Return Based Performance Models

AIM 73.2: Distinguish between basic and advanced return-based performance assessment models.

Return-based models, both basic and advanced, are used to assess investment performance. In this respect they are similar; however, they can be distinguished based on two major aspects.

1. Overall, return-based assessment models are older models, whereas return-based advanced models are relatively newer. Return-based performance analysis models are byproducts of empirical testing of the efficient market hypothesis (EMH) and the development of the capital asset pricing model (CAPM) in I960. Jensens alpha was introduced in 1964—a statistically significant positive alpha offers evidence of the achievement of excess returns, over and above risk-adjusted market (or benchmark) returns, and thus by implication a positive and significant alpha also offers evidence of informational inefficiency of capital markets.

2. Return-based assessment techniques were refined, extended, and broadened statistically and theoretically over a period of time, using rigorous and sophisticated methods. For example, in the CAPM setting, the market portfolio is the only factor which explains the variation in realized returns whereas later models show that there are factors other than beta which account for variations in realized returns. In the next two AIMs we will discuss more about the return-based basic and advanced performance assessment techniques.

AIM 73.3: Describe how basic performance assessment models account for performance and risk.

According to the basic performance assessment models, there are three measures of assessing returns performance-Jensen's alpha, the information ratio, and the Sharpe ratio. Let's discuss how each measure accounts for performance and risk.

Professor's Note: For the exam, it is unlikely that you will need to know the t-tests that test for statistical significance of these measures. The assigned reading only mentions the t-test for the information ratio. The other t-tests are provided for consistency and to help answer the AIM statement.

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