Comparison of The Ratios

Comparison of the ratios
Portfolios contain groups of securities that are selected to achieve the highest return for a given level of
risk. How well this is achieved depends on how well the portfolio manager or investor is able to forecast
economic conditions and the future prospects of companies, and to accurately assess the risk of each
security under consideration. Many investors and some portfolio managers adopt a passive portfolio
management strategy by simply holding a basket of securities that is weighted to reflect a market index,
or by buying securities based on a market index, such as most exchange-traded funds.
Some investors and portfolio managers think they can do better than the market, and so engage
in active portfolio management, buying and selling securities as conditions change. Most active portfolio
managers use sophisticated financial models to base their investment decisions.
However, most studies have shown that few portfolio managers outperform the market, especially over
a long time, and because there are thousands of portfolio managers selling their services, the fact that
some outperform the market over an extended period may be due to luck. For instance, if thousands of
portfolios were constructed by choosing securities at random, and buying and selling them at random,
some would do much better than all of the rest—simply by chance. Another factor weighing on the
performance of active portfolios are the fees charged by their managers, and the trading costs of
frequently buying and selling. There are some managers who seem to outperform the market
consistently, such as Warren Buffett of Berkshire Hathaway; however, Warren Buffet uses a buy-and-
hold strategy rather than active trading. Another factor that individual investors doing their own active
portfolio management should consider is whether any gains are worth the amount of time necessary to
actively manage their portfolio.
Portfolio returns come in the form of current income and capital gains. Current income includes
dividends on stocks and interest payments on bonds. A capital gain or capital loss results when a
security is sold, and is equal to the amount of the sale price minus the purchase price. The return of the
portfolio is equal to the net of the capital gains or losses plus the current income for the holding period.
Unrealized capital gains or losses on securities still held are also added to the return to evaluate
the holding period return of the portfolio. The portfolio return is adjusted for the addition of funds and
the withdrawal of funds to the portfolio, and is time-weighted according to the number of months that
the funds were in the portfolio. Below is the formula for calculating the portfolio return for 1 year:
Time Weighted Adjustment of the Portfolio = (Added Funds × Number of Months in Portfolio / 12) -
(Withdrawn Funds × Number of Months Withdrawn from Portfolio / 12)
Portfolio Return Formula
Portfolio Return= Dividends + Interest + Realized Gains or Losses + Unrealized Gains or Losses/ Dividends
+ Interest + Realized Gains or Losses + Unrealized Gains or Losses
Realized gains (or losses) are gains or losses actualized by the selling of the securities,
whereas unrealized gains or losses are securities that are still owned but are marked to market to
determine the portfolio's return.
Comparing Portfolio Returns
There are several ways of comparing portfolio returns with each other and with the market in general. A
simple comparison is to simply compare their returns. However, returns by themselves do not account
for the risk taken. If 2 portfolios have the same return, but one has lower risk, then that would be the
preferable, more efficient portfolio.
There are 3 common ratios that measure a portfolio's risk-return tradeoff: Sharpe's ratio, Treynor's ratio,
and Jensen's Alpha.
Sharpe ratio
The Sharpe ratio (aka Sharpe's measure), developed by William F. Sharpe, is the ratio of a portfolio's

total return minus the risk-free rate divided by the standard deviation of the portfolio, which is a
measure of its risk. The Sharpe ratio is simply the risk premium per unit of risk, which is quantified by
the standard deviation of the portfolio.
Risk Premium = Total Portfolio Return – Risk-free Rate
Sharpe Ratio = Risk Premium / Standard Deviation of Portfolio Return
The risk-free rate is subtracted from the portfolio return because a risk-free asset, often exemplified by
the T-bill, has no risk premium since the return of a risk-free asset is certain. Therefore, if a portfolio's
return is equal to or less than the risk-free rate, then it makes no sense to invest in the risky assets.
Hence, the Sharpe ratio measures the performance of the portfolio compared to the risk taken—the
higher the Sharpe ratio, the better the performance and the greater the profits for taking on additional
risk.
Example—Calculating the Sharpe Ratio
If a fund has a return of 12% and a standard deviation of 15%, and if the risk-free rate is 2%, then what is
its Sharpe ratio?
Solution:
Sharpe Ratio = (12% – 2%) / 15% = 10% / 15% = 66.7% (rounded)

Treynor Ratio
While the Sharpe ratio measures the risk premium of the portfolio over the portfolio risk, or its standard
deviation, Treynor's ratio, popularized by Jack L. Treynor, compares the portfolio risk premium to the
systematic risk of the portfolio as measured by its beta.
Trainer ratio formula= Total Portfolio Return – Risk-Free Rate/ Portfolio Beta
Note that since the beta of the general market is defined to be 1, the Treynor Ratio of the
market would be equal to its return minus the risk-free rate. Note that the Treynor ratio is higher with
either higher portfolio returns or lower portfolio betas, so it is a measure of the return per unit risk.
Jensen's Alpha (aka Jensen Index)
Alpha is a coefficient that is proportional to the excess return of a portfolio over its required
return, or its expected return, for its expected risk as measured by its beta. Hence, alpha is determined
by the fundamental values of the companies in the portfolio in contrast to beta, which measures the
portfolio's return due to its volatility. Jensen's alpha (aka Jensen index), developed by Michael C. Jensen,
uses the capital asset pricing model (CAPM) to determine the amount of the return that is firm-specific
over that which is due to market volatility as measured by the firm's beta in relation to the market beta.
Jensen's Alpha = Total Portfolio Return – Risk-Free Rate – [Portfolio Beta × (Market Return – Risk-Free
Rate)]
Jensen's alpha can be positive, negative, or zero. Note that, by definition, Jensen's alpha of the market is
zero. If the alpha is negative, then the portfolio is underperforming the market; thus, higher alphas are
more desirable.

Comparison of The Ratios

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Comparison of The Ratios

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Comparison of the ratios

Comparing Portfolio Returns

The Sharpe ratio (aka Sharpe's measure), developed by William F. Sharpe, is the ratio of a portfolio's

Risk Premium = Total Portfolio Return – Risk-free Rate

Sharpe Ratio = Risk Premium / Standard Deviation of Portfolio Return

Example—Calculating the Sharpe Ratio

Sharpe Ratio = (12% – 2%) / 15% = 10% / 15% = 66.7% (rounded)

Jensen's Alpha (aka Jensen Index)

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