Essentials of Investments: Chapter 18 - Active Management and Performance Measurement to introduce the most widespread approaches to risk adjustment for performance evaluation. It includes Introduction, The Conventional Theory of Performance Evaluation, Market Timing.
Bodie Kane Marcus Perrakis Ryan Chapter 20 INVESTMENTS, Fourth Canadian Edition Active Management and Performance Measurement Slide 20-1 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Chapter Summary Objective: To introduce the most widespread approaches to risk adjustment for performance evaluation Slide 20-2 Introduction The Conventional Theory of Performance Evaluation Market Timing Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition The Objective of Active Management Are markets totally efficient? Some managers outperform the market for extended periods While the abnormal performance may not be too large, it is too large to be attributed solely to noise Evidence of anomalies such as the turn of the year exist The evidence suggests that there is some role for active management Slide 20-3 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Introduction to Performance Appraisal Complicated subject Theoretically correct measures are difficult to construct Different statistics or measures are appropriate for different types of investment decisions or portfolios Many industry and academic measures are different The nature of active management leads to measurement problems Slide 20-4 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Abnormal Performance What is abnormal? Abnormal performance is measured: Benchmark portfolio Market adjusted Market model / index model adjusted Reward to risk measures such as the Sharpe Measure: E (rp-rf) / sp Slide 20-5 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Factors That Lead to Abnormal Performance Market timing Superior selection Slide 20-6 Sectors or industries Individual companies Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Summary Reminder Objective: To introduce the most widespread approaches to risk adjustment for performance evaluation Slide 20-7 Introduction The Conventional Theory of Performance Evaluation Market Timing Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Risk Adjusted Performance: Sharpe 1) Sharpe Index rp r f sp rp = Average return on the portfolio rf = Average risk free rate sp = Standard deviation of portfolio return Slide 20-8 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Risk Adjusted Performance: Treynor 2) Treynor Measure rp r f bp rp = Average return on the portfolio rf = Average risk free rate bp = Weighted average b for portfolio Slide 20-9 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Risk Adjusted Performance: Jensen 3) Jensen’s Measure p rp r f bp r m r f p = alpha for the portfolio rp = Average return on the portfolio rf bp rm = Average risk free rate = Weighted average b for portfolio = Average return on market index portfolio Slide 20-10 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition M2 Measure Developed by Modigliani and Modigliani Equates the volatility of the managed portfolio with the market by creating a hypothetical portfolio made up of T-bills and the managed portfolio If the risk is lower than the market, leverage is used and the hypothetical portfolio is compared to the market Slide 20-12 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition M2 Measure: Example Managed Portfolio: return = 35% st dev = 42% Market Portfolio: return = 28% st dev = 30% T-bill return = 6% Hypothetical Portfolio: 30/42 = 714 in P (1-.714) or 286 in T-bills (.714) (.35) + (.286) (.06) = 26.7% Since this return is less than the market, the managed portfolio underperformed Slide 20-13 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Which Measure is Appropriate? It depends on investment assumptions 1) If the portfolio represents the entire investment for an individual, Sharpe Index compared to the Sharpe Index for the market 2) If many alternatives are possible, use the Jensen or the Treynor measure The Treynor measure is more complete because it adjusts for risk Slide 20-14 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Limitations Assumptions underlying measures limit their usefulness When the portfolio is being actively managed, basic stability requirements are not met Practitioners often use benchmark portfolio comparisons to measure performance Slide 20-15 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Alternative Performance Measures Mean-variance measures of performance are increasingly challenged The normality or log-normality of returns is also questioned Wilfred Vos proposed a new measure that also captures skewness: VVR (Vos Value Ratio) Slide 20-16 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Summary Reminder Objective: To introduce the most widespread approaches to risk adjustment for performance evaluation Slide 20-17 Introduction The Conventional Theory of Performance Evaluation Market Timing Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Market Timing Adjust the portfolio for movements in the market Shift between stocks and money market instruments or bonds Results: higher returns, lower risk (downside is eliminated) With perfect ability to forecast behaves like an option Slide 20-18 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Rate of Return of a Perfect Market Timer rf rf Slide 20-19 rM Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Returns from 1987 1996 Slide 20-20 Year 1990 1991 1992 1993 1994 Lg Stocks -3.20 30.66 7.71 9.87 1.29 T-Bills 7.86 5.65 3.54 2.97 3.91 1995 1996 1998 37.71 23.07 28.58 5.58 5.58 5.11 1999 21.04 4.80 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition With Perfect Forecasting Ability Switch to T-Bills in 90 and 94 Mean = 18.94%, Standard Deviation = 12.04% Invested in large stocks for the entire period: Mean = 17.41% Standard Deviation = 14.11% The results are clearly related to the period Slide 20-21 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition With Imperfect Ability to Forecast Long horizon to judge the ability Judge proportions of correct calls Bull markets and bear market calls Slide 20-22 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Identifying Market Timing Adjusting portfolio for up and down movements in the market Low Market Return - low ßeta High Market Return - high ßeta Slide 20-23 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Example of Market Timing rp - rf * * * * * * * * * ** * * * * * ** * * * * * rm - rf Steadily Increasing the Beta Slide 20-24 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Superior Selection Ability Concentrate funds in undervalued stocks or undervalued sectors or industries Balance funds in an active portfolio and in a passive portfolio Active selection will mean some unsystematic risk Slide 20-25 Copyright © McGraw-Hill Ryerson Limited, 2003 Bodie Kane Marcus Perrakis Ryan INVESTMENTS, Fourth Canadian Edition Complications to Measuring Performance Two major problems Need many observations even when portfolio mean and variance are constant Active management leads to shifts in parameters making measurement more difficult To measure well Slide 20-26 You need a lot of short intervals For each period you need to specify the makeup of the portfolio Copyright © McGraw-Hill Ryerson Limited, 2003 ... types of investment decisions or portfolios Many industry and academic measures are different The nature of active management leads to measurement problems Slide 2 0-4 Copyright © McGraw-Hill... Fourth Canadian Edition Alternative Performance Measures Mean-variance measures of performance are increasingly challenged The normality or log-normality of returns is also questioned Wilfred... Edition Chapter Summary Objective: To introduce the most widespread approaches to risk adjustment for performance evaluation Slide 2 0-2 Introduction The Conventional Theory of Performance