Performance Evaluation and Risk Management 13-3
In general terms, performance evaluation focuses on assessing how well a
money manager (either a professional or an individual investor) achieves high
returns balanced with acceptable risks.
Performance evaluation is particularly significant when we consider efficient
markets. In a previous chapter, we raised the question of risk-adjusted
performance and whether anyone can consistently earn an "abnormal" return,
thereby "beating" the market. Our goal here, however, is to introduce the primary
assessment tools, rather than discuss whether we should entrust our investment
funds with fund managers.
A. Performance Evaluation Measures
Raw Return: States the total percentage return on an investment without
any adjustment for risk or comparison to any benchmark.
The raw return on a portfolio is a naive measure of performance evaluation. The
fact that a raw portfolio return does not reflect any consideration of risk suggests
that its usefulness is limited when making investment decisions.
So, we shall examine some of the best-known and most popular measures that
include an adjustment for risk.
B. The Sharpe Ratio
Sharpe Ratio: Measures investment performance as the ratio of portfolio
risk premium over portfolio return standard deviation. This ratio was
originally proposed by Nobel Laureate William F. Sharpe.
The portfolio risk premium, Rp – Rf, is the basic reward for bearing risk, while the
return standard deviation is a measure of the total risk for a security or a portfolio.
We referred to the risk premium as “excess return” in a previous chapter.
The Sharpe ratio is a reward-to-risk ratio that focuses on total risk. The
systematic risk principle states that the reward for bearing risk depends only on
the systematic risk of an investment. So no matter how much total risk an asset
has, only the systematic portion is relevant in determining the expected return
(and the risk premium) on that asset. Hence, the Sharpe ratio is probably most
appropriate for evaluating relatively diversified portfolios, since it penalizes non-
diversified portfolios by also taking into account unsystematic risk.
The Sharpe ratio uses total standard deviation, but investors are likely only
concerned about downside volatility (i.e., returns below expectation). The Sortino
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of