INTRODUCTION
Investment management does not end when an Advisor has selected securities for a client’s portfolio.
Advisors must monitor the markets and the client’s needs and goals, and should have a monitoring system in
place to ensure that they have the information they need when they need it. Performance measurement not
only helps Advisors and clients monitor progress toward the client’s goals, but also provides information on
the success of particular strategies.
The chapter begins with a brief discussion of the issues involved in portfolio and client monitoring. The
chapter then discusses performance evaluation. The performance of a portfolio must be measured against a
standard or benchmark. The choice of benchmark depends on the client’s strategic asset allocation, which
in turn is based on the client’s investment objectives and constraints.
© CSI GLOBAL EDUCATION INC. (2012)
17•3
17•4
WEALTH MANAGEMENT ESSENTIALS
PORTFOLIO MONITORING
Implementing a client’s portfolio is not the last step in the investment management process.
Advisors must continue to monitor the financial markets, client needs and goals, and the
client’s portfolio.
Monitoring a client’s portfolio does not imply that the Advisor selected inappropriate securities
or ignored client information. Portfolio monitoring acknowledges that the markets and clients
change and that both must be reviewed periodically to ensure that the portfolio remains
appropriate for the client’s situation.
How often should this information be reviewed? Changes in economic forecasts and the
recommendations of strategists and analysts affect clients’ portfolios in different ways. Clients
who like to trade actively may need frequent informal reviews, most of which take place during
telephone conversations.
Most clients, however, are concerned with the long-term view. Daily and weekly reviews are not
needed for these clients, and even monthly reviews are uncommon. Quarterly reviews are more
appropriate, or even annual reviews.
Advisors need an effective monitoring system to ensure that they have the information they
need when they need it. Computerized contact management software is often helpful. Advisors
should also ensure that their clients understand the importance of informing them of any changes
that affect their financial situation, such as job loss, marital breakdown, death in the family,
inheritance, a change in a company pension plan or a change in their willingness to bear risk. For
example, if a client experiences a disabling accident and can no longer work, the Advisor may
need to reconstruct his or her portfolio to provide more income.
Changes in lifestyle or attitude can also affect investment policy. A workaholic client who
planned to stay on the job until 65 may suddenly decide to retire earlier and enjoy life a little
rather than save money for the children to use. This change in philosophy will call for a review of
the investment policy, because the portfolio is now needed to fund a lifestyle geared to enjoyment
rather than to passing on an estate.
Changes in the economic environment, such as a rise or fall in market rates of return, may also
call for a review. Assets may have to be reallocated. The performance of individual investment
vehicles must also be reviewed from time to time to assess whether they are delivering, and will
continue to deliver, a suitable return.
The following is an example of an effective monitoring system for an Advisor:
1.
Ensure that information affecting the client’s financial situation is up to date.
2.
Ensure that all client contact information is up to date (home address, telephone numbers,
etc.).
3.
Determine how often meetings will take place to discuss the portfolio. This information
should be outlined in the clients’ IPS.
4.
Stay on top of forecasts for economic and financial markets. If forecasts change in a material
way, it may affect clients’ tactical or strategic asset allocations.
© CSI GLOBAL EDUCATION INC. (2012)
SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
5.
17•5
If clients have invested in managed products, review the performance of fund managers
regularly. Pay close attention to the manager’s performance over an economic cycle
(approximately three to five years) and a five-year and ten-year time period. If there is a
change in fund managers, it is also important to assess the impact of this change.
During quarterly or annual client reviews, Advisors should ask clients if their goals or personal
circumstances have changed in any way. Not all clients may be forthcoming and state that, for
example, they have recently been diagnosed with an illness. However, important changes that
affect the client’s goals are important to Advisors and should be disclosed by clients.
PORTFOLIO PERFORMANCE EVALUATION
From an investment management perspective, portfolio performance evaluation is an important
part of any client review meeting. For many Advisors this may simply mean telling clients what
their portfolios earned in the previous year or quarter and then comparing this return to their
long-term return objective. There may also be some discussion of how the markets performed and
the effect it had on the performance of a client’s portfolio.
There are two stages in portfolio performance evaluation:
1.
Performance measurement involves the calculation of the return realized by a
portfolio over a specific period of time, called the evaluation period. Because only four
fundamental types of transactions occur within portfolios – security purchases, security
sales, contributions and withdrawals – measuring return sounds as if it should be relatively
straightforward. As we will see though, several important points must be addressed in
developing a methodology for calculating a portfolio’s return.
2.
Performance appraisal is an assessment of how well a portfolio has done over the
evaluation period. Given the costs clients incur to have their portfolios managed, they need
to know if the cost justifies the service. Thus, performance measurement and appraisal
together yield a cost-benefit analysis of the Advisor’s recommendations.
Reporting on the performance of the portfolio requires more than simply providing a list of the
securities held, their cost base and ending market value. Performance reporting evaluates the
ability of the Advisor to achieve the risk and return preferences of the clients as stated in the
investment policy.
© CSI GLOBAL EDUCATION INC. (2012)
17•6
WEALTH MANAGEMENT ESSENTIALS
Performance Measurement
Most Advisors have access to in-house software that produces client portfolio reports. While the
format of these reports varies across firms, most provide the following information:
•
A list of the portfolio’s securities as of the report’s date, including the name and amount
of each security owned, separated into at least three asset classes (cash, debt securities and
equity securities).
•
The cost (or book) and market values of each security.
•
Each security’s weight (based on market values) within the portfolio.
•
Each security’s dividend or interest rate, the annualized income and current yield.
Measures of the portfolio’s return over specified historical periods may also be included in these
reports, or generated on a separate report.
These portfolio reporting systems allow Advisors to combine several accounts into a single report.
This is useful when a client or client group (for example, a husband and wife) has more than one
account (for example, registered and non-registered).
Figures 17.1 and 17.2 show sample reports from an investment dealer. Figure 17.1 is a detailed
list of the securities in the accounts of Paul and Phyllis Anderson as of January 31, 2012.
Figure 17.2 is a portfolio returns report for Joe Smith as of December 31, 2011. These are
samples only. Actual reports – and the details provided – vary with the firm. As well, most firms
have a glossary of terms available for their clients who want to know more about the terminology
used in their reports.
