Cml, Sml

In: Business and Management

Submitted By raza19086
Words 1872
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Can We Measure Portfolio Performance?

by Steen Koekebakker and Valeri Zakamouline

Introduction

The risky assets available to investors are numerous: mutual funds, hedge funds, structured products, equity-linked notes to name a few. The characteristics of each asset class can be summarized in the different return distributions. Even within a single asset class the return distributions of assets are not alike. We assume that the return distributions of all risky assets are known and would like to choose the best asset to invest to, meaning that the risky assets are mutually exclusive investment alternatives. How to do this? The standard approach in financial theory and practice is to employ some portfolio performance measure to rank the various risky investments. Each portfolio performance measure calculates a score for each asset using its probability distribution of returns. The best asset to invest to is the asset with the highest score.

The Sharpe ratio is a commonly used measure of portfolio performance. But because it is based on mean-variance theory, this measure can only be used in some restrictive cases, for example, when return distributions are normal. When return distributions are non-normal, the Sharpe ration can lead to misleading conclusions and unsatisfactory paradoxes, see Bernardo and Ledoit (2000) and Hodges (1998). There have been proposed numerous universal performance measures that, in one way or the other, are alternatives to the Sharpe ratio and try to take into account non-normality of return distributions. For some examples, see Sortino and Price (1994), Dowd (2000), Stutzer (2000), Keating and Shadwick (2002), Gregoriou and Gueyie (2003), Kaplan and Knowles (2004), and Ziemba (2005). The main drawback of many of these alternative performance measures is that they lack a solid theoretical underpinning. In this paper we…...

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