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Questions and Answers

What is the main goal of portfolio performance evaluation?

  • To maximize the returns on investment
  • To minimize the risk associated with the portfolio
  • To measure value creation provided by the portfolio management industry (correct)
  • To predict the state of the economy
  • What is the key distinction between traditional performance measures and conditional performance measures?

  • Traditional measures assume risk stability, while conditional measures allow risk to vary with the state of the economy (correct)
  • Traditional measures focus on maximizing returns, while conditional measures focus on minimizing risk
  • Traditional measures are based on historical data, while conditional measures are based on future projections
  • Traditional measures are suitable for long-term investments, while conditional measures are suitable for short-term investments
  • What is the significance of conditional measures in portfolio performance evaluation?

  • They allow expected returns and risk to vary with the state of the economy (correct)
  • They are based on historical data rather than future projections
  • They provide fixed and unchanging performance indicators
  • They focus solely on short-term investment strategies
  • Which model extends the Fama-French model with a momentum factor?

    <p>Carhart's four-factor model</p> Signup and view all the answers

    What does the construction of size and book-to-market factors in finance rely on?

    <p>Quartiles of firms' size and book-to-market ratios</p> Signup and view all the answers

    What do conditional models allow to vary over time based on lagged public information?

    <p>Risk exposures</p> Signup and view all the answers

    What does successful market timing strategy imply in terms of betas?

    <p>Higher betas when the market goes up and lower betas when it goes down</p> Signup and view all the answers

    What does Conditional Jensen's alpha account for?

    <p>Beta sensitivity to macroeconomic variables</p> Signup and view all the answers

    What do investors' expectations and second moments vary over, impacting portfolio returns?

    <p>Time</p> Signup and view all the answers

    What do factors like size and book-to-market ratio explain changes in?

    <p>Portfolio returns</p> Signup and view all the answers

    What does the four-factor model proposed by Carhart add to the Fama-French model?

    <p>Momentum factor</p> Signup and view all the answers

    Which measure allows portfolios' risk and market premiums to vary over time with the state of the economy?

    <p>Conditional performance measures</p> Signup and view all the answers

    What is the major shortcoming of traditional (unconditional) performance measures?

    <p>Assumption of constant risk over the evaluation period</p> Signup and view all the answers

    Which measure focuses on downside risk by considering returns below a specified required rate of return?

    <p>Sortino Ratio (SR)</p> Signup and view all the answers

    What does the Sharpe ratio measure?

    <p>Ratio of portfolio return in excess of risk-free rate over its standard deviation</p> Signup and view all the answers

    Which measure appraises the expected return from an active management strategy divided by the cost of such strategy?

    <p>Information Ratio (IR)</p> Signup and view all the answers

    What is the drawback of the Sharpe ratio?

    <p>Difficulty in interpretation when excess return is negative</p> Signup and view all the answers

    What does Modigliani and Modigliani Ratio (M & M) measure?

    <p>Returns of a portfolio relative to a benchmark, considering the amount of portfolio risk</p> Signup and view all the answers

    What is the Sharpe ratio calculated as?

    <p>Ratio of portfolio return in excess of risk-free rate over its standard deviation</p> Signup and view all the answers

    What does the Information Ratio (IR) measure?

    <p>Managers' ability to generate higher returns relative to a benchmark portfolio</p> Signup and view all the answers

    What is the drawback of the Sharpe ratio?

    <p>Difficulty in interpretation when excess return is negative</p> Signup and view all the answers

    What does Sortino Ratio (SR) focus on?

    <p>Downside risk by considering returns below a specified required rate of return</p> Signup and view all the answers

    What does the Sharpe standard deviation measure consider?

    <p>Only returns below a certain threshold</p> Signup and view all the answers

    What does the Treynor Ratio require for its calculation?

    <p>An efficient market index</p> Signup and view all the answers

    For which type of portfolio is the Treynor Ratio most relevant?

    <p>A portfolio that does not represent the entire investor's assets</p> Signup and view all the answers

    What is Value at Risk (VAR) primarily concerned with?

    <p>The potential loss in value over a time frame for a given confidence level</p> Signup and view all the answers

    What does Jensen's Alpha measure?

    <p>The abnormal return in excess of what would be predicted by a broader market index</p> Signup and view all the answers

    What does the addition of a quadratic term in the Treynor & Mazuy Measure aim to distinguish?

    <p>Stock picking skills and market timing skills</p> Signup and view all the answers

    What additional term does the Henriksson & Merton Measure include?

    <p>A term containing a dummy variable</p> Signup and view all the answers

    What do traditional performance measures assume about risk over time?

    <p>That risk is constant over time</p> Signup and view all the answers

    What do empirical results using Treynor & Mazuy and Henriksson & Merton models indicate about passive investment strategies?

    <p>They can generate positive market timing coefficients</p> Signup and view all the answers

    What should theoretically be generated by a passive strategy according to Treynor & Mazuy and Henriksson & Merton models?

    <p>Non-significant coefficients</p> Signup and view all the answers

    What is a potential explanation for the puzzling findings of Treynor & Mazuy and Henriksson & Merton models?

    <p>Constant risk assumption over time</p> Signup and view all the answers

    What does the sensitivity of Jensen's alpha to the market index imply?

    <p>It does not allow a comparison of portfolios with different levels of risk</p> Signup and view all the answers

    Which measure is revisited, suggesting the use of financial analysts' forecasts/expectations interacted with $(RMt - Rft)$?