© CSI GLOBAL EDUCATION INC. (2012)
17•7
SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
FIGURE 17.1
SAMPLE PORTFOLIO REPORT #1
A detailed list of the securities in the accounts of Paul and Phyllis Anderson as of January 31, 2012
This portfolio combines holdings for the following clients:
15123456
Paul E. Anderson
15787878
Phyllis Anderson
CANADIAN ASSET MIX AS AT 31-JANUARY-2012
Cost
Market
% Of
Annualized
Value
Value
Portfolio
Income
7,450
7,450
Total Fixed-Income Securities
31,230
33,250
1,215
3.65
Total Common-Equity Securities
92,366
103,756
2,764
2.66
131,046
144,456
4,016.25
2.78
Total Cash and Cash Equivalents
Total Canadian Portfolio
37.25
100.00
Yield
0.50
CANADIAN PORTFOLIO HOLDINGS AS AT 31-JANUARY-2012
Holdings Security
Cost
Cost
Market
Market
Price
Value
Price
Value
% Of
Div($)/
Annualized Current
Portfolio Int (%)
Income
Yield
37.25
0.50
37.25
0.50
Cash and Cash Equivalents
2,450
CASH
Total Cash and Equivalent
7,450
7,450
5.16
7,450
7,450
5.16
0.50%
Fixed-income Securities
10,000
Ontario 4.40% 08Mar16
102.50
10,250
110
11,000
7.61
4.40%
440
1.86
10,000
Canada 3.50% 01Jun20
107.50
10,750
112
11,200
7.75
3.50%
350
1.93
10,000
Quebec 4.25% 01Dec21
102.30
10,230
110.50
11,050
7.65
4.25%
425
3.01
33,250
23.01
1,215
3.65
Total Fixed-Income
Securities
31,230
Common Equity
400
Barrick Gold Corp.
26.00
10,400
49.46
19,784
13.70
0.60
240
1.21
600
Loblaw Companies Limited
42.10
25,260
36.40
21,840
15.12
0.84
504
2.30
600
Suncor Energy Inc.
22.76
13,656
34.54
20,724
14.35
0.44
264
1.27
1300
Manulife Financial Corporation
13.50
17,550
11.71
15,223
10.54
0.52
676
4.44
500
Royal Bank of Canada
51.00
25,500
52.37
26,185
18.13
2.16
1,080
4.12
92,366
103,756
71.83
2,764
2.66
131,046
144,456
100.00
4,016.25
2.78
Total Common Equity
Total Canadian Portfolio
Information contained herein has been obtained from sources which we believe to be reliable but is not guaranteed.
Investment Advisor: Walter T. Allen
Date Printed: 20-February-2012
© CSI GLOBAL EDUCATION INC. (2012)
17•8
WEALTH MANAGEMENT ESSENTIALS
FIGURE 17.2
SAMPLE PORTFOLIO REPORT #2
A portfolio returns report for Joe Smith as of December 31, 2011
WEIGHTED RATES OF RETURN AS OF PERIOD ENDING 31-DEC-2011
Client:
66000001 Joe Smith
Combined Report For:
Calendar Years
I.A.:C12 Fred Allenby
Client
Current Market
Value $
% Of Overall
Market Value
66000001 Joe Smith
135,000
100.00
% Rates of Return
2008
3.51
2009
10.06
2010
5.64
2011
19.21
AVERAGE ANNUAL COMPOUND RATE OF RETURN (%) FOR PERIOD ENDING 31-DEC-2011
1 Year
19.21
2 Year
12.22
3 Year
11.50
4 Year
9.44
2011 CALENDAR YEAR RATES OF RETURN
Period
% Rates of Return
Year-to-Date
13.33
13.33
February 2011
0.21
13.57
March 2011
0.00
13.57
April 2011
0.00
13.57
May 2011
6.21
20.62
June 2011
0.00
20.62
July 2011
0.00
20.62
August 2011
0.62
21.37
September 2011
0.00
21.37
October 2011
0.00
21.37
November 2011
(1.78)
19.21
December 2011
0.00
19.21
13.57
13.57
Second Quarter 2011
6.21
20.62
Third Quarter 2011
0.62
21.37
Fourth Quarter 2011
(1.78)
19.21
January 2011
First Quarter 2011
Information contained herein has been obtained from sources which we believe to be reliable but is not guaranteed by
ABC Securities Inc.
© CSI GLOBAL EDUCATION INC. (2012)
17• 9
SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
It is important to distinguish between these portfolio reports and the official record of the client’s
holdings, which, for clients of IIROC dealer members, is communicated through statements
produced in accordance with IIROC Rule 200. These statements include not only a listing of the
cash and securities in the account as of the statement date, but also a list of transactions since the
previous statement date. According to the regulation, statements must be sent:
monthly for all customers who have affected [sic] a transaction, or the [IIROC] Member has
modified the balance of securities or cash in the customer’s account, unless the entries refer to
dividends or interest; quarterly for all customers having any debit or credit balance or securities
held (including securities held in safekeeping or in segregation) at the end of the quarter.
PORTFOLIO RETURNS
Most portfolio reporting systems can calculate portfolio returns for different timeframes,
including the past month, quarter and year. In the Financial Math Appendix at the end of this
text we show how portfolio returns can be calculated using the returns on the securities in the
portfolio. We note, however, that this method is inappropriate for actual client portfolios, because
it assumes that the securities are held for the entire return measurement period, and it does not
allow for contributions to or withdrawals from the portfolio. (Contributions and withdrawals in
the form of either cash or securities are frequently referred to as portfolio cash flows.) Computing
the return on a portfolio (with or without cash flows) when securities are bought and sold during
the return measurement period means considering the total dollar value of the portfolio rather than
the returns on individual securities in the portfolio.
If there are no cash flows, then the portfolio’s return is simply the percentage change in its market
value from the beginning of the evaluation period to the end of the evaluation period, as shown
in Equation 17.1.
RP
=
MVE - MVB MVE
=
-1
MVB
MVB
(17.1)
Where:
MVE = the market value of the portfolio at the end of the evaluation period
MVB = the market value of the portfolio at the beginning of the evaluation period
With Equation 17.1, there is no need to explicitly consider the return on any individual security,
including income paid by the security, because the market value at the end of the period
incorporates this information. For the purpose of calculating portfolio returns, individual security
returns don’t really matter anyway; what matters is how much the total value of the portfolio
has changed.
EXAMPLE 17.1
If a portfolio had a market value of $500,000 at the end of March and $525,000 at the end of June,
then its three-month, or quarterly, return was 5%.
RP
=
$525, 000
-1 = 0.05 = 5%
$500, 000
© CSI GLOBAL EDUCATION INC. (2012)
17•10
WEALTH MANAGEMENT ESSENTIALS
Equation 17.1 does not take into account portfolio cash flows, which can affect the portfolio’s
return. Therefore, Equation 17.1 is appropriate only when there are no cash flows during the
return measurement period.
