Handbook of Finance: Investment Management and Financial Management

Chapter 23. Evaluating Portfolio Performance: LPM-Based Risk Measures and the Mean-Equivalence Approach

BANIKANTA MISHRA, PhD

Visiting Professor of Finance, University of Michigan and Professor of Finance XIM-Bhubaneswar, India

MAHMUD RAHMAN, PhD

Professor of Finance, Eastern Michigan University

Abstract: Since different portfolio managers offer portfolios with different characteristics, evaluating their absolute and relative performance becomes important. In particular, when analyzing the performance of a broad-based mutual fund that tracks a market index such as the Standard & Poor's (S&P) 500, it is imperative to examine whether the fund has done "better" than the existing index and other broad-based mutual funds. This analysis involves comparing the realized (actual) return and risk of the fund to that of other indices and funds. Different performance measures entail different ways of comparing performance. Some focus on the excess return—return realized in excess of what is required commensurate with the risk—obtained by the fund, while others focus on the ratio of the risk premium—return in excess of risk-free rate—to risk. Then again, while some take risk to be total risk, others take it to be the no diversifiable risk (or what some call beta risk). There are also differences here in that, while some use variance-based risk measures, others measure risk through some downside risk measures such as the semivariance or lower partial moment (LPM). The advantage of the LPM-based measures ...