Chapter 4

“An Analytical Approach to

Investments, Finance and Credit”

RISK, RETURN, MARKET AND OTHER PORTFOLIO COMPARATIVE ANALYSIS

Sharpe Ratio, CAPM, Jensen’s

Alpha, Treynor Measure, and M-
Square
Portfolio Management Performance Measurement: An Overview
• There are many ways to measure the performance of a portfolio.
• The most common method is to compare the performance against last year or against last
few years, often called trend analysis.
• Investors will always ask how the portfolio returns are performing from year to year.
• However, displaying the trend analysis to an investor who is in the process of deciding
whether to come into the fund is not enough.
• The investor will demand a comparative analysis of portfolio performance against other
portfolios, or against other asset classes, or the market.
• These comparative measures include ratios such as the Sharpe ratio, CAPM, Jensen’s
Alpha, and Treynor measure—all these are ratios that give the investor comfort about how
the portfolio performed against the market or other assets.
Portfolio Efficiency to Optimization
From the point of efficiency, the portfolio FROM EFFICIENCY TO OPTIMIZATION
manager is seeking to achieve an even a
higher return delta (rate of change), but as Ws=100% STOCKS
discussed, it will also come with higher risk. (R=25%, σ=14%)

The optimization point is where the Return (R)

additional return, or the rate of change

σ = 7%
going from bonds to stocks, is lower than (Wb=55%.Ws=45%)

the rate of change of additional risk— R =16% OPTIMIZATION

basically, higher return delta at a lower risk ΔR =2% R = 14% EFFICIENT ΔR / Δσ = 2 /1 = 2.0x
delta. That achievement is called the FRONTIER
(Wb=60%.Ws=40%)

σ = 6%
optimum point and is the basis of the
Wb =100% BONDS
Sharpe ratio. Figure 4.3 shows a basic (R=6%, σ=8%)
illustration of the optimization process.
Δσ=1% RISK (σ)

Fig. 4.3
PORTFOLIO PERFORMANCE RATIOS
• Sharpe Ratio (Optimization Point)
The Sharpe ratio, in its basic form, is the relationship between return (numerator) and risk
(denominator). The numerator is adjusted to reflect the risk premium, done by taking the absolute rate
of return and subtracting the risk-free rate, which, by definition, has little to no risk for the given period.
The denominator representing the risk is measured by the volatility of the investment return or the
standard deviation of the asset class for the same time period. The Sharpe ratio formula is as follows:

where, 𝑅 is the absolute return of a given portfolio, 𝑅𝑓 is the risk-free rate, and 𝜎 is the standard
deviation of the portfolio.
PORTFOLIO PERFORMANCE RATIOS
EXAMPLE OF COMPARING TWO PORTFOLIOS AND THE MARKET:
Figure 4.4 below compares the measurements portfolio Z to portfolio X
and as compared to the stock market benchmark.
Portfolio Perfomance Ratio Analysis
Stock
Stock Stock Benchmark
Description Symbol Calculation Portfolio Z Portfolio X Market (m)
Average Return R 19.00% 20.00% 10.00%
INPUT

Risk Free Return Rf 2.00% 2.00% 2.00%

Standard Deviation σ 26.00% 36.00% 18.00%
Beta β 1.300x 1.500x 1.000x

Risk Premium Return RPR R - Rf 17.00% 18.00% 8.00%

Market Premium Pm Rm - Rf 8.00% 8.00% 8.00%
Capital Asset Pricing Model CAPM Rfr + β. Pm 12.40% 14.00% 10.00%
Sharpe Ratio SR RPR / σ 0.654 0.500 0.444
OUTPUT

Jensen's Alpha α R - CAPM 6.600% 6.000% 0.000%

Treynor Measure T RPR / β 13.077% 12.000% 8.000%
M-Square M2 ((σm/σp)*P)+Rf 13.769% 11.000% 10.000%

Figure 4.4
PORTFOLIO PERFORMANCE RATIOS
From Portfolio Efficiency to Optimization – Example:
FROM EFFICIENCY TO OPTIMIZATION
Assuming a 3.0% risk-free rate that has a 0%
standard deviation, the Sharpe ratio is calculated as Ws=100% STOCKS
follows: (R=25%, σ=14%)
Return (R)

σ = 7%
(Wb=55%.Ws=45%)

The calculation shows that every 1.86% increase in R =16% OPTIMIZATION

return comes with an equivalent 1% of risk. The ΔR =2% R = 14% EFFICIENT ΔR / Δσ = 2 /1 = 2.0x
optimization point is the point with the highest FRONTIER

possible Sharpe ratio. Using the same illustration

(Wb=60%.Ws=40%)