When there are cash flows, a portion of the change in the value of the portfolio is the result of
the cash flows themselves. For instance, if a portfolio is worth $100,000 at the start of the year
and $150,000 at the end of the year, and the client added $15,000 in cash to the portfolio during
the year, then $15,000 of the $50,000 increase in the value of the portfolio comes from the
contribution, not return on investment.
The return on a portfolio is affected by both the amount and timing of portfolio cash flows.
There are several ways to deal with these issues, and different portfolio reporting systems use
different methods. Advisors should know which method their firm’s system uses.
One way to deal with cash flows is to assume that all contributions occur at the beginning of the
period and all withdrawals occur at the end of the period. With these assumptions, Equation 17.2
can be used to calculate the portfolio’s return.
RP
=
MVE - MVB - Contributions + Withdrawals
MVB + Contributions
(17.2)
Where:
MVB =
the value of the portfolio just before any contributions
MVE =
the value of the portfolio just after any withdrawals
The numerator of Equation 17.2 adjusts the change in the value of the portfolio by the amount
of any contributions or withdrawals. Since contributions increase a portfolio’s value and
withdrawals decrease its value, the numerator of Equation 17.2 isolates how much of the change
was due to a return on the portfolio’s investments by subtracting the value of the contributions
and adding the value of the withdrawals from the change in the value of the portfolio. The
numerator of Equation 17.2 is therefore a measure of the dollar return on the portfolio’s
investments net of any portfolio cash flows.
To convert the dollar return to a rate of return, the dollar return is divided by the market value
of the portfolio at the beginning of the period plus the value of the contributions, because the
contributions were used to earn part of the return on the portfolio’s investments.
EXAMPLE 17.2
Suppose a portfolio has a market value of $500,000 at the end of March and $535,000 at the end of
June. In early April, the owner of the portfolio contributed an additional $10,000 to the portfolio.
In this case, the dollar return is $25,000, but the return on the portfolio is only 4.90%, because the
dollar return was earned on a larger investment base.
RP
=
$535, 000 - $500, 000 - $10, 000 + $0
$500, 000 + $10, 000
=
$25, 000
$510, 000
=
0.0490
=
4.90%
© CSI GLOBAL EDUCATION INC. (2012)
17•11
SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
As mentioned, Equation 17.2 assumes that contributions are received at the beginning of the
period and withdrawals are made at the end of the period. Some portfolio reporting systems calculate
returns using this assumption.
If, however, contributions occur later in the period, or withdrawals occur earlier in the period,
this method understates the actual return. For example, if the investor in Example 17.2
contributed the $10,000 just before the end of the period, then 5% (rather than 4.90%) is a
better measure of the actual return on the portfolio, because the $25,000 dollar return was earned
on a smaller investment base ($500,000 rather than $510,000).
If a portfolio reporting system can calculate returns based on a more precise timing of cash flows,
then it will likely use one of two methods: the dollar-weighted (or money-weighted) return or the
time-weighted return.
DOLLAR-WEIGHTED RETURN
The dollar-weighted or money-weighted return measures the performance of the portfolio
as experienced by the investor. This performance is based not only on how well the portfolio’s
investments do, but also on the amount and timing of portfolio cash flows.
EXAMPLE 17.3
Suppose a client’s portfolio is worth $500,000 on March 31. In April, the portfolio appreciates 8%,
so that at the end of April the portfolio is worth $540,000. On April 30, the client deposits $10,000,
so that the portfolio is now worth $550,000. In May, the portfolio declines by 5%, so that on May 31
the portfolio is worth $522,500. On May 31, the client deposits an additional $22,500, so that the
portfolio is now worth $545,000. In June, the portfolio appreciates 10%, so that on June 30, the
portfolio is worth $599,500. The following table summarizes the portfolio values and cash flows:
Portfolio Value
Before Contribution
Contribution
Portfolio Value
After Contribution
March 31
–
–
$500,000
April 30
$540,000
$10,000
$550,000
May 31
$522,500
$22,500
$545,000
June 30
$599,500
–
–
Date
(We do not need the interim values of the portfolio to calculate the dollar-weighted return. They
are shown here because they will be used in a later comparison and in the next section on the timeweighted return calculation.)
The first step in finding the dollar-weighed return is to determine how long each of the contributions
were invested in the portfolio (or how long each of the withdrawals were out of the portfolio),
relative to the total length of time for which the rate of return is being measured. For instance, the
first contribution, $10,000 on April 30, was invested for two months out of three, which is 2/3 of
the return measurement period. The second contribution, $22,500 on May 31, was invested for one
month, or 1/3 of the period.
The dollar-weighted return is the value of DWR that solves the following equation:
[$500,000  (1 + DWR) 1] + [$10,000  (1 + DWR) 0.66] + [$22,500  (1 + DWR) 0.33 ] = $599,500
© CSI GLOBAL EDUCATION INC. (2012)
17•12
WEALTH MANAGEMENT ESSENTIALS
The dollar-weighted return is an internal rate of return that equates the ending value of the
portfolio to the beginning value of the portfolio and all portfolio cash flows. Alternatively, we can
set up the problem so that we are trying to find the return that equates the beginning value to
the ending value and all portfolio cash flows. In essence, it is a time value of money problem that
solves for the discount rate, which in this case is the portfolio return.
Internal rates of return are used extensively in several different investment applications. For
example, the yield to maturity on a bond is an internal rate of return that equates the price of the
bond to the bond’s coupon rate and maturity value. In almost all cases, however, it is not possible
to solve directly for an internal rate of return. Rather, a trial-and-error process is required. In
other words, guess the correct portfolio return and plug the value into the left-hand side of the
dollar-weighted return formula and see how the ending value comes out.
If the ending value for the portfolio in Example 17.3 based on your first guess is less than
$599,500, then you guessed too low and you should raise the portfolio return value. If the
ending value is greater than $599,500, then your guess was too high and it should be lowered.
Eventually, you will hone in on the correct portfolio return. An alternative to guessing is to use a
financial calculator or spreadsheet program (which uses the same process, but does it much faster)
for an answer of 13.05%.
The dollar-weighted return is strongly influenced by the client’s decision to contribute to or
withdraw money from the portfolio. We can show this with a simple example.
