Chapter 22

EVALUATION OF INVESTMENT PERFORMANCE

Multiple Choice
Performance Measurement Issues
1.

The major question when evaluating the performance of a portfolio is:

a.

Does the portfolio match the investor characteristics of the individual

investor?
Does the expected return of the portfolio meet the needs of the individual
investor?
Is the return on the portfolio adequate to compensate for the risk taken?
Is the risk on the portfolio in line with the personal characteristics of the
investor?

b.
c.
d.

(c, difficult)
2.

The --------------------- is the legitimate alternative to a portfolio that

accurately reflects the objectives of the portfolio owners.

a.
b.
c.
d.

market average index

efficient portfolio
benchmark portfolio
performance standard

(c, moderate)
3.

Which of the following statements regarding the dollar-weighted rate of

return is not true?

a.
b.
c.
d.

It is equivalent to the internal rate of return.

It is a measure of the rate of return to the portfolio owner.
It equates all cash flows with the beginning market value of the portfolio.
It is considered useful when making comparisons to other portfolios or to
market indexes.

(d, difficult)

Chapter Twenty-Two
Evaluation of Investment Performance

27

4.

The __________ indicates the percentage of the variance in the portfolio's

returns that is explained by the market's returns.

a.
b.
c.
d.

standard deviation
coefficient of determination
beta
alpha

(b, moderate)
5.

If we are to assess performance carefully, we must do so on a(n) ___ basis.

a.
b.
c.
d.

quarterly
annual
risk-adjusted
independent

(c, moderate)
6.

The degree of diversification of a portfolio is measured by

a.

calculating the correlation coefficient between a stock's returns with those

of the market.
calculating the coefficient of determination.
computing the beta of a portfolio.
dividing the average return of a portfolio by its beta.

b.
c.
d.

(b, difficult)
Risk-Adjusted Measures of Performance
7.

The reward-to-variability ratio measures:

a.
b.
c.
d.

return above the risk-free rate.

excess return per unit of total risk.
total risk per unit of excess return.
return above the risk-free rate relative to the risk-free rate.

(b, easy)

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Evaluation of Investment Performance

28

8.

Which one of the following statements is true?

Notation: RVAR: Sharpes reward-to-variability measure
RVOL: Treynors reward-to-volatility measure

a.
b.
c.

RVOL is based on total risk while RVAR is based on systematic risk.

RVAR is based on total risk while RVOL is based on systematic risk.
RVAR is based on unsystematic risk while RVOL is based on systematic
risk.
RVOL is based on systematic risk while RVAR is based on unsystematic
risk.

d.

(b, moderate)
9.

Which is the better measure to estimate the performance of a welldiversified portfolio in relation to the market index?

a.
b.
c.
d.

Sharpes RVAR
Treynors RVOL
Total return (alone)
Portfolio beta (alone)

(b, moderate)
10.

According to Jensen's differential return measure, what is alpha?

a.
b.
c.
d.

The intercept of the SML line

The intercept of the CML line
A means of identifying superior or inferior portfolio performance
The actual excess return on a portfolio during one period

(c, difficult)
11.

The return on a portfolio during a particular period was 13 percent, the

risk-free rate was 6 percent, the return on the market was 12 percent, and
the portfolio beta was 1.2. The performance of the portfolio (according to
Jensen's measure) was __________ the market.

a.

inferior to
Solution:
p
=
(Rp RF) [p(RM
RF)]
superior to
=
(13 6) [1.2(13
6)]
the same as
=
-0.2 percent
not compared to
Negative alpha, if statistically significant,
means inferior performance.

b.
c.
d.

(a, difficult)

Chapter Twenty-Two
Evaluation of Investment Performance

29

12.

The alpha for a particular fund for a particular period can be

a.
b.
c.
d.

zero or positive, but not negative.

zero or negative, but not positive.
positive or negative, but not zero.
positive, zero, or negative.

(d, moderate)
The following information is to be used to answer questions 13-17.
R2_
0.95
0.80
0.90
0.65

SD_
Beta
alpha
Fund 1 1.97
1.0
1.3
Fund 2 2.94
0.8
0.6*
Fund 3 3.82
1.2
-3.5
Fund 4 4.70
1.4
4.2
*Significant at the 5 percent level
13.

Which of the funds' returns are best explained by the market's returns?

a.
b.
c.
d.

Fund 1
Fund 2
Fund 3
Fund 4

Solution:

Fund 1 has highest R2.

(a, moderate)
14.

Which of these four funds had the largest market risk?

a.
b.
c.
d.

Fund 1
Fund 2
Fund 3
Fund 4

Solution:

Fund 4 has the highest beta.

(d, moderate)
15.

Which of these four funds had the largest total risk?

a.
b.
c.
d.

Fund 1
Fund 2
Fund 3
Fund 4

Solution:

(d, moderate)

Chapter Twenty-Two
Evaluation of Investment Performance

30

Fund 4 has the highest standard

deviation

16.

Which of these funds had the highest performance as determined by

Jensen's performance measure?

a.
b.
c.
d.

Fund 1
Fund 2
Fund 3
Fund 4

Solution:

Fund 2 has the only positive,

statistically significant alpha

(b, moderate)
17.

