Evaluating the performance of a particular portfolio involves measuring both the realized return and the differential risk of the portfolio and recognize any constraint the portfolio manager may face. A 14% return by itself is meaningless figure unless it is viewed in comparison with benchmark figure or average return of that category over same time frame and similar level of risk taken.
Measure of return is always done in relation to risk taken.
In order to evaluate performance properly, we must determine whether returns are good enough for the amount of risk taken. We must always asses risk-adjusted returns.
An equity portfolio consisting of sensex stocks should be evaluated relative to BSE sensex. on the other hand equity portfolio of small cap stock should not be judged against sensex.
It is important to evaluate portfolio not only with performance but also how much risk is taken. William Sharpe, Jack Treynor and Micheal Jensen developed the measures of portfolio performance.
Reward-to-variability ration (RVAR). The measure uses benchmark based on the ex post capital market line. Sharpe used RVAR to:
- Measure the excess return per unit of total risk(as measured by standard deviation)
- Rank portfolios by RVAR ( the higher the RAVR, better the portfolio performance)
Rp = Return of the portfolio
Rf = Risk free return
SD = Standard Deviation or portfolio (total risk)
Trey nor Measure
Jack Treynor measures called reward-to volatility ratio (RVOL).
RVOL = Rp - Rf
It measure the portfolio performance with differential return measure(ALPHA).
It attempts to measure the constant return that the portfolio manager earned above or below the return of an unmanaged portfolio with the same market risk.
Jensen's index = Rp - [Rf + (Rm- Rf)*B]
Rp = return of portfolio
Rf = risk free return
Rm = Market return (Index return)
B= Beta of portfolio (Beta is the measure of market risk of the portfolio)