    <p>Ferson &amp; Schadt measure</p> Signup and view all the answers

    What does the proposed equation include to capture the switch from one regime to another?

    <p>A smooth transition continuous function (F)</p> Signup and view all the answers

    What does the traditional Henriksson & Merton model criticize for not considering relevant information?

    <p>Duration and magnitude of bull and bear markets</p> Signup and view all the answers

    What is advocated for in evaluating portfolio performance?

    <p>Standardized risk-adjusted measures</p> Signup and view all the answers

    Which model is suggested as an alternative to better reflect managers' expectations about the future state of the economy?

    <p>STAR and TAR models</p> Signup and view all the answers

    What is the proposed approach to constructing in both bull and bear market periods?

    <p>Hedge market timing portfolio</p> Signup and view all the answers

    What is suggested as an alternative to the traditional Henriksson & Merton model?

    <p>STAR and TAR models</p> Signup and view all the answers

    What is the focus of the proposed equation in capturing the switch from one regime to another?

    <p>Smooth transition from one regime to another</p> Signup and view all the answers

    Which model is suggested as an alternative to better reflect managers' expectations about the future state of the economy?

    <p>STAR and TAR models</p> Signup and view all the answers

    What does the Ferson & Schadt measure suggest the use of interacted with $(R_{Mt} - R_{ft})$?

    <p>Financial analysts' forecasts/expectations</p> Signup and view all the answers

    What does the paper suggest the need for in measuring portfolio performance?

    <p>Standardized risk-adjusted measures</p> Signup and view all the answers

    What does the authors advocate for in evaluating portfolio performance?

    <p>Consideration of multiple risk factors</p> Signup and view all the answers

    What do regime switching models like STAR and TAR aim to better reflect?

    <p>Duration and magnitude of bull and bear markets</p> Signup and view all the answers

    What does the proposed equation include to capture the switch from one regime to another?

    <p>Smooth transition continuous function (F)</p> Signup and view all the answers

    What does the Ferson & Schadt measure aim to revisit and suggest the use of?

    <p>Financial analysts' forecasts/expectations</p> Signup and view all the answers

    What do the authors propose new avenues for in the context of portfolio performance?

    <p>Future research and improvements to existing measures</p> Signup and view all the answers

    Study Notes

    Portfolio Performance Measurement and Research

    • Increasing demand for reliable performance measures due to the surge in investment in mutual and exchange traded funds by small investors globally
    • Research provides a comprehensive overview of portfolio performance measures, discussing their limitations and categorizing them based on properties and objectives
    • Distinguishing between traditional (unconditional) and conditional performance measures, with traditional measures influenced by the Capital Asset Pricing Model (CAPM)
    • Major shortcoming of traditional measures is the assumption of constant risk over the evaluation period
    • Conditional performance measures allow portfolios' risk and market premiums to vary over time with the state of the economy, with recent empirical findings showing improved investor perception
    • Proposal of improvements to existing approaches and identification of new avenues for future research
    • Unconditional performance evaluation includes measures computed as a ratio, with the most common being the Sharpe ratio
    • Sharpe ratio calculated as the ratio of portfolio return in excess of risk-free rate over its standard deviation, derived from Markowitz portfolio theory
    • Drawbacks of Sharpe ratio include difficulty in interpretation when excess return is negative, assumption of normal distribution of portfolio returns, and lack of consideration for higher moments
    • Introduction of new measures within the category of unconditional performance evaluation, such as the Information Ratio (IR), Modigliani and Modigliani Ratio (M & M), and Sortino Ratio (SR)
    • Information Ratio (IR) measures managers' ability to generate higher returns relative to a benchmark portfolio and appraises the expected return from an active management strategy divided by the cost of such strategy
    • Modigliani and Modigliani Ratio (M & M) measures the returns of a portfolio relative to a benchmark, considering the amount of portfolio risk, and Sortino Ratio (SR) focuses on downside risk by considering returns below a specified required rate of return

    Revisiting Portfolio Performance Measures

    • The paper proposes a new approach to constructing a "hedge market timing portfolio" in both bull and bear market periods.
    • The proposed model includes a market timing factor (AMB) and dummy variables for bull and bear markets.
    • The traditional H&M model is criticized for not considering relevant information linked to the duration and magnitude of bull and bear markets.
    • Regime switching models like STAR and TAR are suggested as alternatives to better reflect managers' expectations about the future state of the economy.
    • The proposed equation includes a smooth transition continuous function (F) to capture the switch from one regime to another.
    • The Ferson & Schadt measure is revisited, suggesting the use of financial analysts' forecasts/expectations interacted with (RMt − Rft).
    • The research aims to revisit and extend the main measures of portfolio performance to control for risk-time variations and include multiple risk factors.
    • The paper highlights that early traditional performance measures do not consider risk-time variations and multiple risk factors, leading to negative average fund performance.
    • The authors propose new avenues for future research and improvements to existing measures.
    • References to seminal works on portfolio performance are provided, including Ferson & Schadt (1996), Sharpe (1966), Markowitz (1952), Sortino (1994), Modigliani (1997), Treynor (1965), Roll (1977), and Jensen (1968).
    • The paper suggests the need for standardized risk-adjusted measures in measuring portfolio performance.
    • The authors advocate for the consideration of multiple risk factors and the control for risk-time variations in evaluating portfolio performance.

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