Consider two methods of attribution analysis along with six different measures of risk-adjusted portfolio performance evaluation namely Sharpe ratio, Risk-adjusted Performance (or M2), Treynor ratio, Jensen alpha, information ratio and Sortino ratio

. a. Describe how you would go about conducting attribution analysis in practice using the two methods. Support your answer with appropriate example. (10 marks)

b. Describe how the six portfolio performance evaluation measures adjust a portfolio’s return performance on a risk-adjusted basis. Which measure do you think is the best in measuring portfolio performance? (15 marks)

ANSWER

a)

The first method of style analysis concentrates on the manager’s holdings. Are they large-cap or small-cap? Value or growth? Bill Sharpe introduced the second type of style analysis 1988. Returns-based style analysis (RBSA) charts a fund’s returns and seeks an index with comparable performance history. Sharpe refined this method with a technique that he called quadratic optimization, which allowed him to assign a blend of indices that correlated most closely to a manager’s returns.

Once an attribution analyst identifies that blend, they can formulate a customized benchmark of returns against which they can evaluate the manager’s performance. Such an analysis should shine a light on the excess returns, or alpha, that the manager enjoys over those benchmarks. The next step in attribution analysis attempts to explain that alpha. Is it due to the manager’s stock picks, selection of sectors,

b)

Treynor Measure

Jack L. Treynor was the first to provide investors with a composite measure of portfolio performance that also included risk. Treynor's objective was to find a performance measure that could apply to all investors regardless of their personal risk preferences. Treynor suggested that there were really two components of risk: the risk produced by fluctuations in the stock market and the risk arising from the fluctuations of individual securities

Sharpe Ratio

The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the standard deviation of the portfolio instead of considering only the systematic risk as represented by beta. Conceived by Bill Sharpe,this measure closely follows his work on the capital asset pricing model (CAPM) and, by extension, uses total risk to compare portfolios to the capital market line

Jensen Measure

Similar to the previous performance measures discussed, the Jensen measure is calculated using the CAPM. Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess return that a portfolio generates over its expected return. This measure of return is also known as alpha.

risk-adjusted return

The risk-adjusted return measures the profit your investment has made relative to the amount of risk the investment has represented throughout a given period of time. If two or more investments delivered the same return over a given time period, the one that has the lowest risk will have a better risk-adjusted return.

information ratio

The information ratio (IR) is a measurement of portfolio returns beyond the returns of a benchmark, usually an index, compared to the volatility of those returns. The benchmark used is typically an index that represents the market or a particular sector or industry.

Sortino ratio

The Sortino ratio measures the risk-adjusted return of an investment asset, portfolio, or strategy. It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally.

i think sortino ratio is the best measure as it is widely used