σ = 6%
(figure 4.3) to calculate the Sharpe ratio using the Wb =100% BONDS

efficient frontier risk and return points, the ratio (R=6%, σ=8%)

calculates as follows:
Δσ=1% RISK (σ)

= Fig. 4.3
PORTFOLIO PERFORMANCE RATIOS
Capital Asset Pricing Model (CAPM)
• The CAPM is a formula that was developed to calculate the expected return of any risky asset class
(𝐄𝐑 𝐢 ) as compared to the systematic market risk. This formula will be used extensively in later
chapters, not only for portfolio management applications, but also as a discount rate for determining
the present value of the equity invested in a firm. The formula is as follows:

where, 𝑅 is the risk-free rate, β is the beta, and 𝐸𝑅 is the expected market return.

• CAPM is used as the basis for the minimum expectation of an investor who is seeking to evaluate
a portfolio of stocks or a single stock adjusted to market fluctuations.
PORTFOLIO PERFORMANCE RATIOS
Capital Asset Pricing Model (CAPM)
The objective of CAPM is set as the basis for evaluating if the stock is fairly valued as compared to the
market.
• For example, let’s assume that the investor is looking to buy XYZ Inc.’s stock that has a beta (β) of
1.5x, which means that the volatility of such stock is 1.5x the volatility of the total equity market index.
If the market is anticipated to grow 10% this year, then the return of such investment should grow at
15% (1.5 x 10%). The CAPM formula adjusts for risk-free rate after establishing the market risk
premium return 𝐸𝑅 − 𝑅 or (10% -𝑅 ), so the expected risk premium return for such stock is 1.5x
the market premium. Assuming the risk-free rate is 2%, the expected investment return is calculated
at 14% as follows:
PORTFOLIO PERFORMANCE RATIOS
Jensen’s Alpha Ratio
Jensen’s alpha, developed by mutual fund manager Michael Jensen in the late 1960s, is a formula that
determines the average return over (positive alpha) or below (negative alpha) the expectation
calculated by the CAPM. As mentioned previously, CAPM represents the minimum expected return of a
portfolio or single stock adjusted to the market expectation. Jensen’s alpha, or simply alpha (α), if
positive, represents the excess return over CAPM. The formula is as follows:
PORTFOLIO PERFORMANCE RATIOS
Jensen’s Alpha Ratio
Using the 20% example, let’s assume portfolio Z had beta (βz) of 1.3 and portfolio X had beta (βx) of 1.5.
Let’s assume the overall market returned 10% and risk-free rate is 2.0% for that period. The following
formulas calculates the alphas for portfolio Z (αz) and portfolio X (αx)

The alpha for portfolio Z at 7.6% is higher than portfolio X of 6.0%, demonstrating that despite both
having beat the market showing positive alpha (α), portfolio Z had a better performance when adjusting
for risk which is determined by the lower beta (β). Let’s use another example where portfolio Z shows
19% return and portfolio X shows 20%
PORTFOLIO PERFORMANCE RATIOS
Treynor Ratio
The Treynor Ratio focuses on the relationship between the portfolio risk premium return and the
beta (β) of the portfolio. It is expressed in factors (positive or negative) or as a multiple of the
market premium risk. The formula is as follows:

The Treynor ratio, also known as the reward-to-volatility ratio, is designed to assess the portfolio’s
performance against the benchmark. Instead of measuring a portfolio return only against the risk-free
rate, the ratio examines how well a portfolio outperforms the market.
PORTFOLIO PERFORMANCE RATIOS
Treynor Ratio
Using the previous example, let’s assume the market benchmark had a 10% return which represents beta (β=1), portfolio Z
and portfolio X returned 19% and 20% respectively. Portfolios Z and X had betas (β) of 1.30 and 1.50, respectively. Also, let’s
assume the risk-free rate (treasury bills) is 2.0%. The Treynor value of each is calculated as follows:

. .
• Market 𝑇𝑚 = = = .080 = 8.000%

. .
• Portfolio Z 𝑇𝑧 = = = .1307 = 13.077%
.

. .
• Portfolio X 𝑇𝑥 = = = .120 = 12.000%
.