EXAMPLE 17.4
Suppose a portfolio is worth $500,000 on March 31, as in the previous example. In each month, the
portfolio is invested in the same securities with the same weighting as the portfolio in the previous
example, so that the monthly returns are 8%, –5% and 10%.This time, however, the investor
contributes $22,500 on April 30 and $10,000 on May 31, which is exactly opposite to the pattern
of contributions in the previous example. The following table summarizes the portfolio values and
cash flows:
Portfolio Value
Before Contribution
Contribution
Portfolio Value
After Contribution
March 31
–
–
$500,000
April 30
$540,000
$22,500
$562,500
May 31
$534,375
$10,000
$544,375
June 30
$598,813
–
–
Date
© CSI GLOBAL EDUCATION INC. (2012)
SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
17•13
EXAMPLE 17.4 – Cont’d
Even though the portfolio was invested in exactly the same manner as the portfolio in Example 17.3,
the ending value is almost $700 less. This is due entirely to the fact that the second investor made the
larger of the two contributions just before May, which was the only month with a negative return. The
smaller contribution was made just before June, which was the month with the best return. The timing
of these transactions led this investor to underperform the other investor by almost $700.
The dollar-weighted return of this portfolio is the DWR that satisfies the following equation:
[$500,000  (1 + DWR)1] + [$22,500  (1 + DWR) 0.66] + [$10,000  (1 + DWR) 0.33 ] = $598,813
A calculation using a financial calculator or spreadsheet reveals that the dollar-weighted return in this
case is 12.81 %.
Using your financial calculator (Sharp EL-738) enter and press the following
-500,000 DATA
-22,500 DATA
-10,000 DATA
598,813 DATA
Then Press 2nd F CASH, 2nd F CA
Press COMP (calculate IRR)
Answer: 4.10%
To find out the answer based on this one period result produced by the calculator, raise the result by
the power of 3, which represents the 3 month period:
=
(1 + r) n -1
=
(1 + 0.0410) 3 - 1
=
(1.0410) 3 - 1
=
1.1281 - 1
=
0.1281 or 12.81%
A final thing to note about the dollar-weighted return is that it assumes a level return – equal to
the dollar-weighted return – in each period.
TIME-WEIGHTED RETURN
Unlike the dollar-weighted return, the time-weighted return eliminates the effect of portfolio
cash flows and measures only the cumulative performance of the portfolio’s investments. If an
Advisor has recommended all the securities in a client’s portfolio, then the time-weighted return
measures the performance of the Advisor’s recommendations. Since the Advisor cannot control
when a client deposits or withdraws money, it is not appropriate to use the dollar-weighted return
to measure the performance of the Advisor’s recommendations.
© CSI GLOBAL EDUCATION INC. (2012)
17•14
WEALTH MANAGEMENT ESSENTIALS
Here’s how to calculate the time-weighted return:
1.
Using Equation 17.1, calculate the total return on the portfolio from the beginning of the
period up to the point at which the first cash flow occurs. The MVB is the value of the
portfolio at the beginning of the period, while the MVE is the market value of the portfolio
just before the cash flow is received.
2.
Using Equation 17.1 again, calculate the total return on the portfolio from just after the first
cash flow is received to just before the next cash flow. The MVB in this case is the value of
the portfolio just after the first cash flow is received, while the MVE is the value of the cash
flow just before the next cash flow.
3.
Repeat this process to the end of the return measurement period. At that point, use
Equation 17.1 to calculate the total return from just after the last cash flow to the end of the
return measurement period.
4.
Calculate the time-weighted return from the sub-period returns.
Once you have the sub-period returns, you can calculate the time-weighted return using
Equation 17.3.
TWR = [(1 + R1)  (1 + R 2)  ...  (1 + RN )]–1
(17.3)
Where:
RN
= the portfolio’s total return during sub-period n
N
= the number of sub-period returns
The time-weighted return is a geometric linking of the individual sub-period returns. As such,
the time-weighted return is the total return on the dollars that have been invested in the portfolio
for the entire period.
Compared to the dollar-weighted return, the time-weighted return is relatively easy to
calculate. To see why, we’ll calculate the time-weighted return of the two portfolios presented in
Examples 17.3 and 17.4. The first portfolio had the values and cash flows shown in Table 17.1.
TABLE 17.1
Portfolio Value
Before Contribution
Contribution
Portfolio Value
After Contribution
March 31
–
–
$500,000
April 30
$540,000
$10,000
$550,000
May 31
$522,500
$22,500
$545,000
June 30
$599,500
–
–
Date
© CSI GLOBAL EDUCATION INC. (2012)
17•15
SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
The sub-period returns are calculated as shown in Table 17.2.
TABLE 17.2
Sub-Period
Return
1 (April)
($540,000/$500,000) – 1 = 0.08
2 (May)
($522,500/$550,000) – 1 = –0.05
3 (June)
($599,500/$545,000) – 1 = 0.10
The second portfolio had the values and cash flows shown in Table 17.3.
TABLE 17.3
Portfolio Value
Before Contribution
Contribution
Portfolio Value
After Contribution
March 31
–
–
$500,000
April 30
$540,000
$22,500
$562,500
May 31
$534,375
$10,000
$544,375
June 30
$598,813
–
–
Date
The sub-period returns are calculated as shown in Table 17.4.
TABLE 17.4
Sub-Period
Return
1 (April)
($540,000/$500,000) – 1 = 0.08
2 (May)
($534,375/ 562,500) – 1 = –0.05
3 (June)
($598,813/$544,375) – 1 = 0.10
Because the sub-period returns for each portfolio were the same, the time-weighted return for
each portfolio is the same and is equal to:
(1.08  0.95  1.10) – 1 = 0.1286 = 12.86%
One problem with the time-weighted return calculation is that the reporting system needs the
value of the portfolio on each day a cash flow occurs. If a portfolio reporting system is not set up
to store this information, it will not be able to calculate the time-weighted return.
© CSI GLOBAL EDUCATION INC. (2012)
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WEALTH MANAGEMENT ESSENTIALS
Performance Appraisal
After obtaining the relevant return data for a client’s portfolio, the Advisor and client should
evaluate the returns. This evaluation usually involves comparing the returns to the return on an
appropriate benchmark portfolio. If adequate data is available, the Advisor may also evaluate the
portfolio’s performance using risk-adjusted return measures.
BENCHMARK COMPARISONS
The primary purpose of a benchmark portfolio is to set a realistic, attainable performance
standard. A portfolio’s strategic asset allocation can be used to construct a benchmark against
which the portfolio’s performance can be measured. The return on the benchmark portfolio for
most individual investors is based on the returns on well known market indexes.
