CHAPTER - VII

PORTFOLIO MANAGEMENT
Portfolio performance measures
Portfolio performance evaluation involves determining periodically how theportfolio performed
in terms of not only the return earned, but also the riskexperienced by the investor. For portfolio
evaluation appropriate measures of returnand risk as well as relevant standards (or
“benchmarks”) are needed. In general, the market value of a portfolio at a point of time is
determined byadding the markets value of all the securities held at that particular time. The
marketvalue of the portfolio at the end of the period is calculated in the same way, only
using end-of-period prices of the securities held in the portfolio.
The return on the portfolio (rp): rp = (Ve - Vb) /Vb, (7.1)
Here: Ve - beginning value of the portfolio;
Vb - ending value of the portfolio.
The essential idea behind performance evaluation is to compare the returnswhich were obtained
on portfolio with the results that could be obtained if moreappropriate alternative portfolios had
been chosen for the investment. Suchcomparison portfolios are often referred to as benchmark
portfolios. In selecting theminvestor should be certain that they are relevant, feasible and known
in advance. Thebenchmark should reflect the objectives of the investor.
Portfolio Betacan be used as an indication of the amount ofmarket risk that the portfolio had
during the time interval. It can be compared directlywith the betas of other portfolios.You cannot
compare the ex post or the expected and the expected return of twoportfolios without adjusting
for risk. To adjust the return for risk before comparison of
performance risk adjusted measures of performance can be used:
 Sharpe’s ratio;
 Treynor’s ratio;
 Jensen’s Alpha.
Sharpe’s ratio shows an excess a return over risrisk free rate, or risk premium, by unit of total
risk, measured by standard deviation:
Sharpe’s ratio = (rp– rf) / sp,
Here: rp - the average return for portfolio p during some period of time;
rf - the average risk-free rate of return during the period;
sp - standard deviation of returns for portfolio p during the period.
Treynor’s ratio shows an excess actual return over risk free rate, or riskpremium, by unit of
systematic risk, measured by Beta:
Treynor’s ratio = (rp –rf) / ßp,
here: ßp – Beta, measure of systematic risk for the portfolio p.
Jensen‘s Alpha shows excess actual return over required return and excessof actual risk
premium over required risk premium. This measure of the portfoliomanager’s performance is
based on the CAPM.
Jensen’s Alpha = (rp– rf) – ßp (rm –rf),
here: rm - the average return on the market in period t;
(rm –rf) - the market risk premium during period t.
It is important to note, that if a portfolio is completely diversified, all of thesemeasures (Sharpe,
Treynor’s ratios and Jensen’s alfa) will agree on the ranking of theportfolios. The reason for this
is that with the complete diversification total variance isequal to systematic variance. When
portfolios are not completely diversified, theTreynor’s and Jensen’s measures can rank relatively
undiversified portfolios muchhigher than the Sharpe measure does. Since the Sharpe ratio uses
total risk, bothsystematic and unsystematic components are included.
Portfolio management process
• Identification of Objectives

• Selection of the Asset mix

• Formulation of portfolio strategy

• Security Analysis

• Portfolio Evaluation

• Portfolio Revision
 • Identification of Objectives:

The first step in the portfolio management process is identification of objectives.

The investors’ objectives may be income, capital appreciation or a future provision such
as marriage, education etc..

• Selection of the Asset mix:

A proper asset mix between stock and bonds depends upon the risk tolerance and
investment limit of the investors. Asset mix means a proportions of stocks (Ex: Equity
shares and preference shares) and bonds (fixed income securities) in the portfolio.

• Formulation of portfolio strategy:

2 types of investment portfolio management:

 Active portfolio management
 Passive portfolio management
The main points for the passive portfolio management:
• holding securities in the portfolio for the relatively long periods with small
and infrequent changes;
• investors act as if the security markets are relatively efficient. The portfolios they hold may be
surrogates for the market portfolio (indexfunds).
• Passive investors do not try outperforming their designated benchmark.
The reasons when the investors with passive portfolio management makechanges in their
portfolios:
• the investor’s preferences change;
• the risk free rate changes;
• the consensus forecast about the risk and return of the benchmark portfolio
Changes.The main points for the active portfolio management:
• Active investors believe that from time to time there are mispricedsecurities or groups of
securities in the market;
• The active investors do not act as if they believe that security markets are efficient;
There are arguments for both active and passive investing though it is probably a case that a
larger percentage of institutional investors invest passively than do individual investors. Of
course, the active versus passive investment managementdecision does not have to be a strictly
either/ or choice. One common investmentstrategy is to invest passively in the markets investor
considers to be efficient andactively in the markets investor considers inefficient. Investors also
combine the twoby investing part of the portfolio passively and another part actively..
Security Analysis:

