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CHAPTER NINETEEN PERFORMANCE EVALUATION AND ACTIVE MANAGEMENT CHAPTER OVERVIEW This chapter discusses and calculates various return measures and risk-adjusted return measures that are used for evaluation of portfolio managers. The process of decomposing portfolio returns into the various components of the portfolio-building process is presented. This chapter also discusses the role of active portfolio management in a world of efficient markets. Two types of active management strategies are discussed: market timing and security selection. LEARNING OBJECTIVES After studying this chapter, the student should be able to: calculate various risk-adjusted return measures, and use these measures to evaluate investment performance; and decompose excess returns into components attributable to asset allocation choices. Students should be able to evaluate the market timing ability of managers and be able to understand the Treynor-Black model of efficient security analysis and be able to describe how the Treynor-Black model could be implemented. PRESENTATION OF CHAPTER MATERIAL 1. Overview of Performance Evaluation Obtaining an accurate estimate of risk-adjusted performance for a portfolio manager is very difficult. Most of the sound measures of risk-adjusted returns require stability for the portfolio. Most portfolios are actively managed and the stability assumptions are not met. Many industry measures of performance are based on comparisons to some benchmark portfolio. The comparison to the benchmark is only appropriate if the risk is similar. T 19-2 Introduction 2. Abnormal Performance and Risk Adjustments The concept of abnormal performance is critical to the process performance evaluation. It is more common to benchmark or market adjusted returns reported in industry. The measure of abnormal using these risk-adjusted techniques assumes the managed and the benchmark or market portfolio have the same level of risk. The market model or indexed model approaches are theoretically superior since they explicitly adjust for different levels of systematic risk. Factors that lead to superior performance include selection of undervalued stock and the ability to time general movements in the market T 19-3 Abnormal Performance T 19-4 Factors That Lead to Abnormal Performance The Sharpe Measure is also widely accepted in industry. The slope measure is based on the portfolio risk premium and the total risk of the portfolio as measured by standard deviation. 129
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T 19-5 Risk Adjusted Performance: Sharpe The Treynor measure also looks at a measure of reward to variability with the difference being the measure of risk. The measure of risk used in the Treynor measure is the beta coefficient of the portfolio. The Sharpe and the Treynor measures should result in similar rankings for most widely diversified
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