Portfolio Risk and

Performance Analysis

Essentials of Corporate Finance

Chapter 11

Materials Created by Glenn Snyder – San Francisco State University

 Topics
 Asset Management Firms
 Active vs. Passive Portfolio Management
 Roles of Risk and Performance
 Setting Up the Portfolio
 Diversification
 Systematic and Unsystematic Risk
 Stability and Portfolio Turnover
 Risk and Performance Analysis
 Risk Ratios
 The Importance of Beta
 Market Risk Premium
 Sharpe and Treynor Ratios
 Impact on Portfolio Management
 Career Advice for a Risk and Performance Analyst
February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 2
 Asset Management Firms
 An asset management firm is a company that
manages money, in the form of investments, for
their clients
 Essentially, these firms manage their client’s assets
 Asset management firms are typically…
 Mutual Fund Companies
 Pension Fund Companies
 Hedge Fund Companies
 Insurance Companies
 Subsidiaries of Commercial Banks

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 Active vs. Passive Portfolio Management

 Active Portfolio Management

 The portfolio manager invests in securities of their choosing
 The portfolio manager weights the securities as he or she
sees fit
 Keeping the portfolio within the restrictions stated in the
prospectus

 Passive Portfolio Management

 Portfolio securities are made of all securities in the market
(based on the portfolio’s investment objective)
 Portfolio securities are weighted based on each security’s
market capitalization
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 Roles of Risk and Performance
 Asset management companies typically have a risk
and performance group that is independent of the
portfolio management teams

 The role of the risk and performance group is

 To calculate portfolio performance and compare it
applicable index or benchmark
 To calculate risk metrics and analyze the portfolio to
determine if the return of the portfolio is adequate for the
amount of risk
 To analyze the impact of active portfolio management

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 Setting Up the Portfolio
 The portfolio manager will determine how to
structure the portfolio based on the restrictions and
guidelines in the portfolio’s prospectus
 Portfolio Prospectus includes:
 Fees
 Investment Objectives
 What type of securities it can hold
 Market Cap – the size of the securities it can hold
 The portfolio’s benchmark – the index it will be compared against
 Limitations on
 Ownership
 Sector/Industry/Country weighting
 Names of the portfolio managers
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 Diversification
 Why Diversify?
 Higher more consistent return
 Lower risk

 A diversified portfolio will hold a number of

securities
 Diversification is not having all of your eggs in one
basket
 Losses in some securities should be offset by
gains in others

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 Systematic and Unsystematic Risk
 Systematic Risk
 Market Risk – Risk inherent to the market
 Risk that cannot be eliminated

 Unsystematic (Company Specific) Risk

 Risk inherent to the specific security
 E.g. Microsoft Stock has risks beyond investing in the
stock market, such as anti-trust, competitors,
management succession, etc.
 Diversifiable – Can be eliminated through
diversification
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 Systematic and Unsystematic Risk
Percent risk = Variance of portfolio return
Variance of market return
100

80

Total Risk = Diversifiable Risk + Market Risk

(unsystematic) (systematic)
60

40 Portfolio of
U.S. stocks
27%
20 Total
risk Systematic
risk

1 10 20 30 40 50
Number of stocks in portfolio
By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the market’s
return (beta) is reduced to the level of systematic risk -- the risk of the market itself.
February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 9
 Systematic and Unsystematic Risk

 As more stocks are added, each new stock

has a smaller risk-reducing impact

 p falls very slowly after about 10 stocks are

included, and after 40 stocks, there is little, if
any, effect. The lower limit for p is about
27% = M

 M = Market Risk p = Portfolio Risk

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 Stability and Portfolio Turnover

 Portfolio stability is important to many long-

term investors

 Portfolio Turnover is a ratio that calculates

the percentage of securities that changed in
the portfolio over the past year
 If a portfolio has 100 securities and has a turnover
of 25%, then
 75 securities remained constant in the portfolio
 25 securities were bought/sold during the year
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 Risk and Performance Analysis
 Risk and performance analysts calculate on a
monthly basis how a portfolio performs
 Actual basis – actual returns of the portfolio and its
underlying securities
 Relative Basis – portfolio returns compared against the
portfolio’s benchmark or market index
 Peer Basis – many mutual funds are put into peer
universes and are ranked against competitive funds
invested in similar securities
 Risk Basis – ratios that determine performance per unit of
risk and compared against
 Risk free rate
 Benchmark or Index
 Peer portfolios

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 The Importance of Beta

 Beta (ß)
 A measure of market risk, to which the returns on
a given stock move with the market
 If beta = 1.0, average stock
 If beta > 1.0, stock riskier than average
 If beta < 1.0, stock less risky than average
 Most stocks have betas in the range of 0.5 to 1.5

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 Market Risk Premium

 Market Risk Premium (RPM)

 The additional return over the risk-free rate
needed to compensate investors for assuming an
average amount of risk

 RPM = (RM – RF) RM = market portfolio rate

with ß = 1.0

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 Sharpe and Treynor Ratios

 Sharpe Ratio – calculates the average

return over and above the risk-free rate
of return per unit of portfolio risk.

 Sharpe Ratio = (Ri – Rf) / i

Ri = Average return of the portfolio during period i

Rf = Average return of the risk-free rate during period i
i = standard deviation (risk) of the portfolio during period i

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 Sharpe and Treynor Ratios
 Treynor Ratio – calculates the average
return over and above the risk-free rate of
return per unit of the world market portfolio
risk.

 Treynor Ratio = (Ri – Rf) / i

Ri = Average return of the portfolio during period i

Rf = Average return of the risk-free rate during period i
i = The systematic (market) risk of the world market portfolio during
period i

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 Sharpe and Treynor Ratios

 Risk and performance analysts use Sharpe

and Treynor ratios to analyze the
effectiveness of the portfolio manager
 If the Sharpe and Treynor ratios are below 1.0,
then the portfolio manager is taking too much risk
for the return the portfolio is generating

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 Impact on Portfolio Management

 Risk and performance analysis impacts

portfolio management by:
 Guiding the portfolio manager to
 Take additional risk if the portfolio is underperforming its
peers and benchmark
 Take less risk if the Sharpe and Treynor ratios are below
1.0
 Increase diversification to reduce portfolio risk
 Analyzing portfolio management strategies and
their effectiveness

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 Career Advice for a Risk and
Performance Analyst
 CFA (Chartered Financial Analyst)
 The CFA is a 3 year certification that is required for most
risk and performance analysts and portfolio managers
 Sharpen your technical skills
 Highly math and science oriented
 Understand portfolio management
 Learn about portfolio management strategies, techniques,
and analysis
 Many large asset management companies will have
a management training program
 Highly Competitive
 Hands on training
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