Measuring Long-Short Portfolio Performance

Portfolio performance measures are a key factor in the investment decision. Portfolio returns are only part of the story. Without evaluating risk-adjusted returns, an investor cannot possibly see the whole investment picture.

Measurement Tools

There are three sets of performance measurement tools to assist with portfolio evaluations as follows: (i) Sharpe ratio, (ii) Treynor measure, and (iii) Jensen measure.

Sharpe Ratio

The Sharpe ratio was developed by Nobel laureate William F. Sharpe and is defined as the average return earned in excess of the risk-free rate per unit of volatility or total risk. Volatility is a measure of the price fluctuations of an asset or portfolio.

A high Sharpe ratio is good when compared to similar portfolios or funds with lower returns.

This ratio assumes that investment returns are normally distributed, one of the several weaknesses attributed to this measure.

Treynor Measure

Jack L. Treynor suggested that there were really two components of risk (i) one that is produced by fluctuations in the stock market and (ii) the one arising from the gyrations of individual securities.

This measure assumes that the investor already has an adequately diversified portfolio and, therefore, unsystematic risk (diversifiable risk) is ignored.

Treynor introduced the concept of the security market line, which defines the relationship between portfolio returns and market rates of returns whereby the slope of the line measures the relative volatility between the portfolio and the market (as represented by beta). The beta coefficient is the volatility measure of a stock portfolio to the market itself. The greater the line's slope, the better the risk-return tradeoff.

Jensen Measure

Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess return that a portfolio generates over its expected return. This measure of return is also known as alpha.

The Jensen ratio measures how much of the portfolio's return is attributable to the manager's ability to deliver above-average returns adjusted for market risk.

The higher the ratio, the better the risk-adjusted returns. A portfolio with a consistently positive excess return will have a positive alpha while a portfolio with a consistently negative excess return will have a negative alpha.

Last Word

Without evaluating risk-adjusted returns, an investor cannot possibly see the whole investment picture, which almost always leads to poor decisions. At 99rises, we measure volatility-adjusted returns using the Sharpe ratio methodology to make sure we don't take rabid risks on our client's capital just to juice up returns.

As fiduciaries and stewards of capital, we like our clients to sleep well at night!