This step consists of examining the risk-return characteristics' of individual securities. It depends
on the sources of information. Securities are analyzed from the point of their prices, returns, and
risks. During the security analysis fundamental and technical analysis help in the selection of
securities.

Portfolio Selection:

The inputs from the portfolio analysis can be used to identify the set of efficient portfolios. From
these efficient portfolios, the optimal portfolio has to be selected for investment.

Portfolio Evaluation:

It is the process which is concerned with assessing the performance of the portfolio over a
selected period of time in terms of return and risk. Portfolio evaluation is useful to identify the
weaknesses in the investment process and for improving these deficient areas. It provides a
feedback mechanism for improving the entire portfolio management process.

Portfolio Revision:

A portfolio once constructed requires constant monitoring and revision. Changes in investor’s
financial status, his preferences and market conditions will also necessitate changes in portfolio
composition. Such a revision generally involves a shift from one stock to another stock.

Portfolio revision is the process of selling certain issues in portfolio andpurchasing new ones to
replace them. The main reasons for the necessity of theinvestment portfolio revision:
• As the economy evolves, certain industries and companies become either
less or more attractive as investments;
• The investor over the time may change his/her investment objectives and in
this way his/ her portfolio isn’t longer optimal;
• The constant need for diversification of the portfolio. Individual securitiesin the portfolio often
change in risk-return characteristics and theirdiversification effect may be lessened.
Three areas to monitor when implementing investor’s portfolio monitoring:
1. Changes in market conditions;
2. Changes in investor’s circumstances;
3. Asset mix in the portfolio.
The need to monitor changes in the market is obvious. Investment decisionsare made in dynamic
investment environment, where changes occur permanently. Thekey macroeconomic indicators
(such as GDP growth, inflation rate, interest rates,others), as well as the new information about
industries and companies should beobserved by investor on the regular basis, because these
changes can influence thereturns and risk of the investments in the portfolio. Investor can
monitor these changesusing various sources of information, especially specialized websites
(most frequently used are presented in relevant websites). It is important to identify he major
changes inthe investment environment and to assess whether these changes should
negativelyinfluence investor’s currently held portfolio. If it so investor must take an actions to
Rebalance his/ her portfolio.
When monitoring the changes in the investor’s circumstances, followingaspects must be taken
into account:
• Change in wealth
• Change in time horizon
• Change in liquidity requirements
• Change in tax circumstances
• Change in legal considerations
• Change in other circumstances and investor’s needs.
Any changes identified must be assessed very carefully before usually theygenerally are related
with the noticeable changes in investor’s portfolio.
Rebalancing a portfolio is the process of periodically adjusting it to maintaincertain original
conditions. Rebalancing reduces the risks of losses – in general, arebalanced portfolio is less
volatile than one that is not rebalanced. Several methods ofrebalancing portfolios are used:
 Constant proportion portfolio;
 Constant Beta portfolio;
  Indexing.
Constant proportion portfolio. A constant proportion portfolio is one in whichadjustments are
made so as to maintain the relative weighting of the portfoliocomponents as their prices change.
Investors should concentrate on keeping theirchosen asset allocation percentage (especially those
following the requirements forstrategic asset allocation). There is no one correct formula for
when to rebalance. Onerule may be to rebalance portfolio when asset allocations vary by 10% or
more. Butmany investors find it bizarre that constant proportion rebalancing requires the
purchase of securities that have performed poorly and the sale of those that haveperformed the
best. This is very difficult to do for the investor psychologically. But the investor should always
consider this method of rebalancing as onechoice, but not necessarily the best one.
Constant Beta portfolio.The base for the rebalancing portfolio using thisalternative is the target
portfolio Beta. Over time the values of the portfolio components and their Betas will change and
this can cause the portfolio Beta to shift.For example, if the target portfolio Beta is 1,10 and it
had risen over the monitoredperiod of time to 1,25, the portfolio Beta could be brought back to
the target (1,10) inthe following ways:
