Question

Analyze and critically discuss at least three quantitative measures to evaluate portfolio manager’s performance Provide examples to support your points.

Answer 1

The overall performance of portfolio manager can be determined by how well your portfolio is performing. However, total return cannot exclusively be used as the correct benchmark rather it should be risk adjusted return on the portfolio.

For example, a 2% annual total portfolio return may initially seem small. However, if the market only increased by 1% during the same time, then the portfolio performed well compared to the other available securities. Based on the need to accurately measure performance, various ratios are used to determine the risk-adjusted return of an investment portfolio.

Sharpe Ratio

This ratio is also known as the reward-to-variability ratio, & is perhaps the most common portfolio management metric. It measures excess return of the portfolio over the risk-free rate is standardized by the standard deviation of the excess of the portfolio return. Within the risk-reward framework of portfolio theory, higher risk investment should produce high returns. As a result, a high Sharpe ratio indicates superior risk adjusted performance.

Treynor Ratio

The Treynor ratio also calculates the additional portfolio return over the risk-free rate. However, beta is used as the risk measure to standardize performance instead of standard deviation. Thus, the Treynor ratio produces a result that reflects the amount of excess returns attained by a portfolio per unit of systematic risk. Because the Treynor ratio measures portfolio returns on market risk, rather than portfolio specific risk, this ratio is generally looked at in conjunction with other ratios to give a more complete measure of performance.

Information Ratio

The information ratio is slightly more complicated than any other ratios listed above, yet it provides a greater understanding of the portfolio manager's stock-picking abilities. In contrast to passive investment management, active management requires regular trading to outperform the benchmark.

As opposed to the Sharpe, Sortino ratios, this ratio uses the risk or standard deviation of active returns as a measure of risk instead of the standard deviation of the portfolio. As the portfolio manager attempts to outperform the benchmark, manager will sometimes exceed that performance and at other times fall short. The portfolio deviation from the benchmark is the risk metric used to standardize the active return.

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