EXAMPLE 17.5
Suppose a client has a strategic asset allocation of 5% cash, 40% Canadian debt securities, and 55%
Canadian equity securities. The client’s IPS requires the debt and equity allocations to be broadly
diversified, so the return on the DEX Universe Bond Index is used as the debt securities benchmark
and the return on the S&P/TSX Composite Index is used as the equity securities benchmark. The
return on the DEX 90-Day T-bill Index is used as the benchmark for the cash allocation.
Over a particular evaluation period, the client realized a return of 8.50%. Over the same period, the
return on the three indexes was as follows:
S&P/TSX Composite Total Return Index
9.5%
DEX Universe Bond Index
6.7%
DEX 91-Day T-bill Index
1.0%
Thus, the return on the benchmark portfolio was 7.96%.
Return on Benchmark = (0.05  1.0%) + (0.40 x 6.7%) + (0.55  9.5%)
= 0.05% + 2.68% + 5.23%
= 7.96%
Because the client’s portfolio had a return greater than the benchmark return, the portfolio
outperformed its benchmark.
An investor can easily replicate the performance of the benchmark portfolio by investing in
index mutual funds or exchange-traded funds. In this way, using an index as a proxy for an
asset class, an investor can determine what his or her asset allocation should have earned if it
had been passively managed. This return becomes the benchmark for the actual performance
of the portfolio. Setting up a benchmark allows the investor to measure the value added to – or
subtracted from – the portfolio based on the investment decisions.
Over the long term, a client should expect to realize the benchmark return from an asset class
simply by being invested in that asset class. If a client is unable to at least match the returns of
a passively managed benchmark, then the extra fees associated with active management have
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SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
17•17
been wasted, since the investor could have simply replicated the performance of the benchmark
using low-cost index funds or exchange-traded funds. At the end of the day, an Advisor’s
recommendations must add value for the client.
A good benchmark fairly evaluates the portfolio’s performance and provides the client with a
passive alternative to an actively managed portfolio. It has the following characteristics:
•
Investable. The client must be able to invest in the securities that make up the benchmark.
That is, the client can always choose to forgo active management and simply hold the same
securities as those that make up the benchmark portfolio.
•
Unambiguous composition. The securities that constitute the benchmark portfolio and
the weighting scheme must be clearly defined. If it is not clear how the benchmark is
constructed, it is impossible to replicate it.
•
Appropriate. The benchmark must have a similar risk level to that of the client’s portfolio
and must be consistent with the client’s investment style, if any.
•
Attainable. The Advisor must be able to invest in all benchmark securities on behalf of
the client.
•
Specified in advance. The benchmark must be operational before the start of an
evaluation period.
•
Objectively constructed. The benchmark must be designed using objective rules so it is not
tilted in favour of or against the Advisor.
•
Easily measurable. It must be possible to observe performance on a reasonably frequent basis
in order to calculate the benchmark return.
While the criteria listed above are not exhaustive, they are important. If a benchmark does not
possess these properties, it is not an effective appraisal tool.
Classes of Benchmark Portfolios
In practice, four classes of benchmarks have been used to measure investment managers’
performance:
1.
Composite market indexes
2.
Investment style benchmarks
3.
Normal portfolios
4.
Sharpe benchmarks.
Composite market indexes are the best-known type of benchmark portfolio. These published
market indexes are designed to measure the movements of specified markets, not benchmark
performance. As such, composite market indexes may not be suitable for evaluating managers.
For instance, some market indexes are available only in price-return form; that is, without
reinvested distributions. Because portfolio performance is reported with distributions reinvested,
non-total return indexes understate the total return and bias the outcome in favour of
the manager.
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WEALTH MANAGEMENT ESSENTIALS
Another incompatibility is lack of style matching. Using a broad market index as the benchmark
portfolio is appropriate only when the portfolio manager does not have an investment style or the
manager practices a mixture of styles that the index mirrors. The S&P/TSX Composite Index,
for example, could be considered for a manager who combines growth and value styles. Even if
the manager claims not to have a style, a style analysis should probably be done to confirm style
neutrality and therefore the suitability of the index.
Customized investment style benchmarks are developed to more closely reflect the behaviour of
the kind of securities in which the manager specializes. They are for portfolios that have highly
specific return and risk requirements that are not closely tracked by composite indexes. A type
of customized investment style benchmark is an index developed by various consulting firms to
measure particular investment concentrations such as small-capitalization or growth stocks. While
style indexes address some of the drawbacks of market composites, style indexes have their own
unique problems.
First, there is no definitive way to differentiate one particular style from another. For instance,
should value be defined in terms of dividend yield or the price/book ratio? If price/book is used,
what is the threshold value below which a stock can be considered a value stock? Is it small-cap
market value under $100 million, or some other quantity? Consequently, a style index may not
be as closely matched to the portfolio being evaluated as it first appears.
Another problem with using style indexes is the difficulty in classifying a money manager by a
particular investment style. A money manager who selects one-half of his or her portfolio from
the top 100 firms (in market capitalization) of the S&P/TSX Composite Index and the other half
from the bottom 100 stocks in the index could be equally classified as a value, large-cap or smallcap manager. This imprecision has led some involved in the investment management industry to
argue that normal portfolios or Sharpe benchmarks are more suitable.
A normal portfolio is a specialized benchmark that includes all the securities that a manager
normally selects from. In other words, the portfolio manager’s natural habitat is defined. From
that group of securities, a normal portfolio is constructed to serve as a benchmark. The securities
are weighted as the manager would weight them in a portfolio or the weights are picked such
that the risk of the benchmark is close to the risk of the portfolios the individual has managed in
the past.
Advocates claim that normal portfolios are more appropriate benchmarks than market or style
indexes because they control for multiple investment styles. Normal portfolios more precisely
define the security universe in which the manager invests. In effect, the manager is being
challenged to beat his own average.
But a client must recognize that there is a cost to developing and updating a normal portfolio.
Moreover, there is not yet any sound empirical evidence that normal portfolios are better or
worse in explaining performance than style indexes. Defining the set of securities to be included
in the benchmark is based on discussions between the client and the manager and on analysis of
historical portfolios overseen by the manager.
Given these securities, the next question is how they should be weighted in the normal portfolio.
The appropriate weighting scheme (market value-weighted, price-weighted or equal-weighted)
could be determined statistically from historical data to produce the risk level closest to the
manager’s historic risk level. Another methodology measures the sensitivity of the historical
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SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
17•19
portfolios to various factors defined by a factor model and determines the set of weights that
replicates these factor exposures for the normal portfolio. With either approach, the benchmark
portfolio may need frequent rebalancing to stay on track.
