Investment Performance Evaluation

Question 1

What are the 2 Sources of Performance?

Answer 1

Selectivity

• Ability to identify securities that will outperform the benchmark
• Allows the manager to create a better risk-return trade-off

Timing

• Ability to predict the movement of the entire market
• Allows the manager to strategically allocate fund between the risk-free and risky securities and change the risk (sensitivity to market)

Question 2

Why Measure Performance?

Answer 2

Identify skill of an investor/money manager from luck or common knowledge.

Question 3

What are some Performance Measures?

Answer 3

Adjust average return for risk

Alternative 1: Compare average return of portfolio with the average returns of comparable port-
folios
Alternative 2: Risk adjusted metrics

Question 4

What does Sharpe and Treynor Ratios measure?

Answer 4

These ratios measure excess return earned per unit of risk. A higher ratio is better.

Question 5

When do you measure the risk of ß and σ?

Answer 5

The risk measure ( or ) should be estimated in the same period as the average returns.

Question 6

When do you measure total risk? σ

Answer 6

Total risk (σ) is appropriate for the entire portfolio.

Question 7

When do you measure systematic risk?

Answer 7

Systematic risk is appropriate for a component of the portfolio.

Question 8

When do you use Sharpe ratio?

Answer 8

Use Sharpe Ratio to measure the performance of the overall investor portfolio

Question 9

When do you use Treynor Ratio?

Answer 9

Use Treynor Ratio to measure the performance of a component of the overall investor portfolio

Question 10

What does Jensen’s Alpha measure?

Answer 10

Measure of abnormal return relative the passive benchmark.

• very popular measure of performance
  since this single number can be used as a relative as well as absolute measure of performance unlike
  Sharpe and Treynor ratios, which require knowing Sharpe and Treynor ratios of the benchmark

Question 11

How can you overcome Jensen’s Alpha limitations?

Answer 11

The limitation of Jensen’s alpha is overcome by Information ratio, M2 and T2

Question 12

What is the Information Ratio?

Answer 12

Information ratio (IR) measures non-market (or non-factor) return relative to non-market (or non-
factor) risk:

Question 13

What is M2?

Answer 13

M2 is the abnormal return of the portfolio that is leveraged to make its standard deviation equal to
that of the market portfolio.

Question 14

What is T2

Answer 14

In the T2 measure, the portfolio is leveraged to make ßp = ßm = 1

Question 15

How to we Distinguish Skill from Luck

Answer 15

use hypothesis testing

Question 16

Describe Market Timing

Answer 16

With successful market timing, would be high during the periods of high market returns, and low
during the periods of low market returns.

The relationship between the portfolio return and market return would be curved (non-linear) rather
than linear

Question 17

How do you interpret M2

Answer 17

M Squared is the vertical distance between the line
for the portfolio and the line for the market at M in
the Average Return - σ of Returns space.

Question 18

How do you interpret T2

Answer 18

T Squared is the vertical distance between the line
for the portfolio and the line for the market at M
in the Average return - beta space while alpha is
the distance at the portfolio.