《Portfolio Performance Evaluation》.docxVIP

Chapter24: Portfolio Performance EvaluationChapter Openerp. 819PART??VIIHOW CAN WE evaluate the performance of a portfolio manager? It turns out that even average portfolio return is not as straight-forward to measure as it might seem. In addition, adjusting average returns for risk presents a host of other problems. We begin with the measurement of portfolio returns. From there we move on to conventional approaches to risk adjustment. We identify the problems with these approaches when applied in various real-life situations. We then turn to some practical procedures for performance evaluation in the field such as style analysis, the Morningstar Star Ratings, and in-house performance attribution.24.1 The Conventional Theory of Performance EvaluationAverage Rates of ReturnWe defined the holding-period return (HPR) in Section 5.1 of Chapter 5 and explained the differences between arithmetic and geometric averages. Suppose we evaluate the performance of a portfolio over a period of 5 years from 20 quarterly rates of return. The arithmetic average of this sample of returns would be the best estimate of the expected rate of return of the portfolio for the next quarter. In contrast, the geometric average is the constant quarterly return over the 20 quarters that would yield the same total or cumulative return. Therefore, the geometric average is defined by The right-hand side of this equation is the compounded final value of a $1 investment earning the 20 quarterly rates of return over the 5-year observation period. The left-hand side is the compounded value of a $1 investment earning rG?each quarter. We solve for 1 + rG as Each return has an equal weight in the geometric average. For this reason, the geometric average is referred to as a time-weighted average An average of the period-by-period holding-period returns of an investment..p. 820?To set the stage for discussing the more subtle issues that follow, let us start with a trivial example. Consider a stock paying a