Mastering Measures of Portfolio Performance | CFA Level I Portfolio Management

In this lesson, we’ll explore four common approaches to measure the performance of a portfolio.

Four Quadrants of Portfolio Performance Measures

We can divide the four measures we’ll learn into four quadrants, based on total risk or systematic risk only, and based on risk-free rate adjustment or market risk adjustment. These measures are best illustrated with the Capital Market Line (CML) and Security Market Line (SML).

• Sharpe Ratio – Risk-free rate adjusted measure, based on total risk
• M-Squared Measure – Market risk adjusted measure, based on total risk
• Treynor Measure – Risk-free rate adjusted measure, based on systematic risk
• Jensen’s Alpha – Market risk adjusted measure, based on systematic risk

Sharpe Ratio

The Sharpe Ratio is a risk-free rate adjusted measure, based on total risk. It’s calculated as the portfolio return minus the risk-free rate, divided by the portfolio’s standard deviation.

Sharpe Ratio = (Portfolio Return – Risk-free Rate) / Portfolio Standard Deviation

M² Measure

The M² Measure is a market risk adjusted measure, based on total risk. It’s calculated by subtracting the return of the market portfolio above the risk-free rate from the excess return of the portfolio (Sharpe Ratio times the market standard deviation).

Treynor Measure

The Treynor Measure is the equivalent of the Sharpe Ratio but based on systematic risk. The returns are measured per unit of systematic risk. In this case, we replace the portfolio standard deviation with the portfolio beta.

Jensen’s Alpha

Jensen’s Alpha is a market risk adjusted measure based on systematic risk. It measures the excess return of a portfolio based on its beta. The Jensen’s Alpha is calculated as the portfolio’s actual return minus its expected return.

Choosing the Appropriate Measure

Now that we’ve learned the four measures, how do we determine which measure is more appropriate based on the circumstances? In essence, the choice depends on the type of risk that is the more appropriate benchmark for the investor.

Whether risk adjustment should be based on total risk or systematic risk depends on who the investor is. If the investor only owns this particular portfolio, they are exposed to both the systematic and unsystematic risk of the portfolio. This investor should use the Sharpe Ratio and M-Squared Measure to evaluate the portfolio, as these measures are based on total risk.

On the other hand, if this portfolio is just one of the many portfolios that the investor has, the unsystematic risk of the portfolio will be of little significance to the investor if the portfolios are well-diversified from each other. In this case, the investor should use the Treynor Measure and Jensen’s Alpha to evaluate the portfolio, as these measures are based on systematic risk.

Conclusion

And there you have it! We’ve covered the four key measures of portfolio performance: Sharpe Ratio, M-Squared Measure, Treynor Measure, and Jensen’s Alpha. We’ve also discussed how to determine the appropriate measure based on the circumstances.