Investors in the past have based the success of their portfolios solely on returns neglecting to incorporate the risk to attain their returns. Nowadays, there are portfolio performance measurement tools that combine returns and risks. This paper will explain the four measures that are used to determine the performance of a portfolio. The Treynor measure, Sharpe Ratio measure, Jensen measure and the Information Ratio measure will be each defined and explained. Then a brief summary of the advantages and disadvantages each portfolio performance measure is noted.
Treynor Measure
Treynor developed a portfolio performance that incorporated two types of risk in the year 1965. One of the risks in Treynor measure included the risk that is produced …show more content…
Sharpe Ratio Measure
Sharpe introduced the measure to determine mutual funds’ performance in the year 1996. The measure is different from the one introduced by Treynor since it measures the total risk by using the standard deviations of each return. The formula of the Sharpe measure is as indicated below S indicates the performance of the portfolio
The standard deviation in the formula measures the risk premium return earned based on the total risk.
Demonstration of Sharpe measure
Given that the market return is 0.14, the risk free rate is 0.08 and the standard deviation is 0.20 determine the risk adjusted performance of the portfolio indicated below
Portfolio Average annual return Standard deviation Sharpe measure
Market 0.14 0.20 …show more content…
Portfolio D has a low performance compared to the market and should not be considered.
Jensen Measure
Jensen is based on the CAPM model which is used to calculate the expected portfolio return during a particular period. While applying the Jensen measure one is required to apply the risk free rate during each sample period. Jensen measure compares the annual returns and the market annual return each year after including the risk free rate for the assets and market.
Since Jensen measure calculates risk in the form of systematic risk, it cannot be used to measure the ability of the portfolio manager to diversify risk. The Jensen measure is preferred because of its flexibility which allows for alternative methods of the expected returns and risk.
Information Ratio Measure
It is a portfolio performance measure that is used to evaluate the average return of a portfolio that is in excess of the benchmark’s portfolio return. The value after calculating the difference is divided by the excess return standard deviation.
Summary
Treynor
Treynor Measure
Treynor developed a portfolio performance that incorporated two types of risk in the year 1965. One of the risks in Treynor measure included the risk that is produced …show more content…
Sharpe Ratio Measure
Sharpe introduced the measure to determine mutual funds’ performance in the year 1996. The measure is different from the one introduced by Treynor since it measures the total risk by using the standard deviations of each return. The formula of the Sharpe measure is as indicated below S indicates the performance of the portfolio
The standard deviation in the formula measures the risk premium return earned based on the total risk.
Demonstration of Sharpe measure
Given that the market return is 0.14, the risk free rate is 0.08 and the standard deviation is 0.20 determine the risk adjusted performance of the portfolio indicated below
Portfolio Average annual return Standard deviation Sharpe measure
Market 0.14 0.20 …show more content…
Portfolio D has a low performance compared to the market and should not be considered.
Jensen Measure
Jensen is based on the CAPM model which is used to calculate the expected portfolio return during a particular period. While applying the Jensen measure one is required to apply the risk free rate during each sample period. Jensen measure compares the annual returns and the market annual return each year after including the risk free rate for the assets and market.
Since Jensen measure calculates risk in the form of systematic risk, it cannot be used to measure the ability of the portfolio manager to diversify risk. The Jensen measure is preferred because of its flexibility which allows for alternative methods of the expected returns and risk.
Information Ratio Measure
It is a portfolio performance measure that is used to evaluate the average return of a portfolio that is in excess of the benchmark’s portfolio return. The value after calculating the difference is divided by the excess return standard deviation.
Summary
Treynor