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What isn’t Measured – Isn’t Improved

By Jeffrey S. Coons; PhD, CFA

By Christopher J. Cummings; CFA, CFP™ 

Market performance measurement, like physician quality improvement reports, is an important feedback loop to monitor progress towards the goals of the medical professional’s investment program. 

Performance comparisons to market indices and/or peer groups are a useful part of this feedback loop, as long as they are considered in the context of the market environment and with the limitations of market index and manager database construction. 

Introduction

Inherent to performance comparisons is the reality that portfolios taking greater risk will tend to out-perform less risky investments during bullish phases of a market cycle, but are also more likely to under-perform during the bearish phase.  The reason for focusing on performance comparisons over a full market cycle is that the phases biasing results in favor of higher risk approaches can be balanced with less favorable environments for aggressive approaches to lessen/eliminate those biases. 

Can we eliminate the biases of the market environment by adjusting performance for the risk assumed by the portfolio?  While several interesting calculations have been developed to measure risk-adjusted performance, the unfortunate answer is that the biases of the market environment still tend to have an impact even after adjusting returns for various measures of risk. 

However, medical professionals and their advisors will have many different risk-adjusted return statistics presented to them, so understanding the Sharpe ratio, Treynor ratio, Jensen’s measure or alpha, Morningstar star ratings, etc. and their limitations should help to improve the decisions made from the performance measurement feedback loop. 

[a] The Treynor Ratio

The Treynor ratio, named after MPT researcher Jack Treynor, identifies returns above or below the securities market line. It measures the excess return achieved over the risk free return per unit of systematic risk as identified by beta to the market portfolio.  In practice, the Treynor ratio is often calculated using the T-Bill return for the risk-free return and the S&P 500 for the market portfolio. 

[b] The Sharpe Ratio

The Sharpe ratio, named after CAPM pioneer William F. Sharpe, was originally formulated by substituting the standard deviation of portfolio returns (i.e., systematic plus unsystematic risk) in the place of beta of the Treynor ratio.  A fully diversified portfolio with no unsystematic risk will have a Sharpe ratio equal to its Treynor ratio, while a less diversified portfolio may have significantly different Sharpe and Treynor ratios. 

[c] Jensen Alpha Measure

The Jensen measure, named after CAPM research Michael C. Jensen, takes advantage of the Capital Asset Pricing Model to identify a statistically significant excess return or alpha of a diverse portfolio.   

However, if a portfolio has been able to consistently add value above the excess return expected as a result of its beta, then the alpha (a_p) should be positive and (hopefully) statistically significant.

Thus, alpha from a regression of the portfolio’s returns versus the market portfolio (i.e., typically the S&P 500 in practice) is a measure of risk-adjusted performance.  

Now, how do you measure the success or failure of your portfolio?

       

Filed under: Investing, Portfolio Management | Tagged: Christopher J. Cummings, Investing Basics, Jeffrey S. Coons, risk adjusted investing | Leave a comment »