Which of these funds was least well diversified?

a.
b.
c.
d.

Fund 1
Fund 2
Fund 3
Fund 4

Solution:

Fund 4 has the smallest R2.

(d, moderate)
18.

Superior portfolio performance can result from

a.
b.
c.
d.

the ability to select undervalued securities.

the ability to time market turns.
superior selectivity or timing performance.
neither superior selection nor timing. The market is too efficient.

(c, easy)
19.

Select the CORRECT statement about the reward-to-variability ratio

(RVAR).

a.
b.

RVAR is an absolute measure of performance.

RVAR measures the slope of the line from RF to the portfolio being
evaluated.
The closer the RVAR to 0.0, the better is the performance.
RVAR does not take into account how well diversified a portfolio was.

c.
d.

(b, difficult)

Chapter Twenty-Two
Evaluation of Investment Performance

31

20.

The reward-to-volatility ratio measures the excess return per unit of

a.
b.
c.
d.

total risk.
systematic risk.
market risk.
nonmarket risk.

(b, moderate)
21.

Under Jensen's differential return approach to portfolio evaluation,

superior market timing is exhibited by a

a.
b.
c.
d.

statistically significant positive alpha.

statistically significant negative alpha.
zero alpha.
low positive alpha.

(a, moderate)
22.

Which of the following is true regarding M2?

a.
b.
c.
d.

It compares Treasury bills to the S&P 500 Index.

It states its results in both percentage and graphical form.
It equates the volatility of a portfolio with the market.
All of the above are true.

(c, difficult)
Style Analysis and Performance Attribution
23.

One approach to style analysis which uses the stocks in a portfolio to

describe the fund's allocation among asset classes is known as:

a.
b.
c.
d.

returns-based style analysis.

asset allocation style analysis.
holdings-based style analysis.
mix-based style analysis.

(c, moderate)

Chapter Twenty-Two
Evaluation of Investment Performance

32

24.

One problem with style analysis is style:

a.
b.
c.
d.

consistency.
comparability.
correctness.
character.

(a, moderate)
Money Managers and Performance Presentations
25.

The --------------------- has issued minimum standards for investment

performance.

a.
b.
c.
d.

National Association of Security Dealers

Securities Exchange Commission
Association for Security Analysts and Portfolio Managers
Association for Investment Management and Research

(d, difficult)
26.

GIPS presentation standards require

a.
b.
c.
d.

cash accounting.
inclusion of terminated portfolios.
a 10-year performance record as the minimum period to be presented.
exclusion of cash and cash equivalents.

(c, easy)

True/False Questions
Performance Measurement Issues
1.

The DJIA is the most widely used performance benchmark.

(F, easy)
2.

The dollar-weighted rate of return is equivalent to the internal rate of

return.

(T, moderate)
3.

The time-weighted rate of return is affected by any cashflows to the

portfolio.

(F, moderate)
Chapter Twenty-Two
Evaluation of Investment Performance

33

4.

Total risk of a portfolio is measured by the beta coefficient.

(F, moderate)
5.

When evaluating the performance of a mutual fund manager, one should

use the dollar-weighted return method.

(F, moderate)
Risk-Adjusted Measures of Performance
6.

The lower the RVAR, the better the risk-adjusted portfolio performance.

(F, moderate)
7.

Sharpe's measure is a ratio of excess return to unsystematic risk.

(F, difficult)
8.

Treynor's measure is a ratio of realized return to systematic risk.

(F, difficult)
9.

The use of RVOL implies that total risk is the proper measure of risk in
performance evaluation.

(F, moderate)
10.

Jensen's measure of performance is based on the CAPM.

(T, easy)
11.

Investors who have all their assets in one portfolio of securities should
rely on the Sharpe measure rather than the Treynor measure.

(T, easy)
12.

Jensen's alpha measures the contribution of the portfolio manager.

(T, easy)
13.

M2 is a return adjusted for volatility that allows returns between portfolios

to be compared.

(T, moderate)

Chapter Twenty-Two
Evaluation of Investment Performance

34

Style Analysis and Performance Attribution

14.

Style analysis seeks to identify the characteristics of a portfolio.

(T, easy)
15.

The purpose of performance attribution is to assess the risk of a portfolio.

(F, moderate)
Money Managers and Performance Presentations
16.

GIPS requires compliant history for at least 10 years, or since inception, if

less than 10 years.

(F, moderate)
17.

GIPS was created to obtain global acceptance of a standard for fair

presentation.

(T, easy)

Short-Answer Questions
Performance Measurement Issues
1.

Discuss how constraints on portfolio managers affect the portfolio results.

(moderate)
Answer:

Portfolios, such as mutual funds or pension funds, have specific

goals established for them. The goals themselves imply constraints
in regard to risk, investment media, etc. Specific constraints are
often delineated in the charter, management agreements, etc.
Specific constraints might include, for example, not investing in
futures or not investing in taxable bonds. All such factors mold the
portfolio results

Risk-Adjusted Measures of Performance

2.

What is the major difference between the Sharpe and Treynor models?

