8.3 Measuring Portfolio Performance
Advisers must select appropriate performance benchmarks and metrics to evaluate whether active management added value after fees and risk adjustments.
Key NASAA Exam Takeaways
- Time-Weighted Return (TWR) eliminates the distorting effects of client deposits and withdrawals; it is the industry standard for evaluating manager skill.
- Dollar-Weighted Return (IRR) reflects the actual return experienced by the client, accounting for the timing and magnitude of external cash flows.
- Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation (measures return per unit of total risk).
- Treynor Ratio = (Portfolio Return - Risk-Free Rate) / Beta (measures return per unit of systematic risk).
- Jensen's Alpha measures performance relative to the Capital Asset Pricing Model (CAPM) benchmark.
Sharpe Ratio Calculation
Fund A achieved an average return of 14% with a standard deviation of 12%. Fund B achieved an average return of 11% with a standard deviation of 6%. The risk-free rate is 2%. Which fund delivered superior risk-adjusted return?
- Calculate Fund A Sharpe Ratio: (14% - 2%) / 12% = 12% / 12% = 1.00.
- Calculate Fund B Sharpe Ratio: (11% - 2%) / 6% = 9% / 6% = 1.50.
- Compare results: Fund B generated 1.50 units of excess return per unit of risk vs. 1.00 for Fund A.
Result: Fund B delivered superior risk-adjusted performance despite a lower nominal return.
Interactive Knowledge Checkpoint • Section 8.3
Why is Time-Weighted Return (TWR) preferred over Dollar-Weighted Return (DWR) when evaluating the performance of an investment adviser?