by Teri Tynes
Economic Portfolio Benchmarks
Most investors are interested in evaluating portfolio managers in order to know to whom to entrust their funds. For that objective, it is necessary to rank portfolio managers in terms of some appropriate bench mark.
There are 3 major possibilities. The 1st is the naively selected portfolio with a risk roughly equal to that of the actual portfolio. The use of «naive» models or bench marks is a familiar technique in economics, meteorology, and perhaps elsewhere. In economics, it is now ordinary practice to evaluate economic forecasts by reference to naive forecasts such as would be made by assuming that next year will be like this year or that subsequent year will be diverse from this year by the exact same percentage that this year differed from last, fn meteorology, it is commonplace to evaluate weather forecasts by reference to such naive models as one particular which postulates that the next day will be like the existing day or one that selects a forecast for the next day at random with probabilities proportionate to the historic relative frequency of various types of climate.
A second bench mark is naturally supplied by the average performance of the group of actual portfolios which are considered comparable. For instance, it would be suitable to judge the performance of each and every mutual fund having capital appreciation as its objective with the average functionality of all other such funds. In the Jensen study, it would have been feasible to draw a regression line to represent the connection in between threat and price of return for the mutual funds actually studied.
The line PT is the regression line fitted to the fund observations. Its slope, in this instance, is flatter than that of the capital market line RfQ. The ranking can be based on deviations of every single fund from PT in significantly the very same way that funds could be ranked according to their deviations from Sharpe’s capital market place line. Rankings by one strategy may differ from these by the other since of differences in the slopes of the two regression lines. For example, fund A in the diagram is superior to fund B when compared to the capital market line, but inferior to fund B when compared to the regression line for fund returns alone.
Source: New feed