Because of the difficulty of classifying a portfolio manager into any one of the generic investment
styles, William Sharpe suggested that a benchmark could be constructed by combining a variety
of style indexes.1 A Sharpe benchmark is created statistically using multiple-regression analysis.
The average active return over a number of sub-periods can be tested for statistical significance,
and the constancy of a portfolio’s style can be examined by rolling estimates (that is, periodic reestimation of the benchmark).
In addition to performance evaluation, the Sharpe benchmark methodology is useful for style
analysis. Style analysis classifies a manager’s actual investment pattern. It enables an investor
to verify whether a prospective manager was actually consistently implementing the claimed
investment style in the market. Moreover, style analysis can assist investors in developing
performance evaluation benchmarks that more closely reflect a manager’s investment style.
Finally, an important role for style analysis is in helping investors monitor the manager’s
investment properties to reduce style drift.
Style drift occurs when managers stray from their intended style. It may be related to picking up
some extra return by moving into another style category, it may be because the manager does not
have a precise view of what securities fit the asserted style, or it may be caused by inattentiveness
and not removing the portfolio securities that have gravitated out of the style habitat.
Sharpe benchmarks, like other evaluation procedures, have some drawbacks. One is that statistical
models are notoriously unstable. When style measures vary over time, it is not always clear
whether it is a result of shifting styles or the changeability of underlying statistical relationships.
In addition, style indexes are often highly correlated with each other, making it statistically
difficult to separate their unique contributions.
Another problem is that analysis of past returns cannot capture the style of a manager who
changes investment strategy. Sometime has to pass before a change in the style coefficients can be
observed, meaning it takes a while before the analysis catches up to the manager and until it does,
the benchmark will not be appropriate.
General Problems with Benchmark Portfolios
A problem arises with index construction, especially with style indexes. For example, some stocks
defined as value stocks become growth stocks, or at least non-value stocks, as prices increase.
Unless the index is rebalanced regularly, there will be style drift and it will become increasingly
inappropriate for benchmarking value portfolios. Repeated rebalancing, however, moves the index
into the semi-passive category with trading requirements and transaction costs nearly on par with
active management.
A more serious issue is closet indexing. Managers know that penalties for underperforming are
more severe (they can be fired by the client) than rewards for outperforming, particularly with
asset value–based fee structures. This produces incentives to avoid the risks inherent in security
selection and market timing and instead mimic the benchmark. The benchmark’s industry,
economic sector or even individual security weights are duplicated fairly closely to avoid straying
too far from the benchmark.
1
William F. Sharpe, “Determining a Fund’s Effective Asset Mix,” Investment Management Review (December 1988):
59–69.
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WEALTH MANAGEMENT ESSENTIALS
A second way to manoeuvre performance is to assume benchmark risk by holding assets that are
not part of the benchmark universe. For instance, a large-cap equity manager may move part of
the portfolio into small companies if an opportunity for improving performance is seen there. If
the manager has properly anticipated extra return from outside the normal set of securities, the
benchmark is outperformed and the manager looks good. However, the added performance has
not come from security selection or market timing within the universe, but from perceiving that
the designated style will be out of favour.
Finally, benchmark portfolios have their own problems when measuring return. The first is the
handling of transaction costs. Every time the index is rebalanced, transaction costs are implied. If
the benchmark is to represent a legitimate alternative to the portfolio under evaluation, to keep
the comparison fair, reasonable transaction costs incorporating the initial investment and ongoing
rebalancing have to be deducted from returns. Without an adjustment for transaction costs, the
benchmark is biased against the manager.
Second, most money managers hold cash on a regular basis. In contrast, most benchmarks
exclude cash. The exclusion of cash from the benchmark overstates benchmark returns in strongly
rising markets, understates it in down-trending markets and interferes with trying to detect the
manager’s skill signal.
COMPARISON OR PERFORMANCE UNIVERSES
One way of achieving meaningful performance evaluation is to compare a portfolio’s return
with the performance of a large number of other portfolios with similar risk characteristics.
The collection of portfolios that form the basis for comparison is called a comparison or
performance universe.
Comparison universes are constructed by performance appraisal services. The appraisal firms
collect performance information from a large number of managed portfolios and customarily
display the information in the form of a chart, such as the one presented in Figure 17.3. In
each period, the portfolios are ranked by return and industry convention. A first percentile
performance ranking is best; a 100th percentile ranking is the worst. For example, the manager
with the tenth-best performance in a universe of 100 funds would be the 10th percentile
manager: the performance was better than 90% of all competing funds over the evaluation
period. The upper and lower lines forming the rectangle represent the fifth and 95th percentile
managers, respectively. The dotted lines are the 25th and 75th percentile rates of return, and the
solid line is the 50th percentile (median). A manager falling into the area above the top dotted
line has produced first quartile performance (in the top 25% of managers), and a portfolio
placing below the bottom dotted line has suffered bottom quartile performance.
This type of information shows how well all managers did (by position of the rectangle) and the
dot in each bar represents the performance of the manager being evaluated. The performance of
a market index, for instance the S&P/TSX Composite Index, is often pictured in the rectangles.
The information is ordinarily updated quarterly. Similar data on how the manager places with
respect to risk, commonly measured by variability of return, is also usually presented.
© CSI GLOBAL EDUCATION INC. (2012)
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SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
FIGURE 17.3
COMPARISON UNIVERSE
25%
Return (%)
20%
15%
10%
5%
0%
ABC Portfolio
-5%
1998-08
99-08
00-08
01-08
02-08
03-08
04-08
06-08
07-08
2008
Period
Problems Associated with Comparison Universes
The contents of many comparison universes are poorly defined, meaning that investors do
not know exactly what the portfolio is being compared against. For example, a balanced fund
universe may contain everything from equity funds with a modest bond component to bond
funds with small stock exposures, while a competitor’s universe may restrict itself to a minimum
25% stock or bond portion.
Broad performance universes also do a poor job of accounting for risk. If the universe is one
of equity portfolios, then managers who concentrate on particular subgroups such as smallcapitalization firms or low-beta stocks will have different risk characteristics than the universe.
Therefore, a portfolio’s performance may be assessed relative to other funds that undertake
different risks. In other words, the benchmark is not appropriate; risk-adjusted comparison is
impossible.
