Financial Portfolio Benchmarks

Financial Portfolio Benchmarks

Financial Portfolio Benchmarks

Financial Portfolio Benchmarks

Most investors are interested in evaluating portfolio managers inorder to know to whom to entrust their funds. For that purpose, itis necessary to rank portfolio managers in terms of some appropriatebench mark.

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There are three main possibilities. The first is the naively selectedportfolio with a risk approximately 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 referenceto naive forecasts such as would be produced by assuming that nextyear will be like this year or that next year will be different fromthis year by the same percentage that this year differed from last, fnmeteorology, it is commonplace to evaluate weather forecasts by reference to such naive models as one which postulates that the next day will be like the current day or one that selects a forecast for the nextday at random with probabilities proportionate to the historic relativefrequency of different kinds of weather.

A second bench mark is obviously provided by the average performance of the group of actual portfolios which are consideredcomparable. For example, it would be appropriate to judge the performance of each mutual fund having capital appreciation as its objective with the average performance of all other such funds. In the Jensenstudy, it would have been possible to draw a regression line to representthe relationship between risk and rate of return for the mutual fundsactually studied.

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The linePT is the regression line fitted to the fund observations.Its slope, in this instance, is flatter than that of the capital marketlineRfQ. The ranking can be based on deviations of each fund fromPT in much the same way that funds could be ranked accordingto their deviations from Sharpe's capital market line. Rankings byone method may differ from those by the other because of differencesin the slopes of the two regression lines. For example, fund A in thediagram is superior to fund B when compared to the capital marketline, but inferior to fund B when compared to the regression line for fund returns alone.

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