Question of the Month (November 2019): Performance Measures

Posted by Mike Long, CFP®, ChFC®, CLU®

Nov 1, 2019

Tim Brown, a new client, has engaged you, a CFP® practitioner. He is asking for investment advice only. In addition to holding the CFP® certification, you are a registered representative of a FINRA broker-dealer. Tim's portfolio of stocks has been purchased through dollar-cost averaging over the years and contains 7 equally weighted stocks in very different industries. What composite (risk adjusted) measure of portfolio performance should you implement?

  1. Treynor ratio
  2. Sharpe ratio
  3. Jensen (alpha) measure
  4. Coefficient of determination

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Correct answer: B. Sharpe ratio

Instructor insight:

A decent argument can be made for either Sharpe or Treynor depending on your definition of a “diversified portfolio”. Some sources maintain that 10-15 securities is the minimum required, while others claim diversification can be achieved with as little as 3 stocks. In reality, diversification will depend on the makeup of the portfolio. A portfolio of 50 pharmaceutical companies would not be well-diversified, as it's too focused in one area regardless of the large number of individual securities. Meanwhile, a portfolio of 7 securities that vary in type from small cap to large cap, from domestic to international and from growth to value, could be considered a well-diversified portfolio due to its very diverse makeup.

In this question, because we do not know the makeup of the 7 securities in the portfolio we have to assume that it is not a well-diversified portfolio. Therefore the correct answer is the Sharpe ratio, as the portfolio contains both systematic and unsystematic risk.

If we knew more about the 7 securities and found we could assume the portfolio is diversified then the Treynor ratio would be the correct answer. And the Jensen measure would be the correct answer if the question was asking how well the portfolio manager performed against the overall market. Coefficient of determination is just a buzz word that has nothing to do with this situation.

 

Topics: Practice Questions

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