Universe providers are responding to concerns about mismatched risks and creating sub-universes
to represent more closely a manager’s style, such as small-capitalization and large-capitalization
equity sub-universes. However, as sub-universes move closer to precisely defined managerial
styles, they quickly shrink in size and thereby raise questions about the statistical reliability of
any comparison.
It is even more difficult to partition fixed-income universes. For example, fixed-income portfolio
managers’ duration choices range significantly, so grouping categories by default-risk, class or
duration would lead to unacceptably small sub-universes. In fact, because of the lack of widely
available manager sub-universe comparisons, many fixed-income portfolio managers rely on
various bond indexes as representative benchmarks for assessing style differences.
Furthermore, the returns used in performance universes are gross of management fees, making it
impossible to determine net value–added performance. Because of the range of fees charged, the
rankings could change considerably if a net-of-management-fee return comparison was possible.
To a lesser extent, the same applies to administrative costs, which also vary across funds.
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WEALTH MANAGEMENT ESSENTIALS
Survivorship bias is also a problem in some form. As defunct portfolios drop out, they have to
be excluded from rankings in subsequent quarters. Therefore, a performance universe is always
a universe of survivors. As unsuccessful funds are typically terminated or cease to exist, there is
an upward bias in the longer-run cumulative returns. This benchmark creep makes average and
moderately good managers look like ever-increasing underperformers as the historical period
involved in a comparison lengthens.
Universe construction and compilation is similar across appraisal services, but each has its own
methodology. The differences are substantial enough that a manager may rank in the top half
of managers in one universe and fall into the bottom half in a competing universe. Another
difference arises from the treatment of managers overseeing more than one portfolio. Some firms
will include multiple results from the same manager, while others use one composite number per
manager. In the former, the larger managers with a greater number of funds under management
have greater proportionate weighting in determining the median or quartile breaks.
Finally, universe comparison suffers from a structural defect. The median manager is not an
investable benchmark because no one knows beforehand who the median manager will be.
Moreover, the median manager changes from period to period. The median portfolio for the
quarter is probably different from the one for the year and different again from the five-year
evaluation. Universe comparison does not present a passive investment alternative to a manager.
RISK-ADJUSTED RETURNS
Risk-adjusted return measures compare the returns generated by a managed product to the level
of risk taken to earn those returns. Because they incorporate both risk and return, they can be
used to compare managed products with different investment mandates.
Alpha
Alpha represents the degree to which the fund’s manager has added value relative to the fund’s
benchmark index, given the portfolio’s systematic risk (as measured by its beta) relative to the
index. When comparing the alphas of two funds, the fund with the greater alpha has the better
risk-adjusted performance.
In Chapter 12, we noted that there are two ways to calculate the beta of a portfolio. The CAPMbeta measures the sensitivity of a portfolio’s returns to the return on the market portfolio minus
the risk-free rate (with a market index used to approximate the returns on the market portfolio),
while the market model beta measures the sensitivity of a portfolio’s returns to the return on a
market index. Both betas are generally calculated using regression analysis on historical returns.
Alphas are also calculated from the same regression analyses, and as a result there are two versions
of alpha: market model alpha and CAPM-alpha.
The market model alpha is the y-intercept of the linear regression line when the independent
variable is the return on the market index and the dependent variable is the return on the
managed product. Equation 17.4 can be used to calculate the market model alpha.
Market Model Alpha = RP - ( b ´ Ri )
Where:
R P = the average return on the managed product
b
= the product’s market model beta
Ri
= the average return on the market index
© CSI GLOBAL EDUCATION INC. (2012)
(17.4)
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SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
EXAMPLE 17.6
Over the past five years, the XYZ Canadian Small-Cap Fund had a market model beta of 1.4 and an
average return of 14%. During the same period, the average return on the fund’s benchmark was 11%.
The fund’s market model alpha is calculated as follows:
Market Model Alpha
= 14% – (1.4 x 11%)
= 14% – 15.4%
= –1.4%
The fund’s market model alpha is negative, therefore the fund manager underperformed the
benchmark for its level of systematic risk.
The CAPM-alpha, which is also known as Jensen’s alpha, is the y-intercept of the linear
regression line when the independent variable is the average return on the market portfolio minus
the risk-free rate, and the dependent variable is the return on the managed product minus the
risk-free rate. Equation 17.5 can be used to calculate the CAPM-alpha.
CAPM Alpha = RP - RRF - [ b ´ (RM - RRF )]
(17.5)
Where:
R RF
=
the average risk-free rate
RM
=
the average return on the market portfolio
The different ways of calculating alpha affect the value of alpha in the following ways:
•
When beta is greater than 1, the market model alpha will be less than the CAPM alpha.
•
When beta is less than 1, the market model alpha will be greater than the CAPM alpha.
•
When beta is equal to 1, the two alphas will be the same.
Advisors and investors must therefore be sure they know which method has been used if they
compare the alpha of one managed product to another.
Sharpe Ratio
The Sharpe ratio, which is sometimes called the Sharpe index or Sharpe measure, measures the
excess average return per unit of total risk for a given time period. Total risk is measured as the
standard deviation of returns.
The first step in calculating the Sharpe ratio is to convert the average total return to an average
total excess return by subtracting the average risk-free return from the fund’s average total return.
Since anyone can earn the risk-free return by simply investing in a risk-free Treasury bill, the
excess return measures how much additional return was generated by taking on more risk.
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WEALTH MANAGEMENT ESSENTIALS
The next step is to divide the excess return by the managed product’s standard deviation to get a
measure of excess return per unit of total risk. Equation 17.6 is used to calculate the Sharpe ratio.
=
RP - RPF
sP
SP
=
the Sharpe ratio of managed product P over the evaluation period
Rp
=
the average on managed product P over the evaluation period
SP
(17.6)
Where:
R RF =
the average risk-free return over the evaluation period
σP
the standard deviation of managed product P’s returns over the evaluation period
=
On its own, the Sharpe ratio of a product indicates whether the product’s average return was
greater than or less than the average risk-free return. A positive Sharpe ratio indicates that the
product’s average return was greater than the risk-free return, while a negative Sharpe ratio
indicates its average return was less than the risk-free return.
However, by comparing the Sharpe ratio of one product to the Sharpe ratio of the product’s
benchmark or to the Sharpe ratio of other products, you can determine whether that product has
outperformed or underperformed the benchmark or other product on a risk-adjusted basis.
•
If the Sharpe ratio of a managed product is greater than the Sharpe ratio of its benchmark or
another product, then the product has outperformed the benchmark or other product on a
risk-adjusted basis.
