Portfolio Performance Evaluation Flashcards
State the main differences between Passive and Active Management
Passive:
- believe that markets are self-Efficient and fairly-priced
- Aim: trying to match return to board diversifed indexs (benchmark)
- Use Tracking Error which emasures how closley a portfolio’s returns foolow the returns of teh benchmark, (a LOWER error means closer alignment)
Active
- believe that there are inefficiencies in the market and want to earn excess risk-adjusted return or “alpha”
- charge clients higher fees for this service
What is Alpha? What is the other word for it? What are some evaluations for it?
“Alpha” also known as “excess risk-adjusted returns”
- delivered higher (excess) returns given the level of risk
Reminder:
- Excess Return (Alpha): Portfolio return - Benchmark (rf rate)
- Risk-adjusted evaluations:
- Sharpe Ratio: measure return per unit of total risk (volatility)
- Alpha
-
Treynor Ratio: measures return per unit of systematic risk/beta
- more specifc than Sharpe
Are Markets always efficient (price reflects all available info into the price)? What does the evidence suggest?
(evidence to support active managemnt)
1) Some managers outperform the market in a certain time period
For Ex.
- In berkeley studies (1999-2003), active managers underperformed the market
- In Vanguard study (2008), active managers out performed the market
2) Evidence of anomalies (irregular patterns in market behaviour) such as small cap stocks, value stocks, and January effect (stocks tend to perform better) - these effects increase returns
3) Evidence of market bubbles
Happens when:
- People get overly excited over speculation & hype and believe prices will keep going up, so they buy more.
- This creates even higher prices, attracting more buyers, like a “snowball effect.”
- Eventually, the bubble bursts because prices can’t stay inflated forever. When people realize the prices are too high and start selling, prices crash rapidly.
What is the difference between Arithmetic vs Geometric Mean?
Both are used to calulate average return
Arithmetic Mean (AM)
best for predicting/estimating the next period’s return
Geometric Mean (GM)
the constant period return that would yield the same cumulative return over a longer time frame.
- Usually preferable for measuring past performance
After calculating the Average returns, returns must be adjusted for “?” before they can be compared.
The simplest and most popular way to adjust returns for risk is to compare the portfolio’s return with the returns on a “?”.
define the second “?”
“Risk”
The Comparison Universe is a benchmark composed of a group of funds or portfolios with similar “style” and risk characteristics, such as growth stock funds or high-yield bond funds.
What are the risk-adjustment measures? What is the problem with Sharpe Ratio?
Sharpe ratio: Measures return per unit of total risk (volatility)
Major problem: It assumes returns follow a normal distribution, ignoring skewness or fat tails that could understate risks.
- better to use Sortino Ratio: it focuses only on downside volatility
Treynor’s measure: Measures return per unit of systematic risk (beta)
Jensen’s alpha: Measure how well a portfolio or investment performed compared to its expected performance, given its risk level (CAPM-based).
Information ratio: Assesses return above a benchmark (active return) relative to the tracking error, indicating consistency of outperformance.
- A higher IR indicating better risk-adjusted performance.
Morningstar risk-adjusted return: assigns 1 to 5 stars to a fund depending on the fund’s risk-adjusted return within a given peer group
- one star for the lowest ranking funds
- five stars for the highest (top 10% of funds in its category)
MRAR is a measure of a fund’s annualized excess return (relative to the return on T-bills) adjusted for the fund’s volatility
In what situations do the measures perform well in? (out of the four risk adjusted return measures)
Sharpe ratio – when the portfolio represents the entire investment fund.
Information ratio – when the portfolio represents the active portfolio to be mixed with the passive (index) portfolio (active adds incremnetal value to passive port.)
Treynor or Jensen – when the portfolio represents one portfolio of many (trying to reduce risk)
Morningstar – when comparing funds in the same category or sector.
If P or Q represents the entire investment, Q is better because of its higher ”?” (more excess return per unit of total risk)
If P and Q are competing for a role as one of a number of sub-portfolios, Q also dominates because its ”?” measure is higher.
If we seek an active portfolio to mix with an index, portfolio P is better due to its higher ”?”. For example, a passive pension fund who is adding a hedge fund to its portfolio.
Sharpe measure, Treynor, Information Ratio
What are the two factors that lead to an abnormal performance “alpha”
-
Market timing: Adjust the portfolio for movements in the market, shift between stocks, bonds, etc.
- Asset Allocation (stocks, bonds, cash, AI) -
Superior selection: Concentrate funds in undervalued stocks or undervalued sectors or industries
- Sectors or industries
- Individual companies
How to breakdown Alpha: explain the style anlysis and Performance Attribution
Style Analysis:
- Focuses on identifying the investment styleof a portfolio, such as:
- Large cap vs. small cap
- Value vs. growth
- It uses regression analysis to compare portfolio returns to a benchmark and determine the style.
- Pros: Easy to calculate and explain.
- Cons: Requires a benchmark, and it’s not widely accepted in the industry.
Performance Attribution Analysis:
- Focuses on understanding why a portfolio performed the way it did by attributing performance to:
- Asset Allocation (market timing or top-down decisions).
- Stock Selection (picking individual securities, bottom-up approach).
- Pros: Easy to explain and widely accepted in the industry.
- Cons: More complex to calculate.
Complications for all Performance Measurements
Major Problems:
1. Finding the right Observation Period
- Too short an observation period may include a luck component
- Too long an observation period may include shifting strategies
- Finding the right Benchmark
- finding the exact match for a benchmark is very difficult
- as you want to find one that has similar style and risk characteristics