The higher the Treynor ratio (T), the more efficient the portfolio. Like the Sharpe Ratio discussed above, if the analyst was
only evaluating the portfolio on return performance alone, he or she may have recognized that portfolio X have returned
the best results. The Treynor ratio is adjusted to reflect the risk adjusted to the market
PORTFOLIO PERFORMANCE RATIOS
M Squared Ratio
M2 measures the difference between the excess return of the portfolio over the market. Unlike the Sharpe
ratio that is measured in units of return versus risk, M2 is expressed as a percentage return making it easier for
the investor to read when analyzing a portfolio. M2 is one of the newest modern portfolio measurement
methods only developed in 1997 by the Nobel prize winner Franco Modigliani and his granddaughter, Leah
Modigliani, hence the concept of M squared. The formula is as follows:

Where, 𝑆𝑅 is the Sharpe ratio of the risky portfolio, 𝜎 is the market benchmark standard deviation and 𝑅 is
the risk- free rate. The M2 ratio can be written also as follows:

or

Where is 𝑅𝑃𝑅 is the portfolio risk premium return, 𝜎 is the portfolio’s standard deviation, 𝜎 is the market
benchmark standard deviation and 𝑅 is the risk- free rate.
PORTFOLIO PERFORMANCE RATIOS
M Squared Ratio
Let’s use the same information used above to compare portfolio Z to portfolio X in order to measure
their M2s. Let’s assume portfolio Z had returns of 19% with standard deviation of 26% and portfolio X
had returns of 20% with standard deviation of 36%. The market benchmark had return of 10% with
standard deviation of 18%. The risk-free rate had a return of 2.0%. The M2s for these portfolios are
calculated as follows:
%
(19% - 2%) + 2% = 13.769%
%

%
(20% - 2%) + 2% = 11.000%
%

From the calculations above the analyst can conclude that despite the absolute return for portfolio X of
20% is higher than portfolio Z’s 19.0%, portfolio Z has a significant higher M2 of 13.769% versus 11.00%.
PORTFOLIO PERFORMANCE RATIOS
Other Useful Portfolio Analysis Ratios

Burke Ratio (based on Drawdowns instead of Standard Deviation)

The Burke ratio, also referred to as “a sharper Sharpe ratio”, is similar to the Sharpe Ratio in that it
also measures the risk-adjusted performance of the portfolio. It uses the same numerator of Rp – Rf,
but instead of using the portfolio’s standard deviation as the denominator, the Burke ratio uses the
concept of drawdowns.

Where, 𝑅𝑝 is the portfolio return, 𝑅 is the risk-free return and D is the drawdown.
PORTFOLIO PERFORMANCE RATIOS
Other Useful Portfolio Analysis Ratios

Omega Ratio (based on Min/Max Variance instead of Standard Deviation)

This ratio is similar to the Sharpe ratio in that it compares the return to volatility. The Omega ratio,
however, uses the higher points of distribution, arguing that these points could show a better
assessment of volatility. It is done to combat the tendency of a distribution to be asymmetric with
tail risk or negative skewness. The formula is a little complex but is written as follows:

Where, F(x) is the cumulative probability distribution function of the returns

PORTFOLIO PERFORMANCE RATIOS
Other Useful Portfolio Analysis Ratios
• Sortino Ratio (based on Loses instead of Standard Deviation)
The Sortino Ratio is a ratio that adjusts for trading losses. Using the standard deviation, the basis of calculating the
Sharpe ratio, the measure is penalized by both downside and upside volatility. Sometimes investors will like to show the
sudden uptick in their portfolio based on decisions they’ve made and using the Sharpe ratio might not make this as obvious
as one might desire. This is due to the fact that it is offset by the series of historical downsides and upsides equally. The
Sortino Ratio on the other hand only penalizes downside risk. The formula is as follows:

𝐸𝑅𝑝 − 𝑅𝑓
𝑆𝑜𝑅 =
𝜎
Where, 𝐸𝑅𝑝 is the expected return of the portfolio, 𝑅𝑓 is the risk-free rate and 𝜎 is the standard deviation of negative
asset returns (downside risk). The downside risk is calculated as follows:

∑ 𝑅 − 𝐸𝑅 𝑓 𝑡
𝜎 =
𝑛
Where 𝑅 are the historical returns of the portfolio, 𝐸𝑅 is Expected Return (threshold), 𝑛 is the number of years or
observations, 𝑓 𝑡 represents the arguments that are tested if the returns are higher or lower than the expected return
(𝐸𝑅 ) . For example, 𝑓 𝑡 = 1 when total returns are higher than the target return (𝐸𝑅 ) and 𝑓 𝑡 = 0 if the historical
returns are equal to zero or higher than the target return 𝑜𝑓 (𝐸𝑅 ).