(moderate)
Answer:

Sharpe used standard deviation as the risk measure to capture the

overall risk of the portfolio. Treynor used beta as the risk measure
to capture the volatility of the portfolio relative to the market.

Chapter Twenty-Two
Evaluation of Investment Performance

35

3.

How is regression analysis used to measure portfolio diversification?

(difficult)
Answer:

4.

The portfolios returns are regressed against the markets returns.

The coefficient of determination, R2, indicates what percentage of
the variance in the portfolios returns is attributable to the
markets returns. R2 can range from zero to 1.0. The higher the
coefficient of determination is, the better the diversification.

What are the appropriate uses of the Sharpe and the Treynor performance
measures?

(moderate)
Answer:

5.

Sharpes RVAR considers total risk and is appropriate for someone

more interested in the total risk of the portfolio than in only market
risk. Treynors measure, on the other hand, uses market risk and is
appropriate for someone interested in portfolio performance
relative to the market.

Explain the characteristic line in excess return form for the Jensen alpha
measure.

(difficult)
Answer:

6.

The chart has the excess return of the market (RM RF) on the xaxis and the excess returns of the portfolio (Rp RF) on the y-axis.
The y-axis intercept is alpha. Alpha is the excess return on the
portfolio above or below what is predicted by the portfolios beta
and the SML.

Sharpes RVAR measures the slope of the line between RF and the
portfolio being evaluated. If the line is plotted between RF and a market
index, where would superior portfolios lie? Inferior portfolios?

(moderate)
Answer:

Superior portfolios lie above the line and inferior ones

below the line.

Style Analysis and Performance Attribution

7.

What is performance attribution?

(moderate)
Answer:

Performance attribution is an attempt to determine why a portfolio

performed as it did. A top-down approach is often used to look at

Chapter Twenty-Two
Evaluation of Investment Performance

36

various aspects of the portfolio management process, beginning

with the policy statement for the portfolio..

Critical Thinking/Essay Questions

1.

A retired couples assets consist of a $100,000 house, a $400,000

securities portfolio, a $15,000 car, and personal effects. Would they be
more concerned with the Sharpe performance measure or the Treynor
performance measure for the portfolio?

(difficult)
Answer:

2.

Since the securities portfolio constitutes the major proportion of

their assets, they would be more interested in Sharpes measure
because it uses the standard deviation as the risk measure. The
standard deviation measures total risk, systematic and
unsystematic. This couple is interested in the safety of principal
and income, regardless of the source of variability. If
circumstances were different, so that the portfolio constituted a
relatively small part of the couples total assets, they might turn
their attention to the Treynor measure, which focuses on the
market risk of the portfolio.

What are some of the problems associated with using risk-adjusted

portfolio performance measures?

(moderate)
Answer:

(1) The Treasury bill rate may not be a good proxy for the risk-free
rate. (2) A market index may not be a good proxy for the market
as a whole. (3) Beta is not a clear-cut measure of risk. This may
cause benchmark errors if the SML used is not the true SML. (4)
Global investing increases the problem of benchmark error. (5) A
long evaluation period is needed to rule out luck.

Problems
1.

The following data are available for five portfolios and the market for a
recent 10-year period:

Portfolio
1
2
3
S&P 500
RF
6

Average
Annual
Return (%)
14
16
20
12

Chapter Twenty-Two
Evaluation of Investment Performance

Standard
Deviation
21
24
28
20

37

Beta
1.15
1.00
1.25

R2_
0.70
0.98
0.90

a.
b.
c.

Rank these portfolios using the Sharpe measure (3 = highest).

Rank these portfolios using the Treynor measure.
Which of these portfolios outperformed the market?

(difficult)
Solution:
(a)
RVAR
Fund 1 (14 - 6)/21 = .38
Fund 2 (16 - 6)/24 = .42
Fund 3 (20 - 6)/28 = .50
Market (12 - 6)/20 = .30
(b)
RVOL
Fund 1 (14 - 6)/1.15 = .07
Fund 2 (16 - 6)/1.0 = .10
Fund 3 (20 - 6)/1.25 = .112
Market (16 - 6)/1.0 = .10

Rank
1
2
3
Rank
1
2
3

(c)

Using RVAR, all three funds outperformed the market. Using RVOL, only
fund 3 outperformed the market, with fund 2 tying the market

2.

Consider the five funds shown below:

1
2
3
4
5
a.
b
c.
d.

Fund
_a_
_b_
R2_
4.0
0.9
0.90
*
-1.6
1.2
0.95
2.5
0.9
0.90
1.2
0.8
0.89
*
0.9
1.3
0.90
*
Significant at the 5 percent level
Which fund's returns are best explained by the market's returns?
Which fund had the largest total risk?
Which fund had the lowest market risk? The highest?
Which fund(s), according to Jensen's alpha, outperformed the market?

(difficult)
Solutions:
(a)

Fund 2. It has the highest R2.

(b)

Standard deviations are needed to answer this question.

(c)

Fund 4 had the lowest market risk (i.e., beta), while fund 5 had the
highest.

(d)

Only fund 5 had a significantly positive alpha.

Chapter Twenty-Two
Evaluation of Investment Performance

38