Literature Review: The performance of active investment managers

Literature Review

May 2017

The performance of active investment managers

Author : Lazrek Narjisse

Due date: 31.05.2017 13:00

Table of content:

Introduction 

1.Conventional Performance Measures

1. Sharpe Ratio
2. Treynor Ratio

      1.3Jensen’s Alpha

1. Performance

       2.1. Conventional performance tests

       2.2. Relative performance evaluations

       2.3. Performance persistence 

1. The Active Managers

       3.1. Measuring manager skills

       3.2 Accomplishment of Active Managers 

       3.3. The Performance of active investment managers

Conclusion

References

Introduction

This literature review will consist on the performance of portfolios, especially the professional managed investment one. In this literature, the research has gone way back to before the 1960’s but it especially was concentrated on the recent years which have shown new methods and new evidence on the subject. This research paper will point out and explain the different methods for measuring performance and the affirmations on the performance of investment portfolio’s that are managed professionally. We will start of this literature review, by presenting the traditional measures, afterwards we will be analyzing the performance evaluation and finally we will point out the skills and accomplishment of the active managers.

1. Conventional performance measures

Whether at the level of investment funds or securities portfolios, there are different methods to analyze and measure performance beyond simply calculating returns.
The best known and used of these methods are the Sharpe, Treynor and Jensen alpha ratios, and the benchmark, which are used to evaluate fund returns based on their volatility or risk.

1. The Sharpe Measure (1966)

Established in 1966 by William Forsyth Sharpe, an American economist, the Sharpe ratio allows us to measure the profitability of a portfolio according to the risk taken. Indeed, for him, the average profitability is not sufficient to make an exact measurement of the performance. The goal of this ratio is ultimately to be the portfolio with the lowest possible risk rate for maximum return. The Sharpe ratio is the quotient of the excess of profitability in relation to the risk-free rate divided by the total risk of the portfolio. In other words, it can be used to calculate the performance of an investment relative to a risk-free investment.

Appreciated by investors, it is nevertheless limited when comparing a portfolio of equities, whose profitability is expressed as a percentage, to a stock index.

1. The Treynor’s Measure (1965)

This ratio was created by the economist Jack Treynor in 1965. Like the ratios of Sharpe and Jensen, it makes it possible to evaluate the profitability of a portfolio in relation to the risk involved. The higher the Treynor ratio, the more attractive the return on the portfolio.
Indeed, based on the CAPM model, this ratio represents the ratio between the excess return of the portfolio of the market and its Beta. It therefore corresponds to the return premium of the portfolio relative to an investment in risk-free assets, per unit of market risk.
Note that Treynor's ratio is very similar to Sharpe’s ratio, except that it uses the portfolio's Beta as the denominator instead of the standard deviation. Thus, this ratio analyzes the relative volatility of the portfolio related to the benchmark, and not just the volatility of the portfolio. Treynor's ratio is therefore adjusted in the context of a well-diversified portfolio relative to its benchmark market.

If we compare the Sharpe and Treynor ratios, it is shown that the difference between them can lead to different portfolio rankings, especially if we compare portfolios with poor diversity, as explained by Bodie (2011) in his book.

1. Jensen’s alpha (1968)

Jensen's alpha, proposed by Michael C. Jensen in 1968, is used to evaluate the performance of a fund or portfolio of financial assets, such as the Sharpe or Treynor ratios.
Based on the CAPM (CAPM), this valuation method compares the portfolio to be analyzed with a combination of risk-free assets and the market portfolio. The Jensen alpha thus measures the outperformance of a portfolio relative to its theoretical performance in the CAPM model. If Jensen's alpha is greater than 0, it means that the portfolio beats its benchmark market. If it is less than 0, the portfolio performs worse than what is provided for in the CAPM model. Even if the Jensen method is one of the most suitable in order to evaluate the performance, this measure has undergone many criticisms. The criticism of Roll (1978) is summarized as follows: the validation of the CAPM relies on the identification of the market portfolio. This should contain all possible titles, including real estate values, human capital, etc. The real market portfolio is not observable. It is almost impossible to find a portfolio that is a good approximation to the market portfolio.

1. Pragmatic tests of Performance

1. Conventional performance tests

Analysts have been working on the normal performance of U.S. value shared assets for quite a few years. Michael Jensen (1968), for instance, presented the popular "alpha" formula as a way to alter common reserve returns for differential exposures to the market portfolio. He found no proofs of orderly manager skill. The theory behind these tests is that dynamic managers need to beat the benchmark and that the level of benchmark risk can be determined by the shareholder.

In Jensen's article the benchmark is actually the portfolio of the market and the accession has been reached out to zero-cost portfolios catching size, esteem, and other CAPM irregularities (Carhart, 1997). the same path is presented by William Sharpe (1992) who determines minimal effort list supports as the variable benchmark. A relevant hidden theory behind these tests is that the element exposures can be reflected by the shareholders and most reviews conclude that these element exposures are in a way regular.

Understanding the potential feedback of accepting a steady beta, Jensen (1967) expressed that the ramifications of utilizing a consistent beta would not predisposition the outcomes. However, by permitting dynamic betas, Jensen (1967) contended that the outcomes would be inclined to show a descending one-sided beta estimate and an upward one-sided alpha estimate.

Late writing has been focused on presenting enhanced renditions of the CAPM and the alpha measure. In this regard, Ferson and Schadt (1996), Chen and Knez (1996) advocate the use of conditional performance models that are steady with a semi-solid type of market efficiency as portrayed by Fama (1970). Keeping in mind the end goal to relieve the stationary beta estimate, conditional performance models permit stores chance exposures and the related market premiums to differ after some time (Ferson and Qian, 2004).

1. Relative performance evaluations

Another way to deal with the subject of dynamic management is to check whether winning administrators rehash their predominant performance. Trial of performance persistence have a long history starting with William Sharpe (1966), who found that wining assets from 1944 to 1954 will probably be among the champs throughout the following time frame. From that point forward, specialists and researchers have kept on discovering confirmation of performance persistence predictable with the theory of differential manager skill. Grinblatt and Titman(1992,1993) found that past risk adjusted relative performance. Goetzmann and Ibbotson (1994), and Goetzmann and Brown (1995) in like manner archived performance persistence utilizing somewhat differing systems. The last paper revealed that perseverance was driven generally by repeat‐losers rather than repeat‐winners, which Carhart (1997) additionally affirmed.

Carhart (1997) revealed that performance persistence was clarified by an energy factor– a steady result with the discoveries by Grinblatt, Titman and Wermers (1995) who found that common funds tend to pursue winning stocks. The net outcome of these reviews is that they give off an impression of being persistence contrasts in manager performance. These distinctions may at last be clarified by varying styles. The literature does not back up the conclusion that contributing with winning managers, will raise the probability of the investor's commun funds to beat the market on a risk‐adjusted premise.