• Put additional money into the stock portfolio and hold cash. Diluting thestocks in portfolio
with the cash will reduce portfolio Beta, because cash hasBeta of 0. But in this case cash should
be only a temporary component in theportfolio rather than a long-term; Put additional money
into the stock portfolio and buy stocks with a Betalower than the target Beta figure. But the
investor may be is not able toinvest additional money and this way for rebalancing the portfolio
can becomplicated.
• Sell high Beta stocks in portfolio and hold cash. As with the firstalternative, this way reduces
the equity holdings in the investor’s portfolio
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• Sell high Beta stocks and buy low Beta stocks. The stocks bought could
be new additions to the portfolio, or the investor could add to existing
positions.
Indexing. This alternatives for rebalancing the portfolio are more frequentlyused by institutional
investors (often mutual funds), because their portfolios tend to belarge and the strategy of
matching a market index are best applicable for them.Managing index based portfolio investor
(or portfolio manager) eliminates concernabout outperforming the market, because by design, it
seeks to behave just like themarket averages. Investor attempts to maintain some predetermined
characteristics ofthe portfolio, such as Beta of 1,0. The extent to which such a portfolio deviates
fromits intended behaviors called tracking error.
Revising a portfolio is not without costs for an individual investor. Thesecosts can be direct costs
– trading fees and commissions for the brokers who cantrade securities on the exchange. With
the developing of alternative trading systems(ATS) these costs can be decreased. It is important
also, that the selling the securitiesmay have income tax implications which differ from country
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Strategic versus tactical asset allocation
An asset allocation focuses on determining the mixture of asset classes that ismost likely to
provide a combination of risk and expected return that is optimal for theinvestor. Asset allocation
is a bit different from diversification. It focus is oninvestment in various asset classes.
Diversification, in contrast, tends to focus more onsecurity selection – selecting the specific
securities to be held within an asset class.
Asset classes here is understood as groups of securities with similar characteristics andproperties
(for example, common stocks; bonds; derivatives, etc.). Asset allocationproceeds other
approaches to investment portfolio management, such as market timing(buy low, sell high) or
selecting the individual securities which are expected will bethe “winners”. These activities may
be integrated in the asset allocation process. Butthe main focus of asset allocation is to find such
a combination of the different assetclasses in the investment portfolio which the best matches
with the investor’s goals –expected return on investment and investment risk. Asset allocation
largely determinesan investor’s success or lack thereof. In fact, studies have shown that as much
as 90 %or more of a portfolio’s return comes from asset allocation. Furthermore, researchers
have found that asset allocation has a much greater impact on reducing total risk than
does selecting the best investment vehicle in any single asset category.
Two categories in asset allocation are defined:
 Strategic asset allocation;
 Tactical asset allocation.
Strategic asset allocation identifies asset classes and the proportions for thoseasset classes that
would comprise the normal asset allocation. Strategic asset allocationis used to derive long-term
asset allocation weights. The fixed-weightings approach instrategic asset allocation is used.
Investor using this approach allocates a fixed percentage of the portfolio to each of the asset
classes.

Generally,these weights are not changed over time. When market valueschange, the investor may
have to adjust the portfolio annually or after major marketmoves to maintain the desired fixed-
percentage allocation.
Tactical asset allocation produces temporary asset allocation weights thatoccur in response to
temporary changes in capital market conditions. The investor’sgoals and risk- return preferences
are assumed to remain unchanged as the assetweights are occasionally revised to help attain the
investor’s constant goals. Forexample, if the investor believes some sector of the market is over-
or under valuated.The passive asset allocation will not have any changes in weights of asset
classes inthe investor’s portfolio – the weights identified by strategic asset allocation are used.
Alternative asset allocations are often related with the different approaches torisk and return,
identifying conservative, moderate and aggressive asset allocation.The conservative allocation is
focused on providing low return with low risk; themoderate – average return with average risk
and the aggressive – high return and highrisk.