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30 - Why Performance Evaluation l Manager compensation l...

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Prof Irvine FINA 4310 Why Performance Evaluation? l Manager compensation: £ portfolio management requires effort ¢ effort as such is unobservable ¢ compensation contracts link pay and performance l Manager selection: £ portfolio management requires skill ¢ skill as such is also unobservable ¢ skill determines performance
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Prof Irvine FINA 4310 Lecture 30 Performance Measurement
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Prof Irvine FINA 4310 Simple Performance Measure l Simplest performance measure is the holding period return l Problems: £ cash comes in at many times £ relative performance counts! 0 0 1 1 P P D P r - + = Investme nt outlay Gross return
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Prof Irvine FINA 4310 Simple Performance Measure – With Leverage l Simplest performance measure with leverage l Or: 1 1 0 0 0 0 P D P V r P I + - = × Investmen t outlay Total Value of initial investment With leverage 1 1 0 0 Value ValueDiv Value r Investment + - =
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Prof Irvine FINA 4310 Relative Performance Measures l Simple returns aren’t very informative £ expected returns are (usually) positive £ high risk, high return £ portfolio returns depend on market returns ¢ are you impressed by a portfolio manager making 10% when the market is up 15% l We want to know performance relative to a reasonable benchmark (bogey)
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Prof Irvine FINA 4310 A Menu of Measures l Different performance measures have been proposed: £ Benchmark returns £ M2 measure £ Jensen’s alpha £ Sharpe measure £ Treynor measure £ Appraisal ratio £ Peer Rank l Which measure should we pick?
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Prof Irvine FINA 4310 Benchmark Returns l Returns relative to some meaningful benchmark (bogey) l Examples: £ general equity portfolio: S&P 500 £ growth stocks: Nasdaq 100 B P r r r - = Portfoli o return Benchmark return
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Prof Irvine FINA 4310 Risk Adjusted Performance: Sharpe 1) Sharpe Index rp - rf rp = Average return on the portfolio rf = Average risk free rate p = Standard deviation of portfolio return p σ σ
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Prof Irvine FINA 4310 Risk Adjusted Performance: Treynor 2) Treynor Measure rp - rf ßp rp = Average return on the portfolio rf = Average risk free rate ßp = Weighted average β for portfolio - Only systematic risk counts
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Prof Irvine FINA 4310 = rp - [ rf + ßp ( rm - rf) ] 3) Jensen’s Measure p p
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