•
If the Sharpe ratio of a managed product is less than the Sharpe ratio of its benchmark or
another product, then the product has underperformed the benchmark or other product on
a risk-adjusted basis.
EXAMPLE 17.7
Consider the following three-year average returns and standard deviations for two Canadian equity
mutual funds and their benchmark:
DEF Canadian
Equity Fund
LMN Canadian
Equity Fund
Canadian Equity
Benchmark
Average fund return
6%
9%
8%
Standard deviation
5%
14%
10%
Average risk-free return
3%
3%
3%
The Sharpe ratios of the two funds and the benchmark are calculated as follows:
SDEF =
(6 - 3) / 5 = 0.60
SLMN =
9-3
= 0.43
14
=
8 -3
= 0.50
10
SB
© CSI GLOBAL EDUCATION INC. (2012)
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SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
EXAMPLE 17.7 – Cont’d
Both funds and the benchmark had a positive Sharpe ratio, which means that all three had an average
return greater than the average risk-free return. Comparing their Sharpe ratios, however, tells you
that the risk-adjusted return on the DEF Canadian Equity Fund was better than the risk-adjusted
return on either the LMN Canadian Equity Fund or the benchmark index. The Sharpe ratios also
tell you that the risk-adjusted return on the LMN fund was less than the risk-adjusted return on the
benchmark.
The Sharpe ratios of Canadian mutual funds are calculated by most mutual fund research firms,
including Morningstar and GlobeFund.
Treynor Ratio
The Treynor ratio, also called Treynor’s reward-to-volatility ratio, is a measure of the average
excess return per unit of risk. The average excess return is defined exactly as it is for Jensen’s alpha:
average portfolio return minus the average risk-free return, with the averages computed over the
evaluation period. Risk, like Jensen’s alpha, is measured by the portfolio’s beta. The Treynor ratio
for portfolio P, denoted TP, is calculated as shown in Equation 17.7.
TP
=
RP - RF
bP
(17.7)
The expression indicates the portfolio’s risk premium per unit of systematic risk over the
evaluation period. The higher the Treynor ratio, the better the portfolio manager did. In
other words, a higher Treynor ratio is preferred to a lower one, which provides for a ranking
across portfolios.
Suppose portfolio P outperforms portfolio Q, that is TP > TQ. We can conclude that the manager
of portfolio P outperformed the manager of portfolio Q over the evaluation period. Nonetheless,
both managers, or only the manager of P, or neither manager, may have outperformed the market
over the evaluation period.
EXAMPLE 17.8
A mutual fund analyst has analyzed the risk-adjusted seven-year performance of three large-cap equity
funds. The first measure the analyst calculated was the Treynor ratio. For his calculations, the analyst
gathered the following data.
Portfolio X
Portfolio Y
Portfolio Z
8.4%
7.5%
7%
Beta
1.2
1.4
0.90
Average risk-free return
5%
5%
5%
Average return
Treynor ratio
8.4% – 5%
7.5% – 5%
= 2.83
1.2
© CSI GLOBAL EDUCATION INC. (2012)
7% – 5%
= 1.79
1.4
= 2.22
0.90
17•26
WEALTH MANAGEMENT ESSENTIALS
EXAMPLE 17.8 – Cont’d
Based on the Treynor ratio, portfolio X, with the highest Treynor ratio, outperformed portfolio Z, which
in turn outperformed portfolio Y. It is interesting to note that even though portfolio Y achieved a higher
average return compared to portfolio Z, it also had a much higher beta, and therefore underperformed
portfolio Z on a risk-adjusted basis.
Both the Jensen and Treynor measures use beta (systematic) risk in adjusting a portfolio’s returns
for risk, and both give the same conclusions regarding the performance of a portfolio relative to
the market portfolio’s performance. When the manager outperforms the market with the Treynor
ratio (that is, TP is larger than TM), Jensen’s alpha will be positive and therefore indicate the same
result. In the same way, a negative JP implies TP is smaller than TM, showing that the manager
underperformed the market by either yardstick.
However, the Treynor and Jensen measures may differ in their rankings of different portfolios
because of the manner in which they incorporate risk. Jensen’s alpha measures deviations from
the capital asset pricing model only in the return dimension, whereas the Treynor procedure
essentially divides the return deviation by beta. Thus, portfolios that differ widely in risk may
conflict in their Jensen and Treynor rankings.
Although of the two methods the Jensen technique is more commonly applied, many people
argue that Treynor’s technique is superior because it shows whether one manager adds more
value per unit of market-related risk than does another manager. This is a particularly important
conclusion if we assume that the same result is obtained at any level of risk.
Other Issues in Performance Evaluation
An important question is whether the returns are presented before or after management fees.
Mutual fund returns are calculated net of fees (after fees have been deducted), but returns on
other managed portfolios are typically reported gross of fees (before fees have been deducted).
A return gross of fees reflects a manager’s raw performance but is not the return of importance
to investors.
Providing returns without subtracting the manager’s fees has two important implications. First,
a portfolio manager’s performance is not comparable to other managers’ returns. The amount of
value that a manager adds depends strictly on net returns exceeding the benchmark return. If the
benchmark is a group of competing managers, the group is impossible to rank unequivocally by
performance because some managers charge more than others for their services. The difference
between performance-based fee structures (a manager’s payment is directly related to how well
the portfolio performs) and asset value–based charges (the fee is calculated on portfolio size, not
performance) also contributes to return comparison incompatibility. Returns gross of fees for
performance-based fee structures generally overstate superior performance to a greater degree
than asset value–based fees because a larger fee would be paid to the performance-based manager
when the portfolio performs well. When portfolio performance is poor, the performance-based
portfolio manager will receive a lower fee. Therefore, in a scenario of poor performance, the
returns gross of fees will understate the performance-based manager’s return to a greater degree
than the asset value–based manager’s return.
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SEVENTEEN • PORTFOLIO MONITORING AND PERFORMANCE EVALUATION
17•27
The second important implication of performance gross of fees is that when the benchmark is a
passive portfolio, the return should be net of fees. When we say a manager has to add value, we
more precisely mean net added value. Investors want more risk-adjusted return than it costs to
produce; otherwise there is no reason to pay for active management.
The next chapter putting it all together allows itself to be self-explanatory in what it is going to
cover. By now the essentials of wealth management should be familiar to you, understanding the
topics of the past chapters and the application of the content should have prepared you to better
manage your clients needs. The next chapter will run you through the process of putting all that
you have learned together.
© CSI GLOBAL EDUCATION INC. (2012)