Question 14 Analyst\'s earnings revisions are often used as a way of identifying

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Question 14 Analyst's earnings revisions are often used as a way of identifying positive alpha for stocks. Why might this be the case? Question 15 Two methods for evaluating actively managed fund performance are the Sharpe measure and the Treynor measure. Under what circumstances is it more appropriate to use either measure? Question 16 When determining the rate of return on a fund either dollar-weighted or time weighted returns can be used. Explain the difference between these two approaches. Which is more appropriate to use?

Explanation / Answer

The sharpe ratio aims to reveal how an equity investment portfolio performs as compared to risk free investment.

The Sharpe ratio calculates either the expected or the actual return on investment for an investment portfolio (or even an individual equity investment), subtracts the risk-free investment's return on investment, and then divides that number by the standard deviation for the investment portfolio. The primary purpose of the Sharpe ratio is to determine whether you are making a significantly greater return on your investment in exchange for accepting the additional risk inherent in equity investing as compared to investing in risk-free instruments.

The Treynor ratio also seeks to evaluate the risk-adjusted return of an investment portfolio, but it measures the portfolio's performance against a different benchmark. Rather than measuring a portfolio's return only against the rate of return for a risk-free investment, the Treynor ratio looks to examine how well a portfolio outperforms the equity marketas a whole. It does this by substituting beta for standard deviation in the Sharpe ratio equation, with beta defined as the rate of return that is due to overall market performance.

Treynor and Sharpe measures are pretty much similar performance measures with very few differences. While one uses the relative market risk or beta to normalize the performance the other uses the standard deviation or the absolute risk. While Sharpe ratio is applicable to all portfolios, Treynor is applicable to well-diversified portfolios. While Sharpe is used to measure historical performance, Treynor is a more forward-looking performance measure. Thus, both these performance measures work in different ways towards better representation of the performance.

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