As an individual investor, you construct your equity portfolio based on various parameters. The various shares in your portfolio were selected after analysing industries, companies and assessing their intrinsic value, confirming with technical analysis, etc. Some of you construct portfolio based on the recommendations of the professional advisors whereas others construct using computer-intensive examining the pricing relationships between the stock, options, and futures markets which helps to identify undervalued stocks. Having constructed an equity portfolio, it is essential to assess the performance of the same. Let us discuss, how to assess portfolio performance as below.
Composite performance measures
During the early stages, investors evaluated portfolio performance almost entirely on the basis of the rate of return. They were aware of the concept of risk but did not know how to quantify or measure it, so they could not consider it explicitly. Post 1960s as they started to quantify and measure risk in terms of the variability of returns. Specifically, the investors’ grouped portfolios into similar risk classes based on a measure of risk (such as the variance of return) and then compared the rates of return for alternative portfolios directly within these risk classes.
Peer group comparison
For quite some time, this was the most common method of evaluating portfolio performance wherein the returns produced by a representative universe of investors over a specific period of time were collected and display them in a simple boxplot format. To aid the comparison, the universe is typically divided into percentiles, which indicate the relative ranking of a given investor. For instance, a portfolio that produced a one-year return of 12.4% would be in the 10th percentile if only nine other portfolios in a universe of 100 produced a higher return. Although these comparisons can get quite detailed, it is common for the boxplot graphic to include the maximum and minimum returns, as well as the returns falling at the 25th, 50th (i.e., the median), and 75th percentiles.
But, there are several potential problems with the peer group comparison method. First, the boxplots do not make any explicit adjustment for the risk level of the portfolios in the universe. Another point is that it is almost impossible to form a truly comparable peer group that is large enough to make the percentile rankings valid and meaningful. Finally, by focusing on nothing more than relative returns, such a comparison loses sight of whether the investor has accomplished his individual objectives and satisfied his investment constraints.
Treynor developed a first composite portfolio performance measure that included risk. His measure of performance would apply to all investors regardless of their risk preferences. Building on developments in capital market theory, he introduced a risk-free asset that could be combined with different portfolios to form a straight portfolio possibility line.
Accordingly, the average rate of return for a portfolio during a specified time period is deducted from the average rate of return on a risk-free investment during the same time period and same is divided by the portfolio’s relative volatility. So, all risk-averse investors would prefer to maximize this value. But, the limitation of this measure is that it implicitly assumes a completely diversified portfolio. This measure is also known as reward-to-volatility ratio.
Sharpe conceived of a composite measure to evaluate the performance of equity portfolio which is similar to the Treynor measure. However, it seeks to measure the total risk of the portfolio by including the standard deviation of returns rather than considering only the beta of the portfolio. Essentially, this measure indicates the risk premium return earned per unit of total risk.
Treynor versus Sharpe
The Sharpe portfolio performance measure uses the standard deviation of returns as the measure of total risk, whereas the Treynor performance measure uses beta of the portfolio. The Sharpe measure evaluates the portfolio performance on the basis of both rate of return and diversification.
For a completely diversified portfolio both the two measures give identical rankings. Alternatively, a poorly diversified portfolio could have a high ranking on the basis of the Treynor performance measure but a much lower ranking on the basis of the Sharpe performance measure. Any difference in rank would come directly from a difference in diversification. Therefore, these two performance measures provide complementary yet different information, and both measures should be used.
To conclude, the performance measures discussed above are only as good as their data inputs. You must be careful when computing the rates of return to take proper account of all inflows and outflows. More importantly, you should use judgement and be patient in the evaluation process. It is not possible to evaluate the performance of the portfolio on the basis of a quarter or even a year. Your evaluation should extend over several years and cover at least a full market cycle.
The writer is associate professor of finance & accounting, IIM, Shillong