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13. Is the confidence index rising or falling?

This Year Last Year
Yield on top-rated corporate bonds 8% 9%
Yield on intermediate-grade corporate bonds 9 10
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19 Behavioral Finance and Technical Analysis

Day Advances Declines
TA B L E 19.6
1 906 704
Market advances
2 653 986
and declines
3 721 789
4 503 968
5 497 1095
6 970 702
7 1002 609
8 903 722
9 850 748
10 766 766

Charting and Technical Analysis
Go to http://finance.yahoo.com. Compare the charts and short interest ratios for GE and
SWY. For each of the companies, compare a one-year chart to the 50- and 200-day
average as well as the S&P 500 Index. Under the charting function, you can specify
comparisons by choosing the technical analysis tab. Short interest ratios are found
under the company profile report.
After you have secured the reports, discuss the following questions:
1. Which if either of the companies is priced above its 50- and 200-day averages?
2. Would you consider its chart as bullish or bearish? Explain.
3. What are the short ratios for the two companies?
4. Has the short interest displayed any significant trend?

1. Suppose a stock had been selling in a narrow trading range around $50 for a substantial period and SOLUTIONS TO
later increased in price. Now the stock falls back to a price near $50. Potential buyers might recall
the price history of the stock and remember that the last time the stock fell so low, they missed an
opportunity for large gains when it later advanced. They might then view $50 as a good opportunity CHECKS
to buy. Therefore, buying pressure will materialize as the stock price falls to $50, which will create
a support level.


3. By the time the news of recession affects bond yields, it also ought to affect stock prices. The
market should fall before the confidence index signals that the time is ripe to sell.
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Essentials of Investments, Management and Active Portfolio Companies, 2003
Fifth Edition Management


> Compute risk-adjusted rates of return, and use these rates
to evaluate investment performance.

> Decompose excess returns into components attributable to
asset allocation choices versus security selection choices.

> Assess the performance of portfolio managers.

> Assess the value of market timing ability.

> Use the Treynor-Black model of efficient security analysis.

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Essentials of Investments, Management and Active Portfolio Companies, 2003
Fifth Edition Management

Related Websites
These websites provide performance information on
pension funds and other money managers.
These websites provide performance information on
mutual funds.

n previous chapters, we derived predictions for expected return as a function of

I risk. In this chapter, we ask how we can evaluate the performance of a portfolio
manager given the risk of his or her portfolio. Even measuring average portfolio
returns is not as straightforward as it might seem. Difficulties in adjusting average
returns for risk present a host of other problems.
We begin with conventional approaches to risk adjustment. These use the risk
measures developed in Part Two of the text to compare investment results. We show
the problems with these approaches when you apply them in a real and complex
world. Finally, we examine evaluation procedures used in the field. We show how over-
all investment results can be decomposed and attributed to the underlying asset allo-
cation and security selection decisions of the portfolio manager.
Even if you largely accept the efficient market hypothesis, we will see that there
are reasons to consider active portfolio management. We consider the objective of
active management and analyze two forms: market timing based solely on macro-
economic factors, and security selection that includes microeconomic forecasting.
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Fifth Edition Management

684 Part SIX Active Investment Management

Comparison Groups
The major difficulty in portfolio performance evaluation is that average portfolio returns must
be adjusted for risk before we can compare them meaningfully.
The fact that common stocks have offered higher average returns than Treasury bonds (as
demonstrated in Table 20.1) does not prove that stocks are superior investment vehicles. One
must consider the fact that stocks also have been more volatile investments. For the same rea-
son, the fact that a mutual fund outperforms the S&P 500 over a long period is not necessar-
ily evidence of superior stock selection ability. If the mutual fund has a higher beta than the
index, it should outperform the index (on average) to compensate investors in the fund for the
higher nondiversifiable risk they bear. Thus, performance evaluation must involve risk as well
as return comparisons.
The simplest and most popular way to adjust returns for portfolio risk is to compare rates
of return with those of other investment funds with similar risk characteristics. For example,
high-yield bond portfolios are grouped into one “universe,” growth stock equity funds are
grouped into another universe, and so on. Then the average returns of each fund within the
universe are ordered, and each portfolio manager receives a percentile ranking depending on
relative performance within the comparison universe, the collection of funds to which per-
formance is compared. For example, the manager with the ninth-best performance in a uni-
verse of 100 funds would be the 90th percentile manager: Her performance was better than
The set of portfolio
90% of all competing funds over the evaluation period.
managers with similar
These relative rankings usually are displayed in a chart like that shown in Figure 20.1. The
investment styles
that is used in chart summarizes performance rankings over four periods: one quarter, one year, three years,
assessing the relative and five years. The top and bottom lines of each box are drawn at the rate of return of the 95th
performance of an
and 5th percentile managers. The three dotted lines correspond to the rates of return of the
individual portfolio
75th, 50th (median), and 25th percentile managers. The diamond is drawn at the average re-
turn of a particular fund, the Markowill Group, and the square is drawn at the average return
of a benchmark index such as the S&P 500. This format provides an easy-to-read representa-
tion of the performance of the fund relative to the comparison universe.
This comparison with other managers of similar investment groups is a useful first step in
evaluating performance. Even so, such rankings can be misleading. Consider that within a par-
ticular universe some managers may concentrate on particular subgroups, so that portfolio
characteristics are not truly comparable. For example, within the equity universe, one manager
may concentrate on high-beta stocks. Similarly, within fixed-income universes, interest rate
risk can vary across managers. These considerations show that we need a more precise means
for risk adjustment.
Arithmetic Geometric Standard
TA B L E 20.1 Average Average Deviation
Average annual
returns by investment Common stocks
class, 1926“2001 of small firms* 18.3 12.2 39.3
Common stocks
of large firms 12.5 10.5 20.3
Long-term Treasury bonds 5.5 5.3 8.2
U.S. Treasury bills 3.9 3.9 3.3

Source: Prepared from data in Table 5.2
*These are firms with relatively low market values of equity. Market capitalization is computed as price per share times shares
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Fifth Edition Management

20 Performance Evaluation and Active Portfolio Management

F I G U R E 20.1
Rate of return (%)
Universe comparison:
30 Periods ending
The Markowill Group December 31, 2003.
S & P 500





1 quarter 1 year 3 years 5 years

Risk Adjustments
Methods of risk-adjusted performance using mean-variance criteria developed simultaneously
with the capital asset pricing model (CAPM). Jack Treynor (1966), William Sharpe (1966),
and Michael Jensen (1969) were quick to recognize the implications of the CAPM for rating
the performance of managers. Within a short time, academicians were in command of a
battery of performance measures, and a bounty of scholarly investigation of mutual fund
performance was pouring from the ivory tower. Soon after, agents emerged who were willing
to supply rating services to portfolio managers eager for regular feedback. These days, risk-
adjusted performance measures are accessible to all investors on the Internet. We will use
these statistics in our analysis here.
We begin with a catalogue of the major risk-adjusted performance measures and examine
the circumstances in which each measure might be most relevant. To illustrate these measures,


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