THE PROCESS OF

PORTFOLIO MANAGEMENT
Jeet R.Shah
-

M.Com ,CFP CM ,Ph.D

 The Life of every man is a diary in which he means to
write one story, and writes another; and his humblest
hour is when he compares the volume as it is with
what he vowed to make it.

- J.M. Barrie

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The Seven Step Process

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 Specification Of Investment Objectives and Constraints
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 Objectives :-
1. Return Requirements –
 Income
 Growth
 Stability
2. Risk Tolerance

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 Specification Of Investment Objectives and
Constraints
5

 Constraints :
1. Liquidity
2. Investment Horizon
3. Taxes
4. Regulations
5. Unique circumstances

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 Selection of Asset Mix
6

 Determine the proportions

e = mc 2
e = energy that sets your wealth growing
m = market force
c = asset allocation
Many studies have shown that 93 % of the returns can
be explained by broad asset allocation and only 7
% by security selection , market timing etc

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 AA
7

Conventional wisdom :-
1. Higher risk tolerance more of risky assets .
2. Longer the investment horizon higher the
proportion of risky assets.
3. More young more risk

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 AA
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 Benjamin Graham :- 50 : 50
 John Bogle : Balanced AA Model

Older
70 : 30 50 : 50

Age
80 : 20 60 : 40

Younger

Accumulation Distribution

Investment Goal
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 Formulation of Portfolio Strategy
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1. Active portfolio Strategy

 Market Timing
 Sector Rotation
 Security Selection
 Use of specialised concept

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 Sector Rotation –
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- The Stock Market and the Business Cycle

peak

trough

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 Sector Rotation –
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- The Stock Market and the Business Cycle
Basic
Industries
Excel

Consumer
Consumer peak Staples Excel
Durables
Excel

Capital
trough Goods Excel
Financial
Stocks Excel
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 Selection Of Securities
12

 Bonds (FRA ‘s )
1. YTM
2. Risk of default
3. Tax shield
4. Liquidity

 Stocks

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 Formulation of Portfolio Strategy
13

2. Passive Strategy
Two Guidelines :-
1. Create a well diversified portfolio at a pre –
determined level of risk .
2. Hold the portfolio relatively unchanged over time
, unless it becomes inadequately diversified or
inconsistent with the investors risk – return
preferences

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 5.Portfolio Execution
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 How to invest ? RCA v/s VA

 With whom to invest ?
 Cash Management

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 6.Portfolio Revision

Portfolio rebalancing
(Reviewing the stock – bond mix) Portfolio Upgrading

1. Buy and Hold 1. Re –assessing the risk – return characteristics of

various securities .
2. Constant Mix Policy 2. Selling overvalued and buying the undervalued
ones.
3. Portfolio Insurance Policy

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 7.Performance Evaluation
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 Rate of return
 Risk

 Performance Measure (Based on

Investments – Bodie, Kane ,Marcus, Mohanty)

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 Factors Leading to Abnormal Performance
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 Market timing

 Superior selection
 Sectors or industries

 Individual companies

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 Risk Adjusted Performance: Sharpe
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1) Sharpe Index
rp - rf

p
rp = Average return on the portfolio
rf = Average risk free rate

p = Standard deviation of portfolio return

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 2
M Measure
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 Developed by Modigliani and Modigliani

 Equates the volatility of the managed portfolio with the
market by creating a hypothetical portfolio made up
of T-bills and the managed portfolio
 If the risk is lower than the market, leverage is used
and the hypothetical portfolio is compared to the
market

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 2
M Measure: Example
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Managed Portfolio: return = 35% standard deviation = 42%
Market Portfolio: return = 28% standard deviation = 30%
T-bill return = 6%
Hypothetical Portfolio:
30/42 = .714 in P (1-.714) or .286 in T-bills
(.714) (.35) + (.286) (.06) = 26.7%
M2 = 26.7 % -28% = -1.3%
Since this return is less than the market, the managed portfolio
underperformed

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 Risk Adjusted Performance: Treynor
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2) Treynor Measure

rp - rf
ßp

rp = Average return on the portfolio

rf = Average risk free rate
ßp = Weighted average  for portfolio
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 Risk Adjusted Performance: Jensen
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3) Jensen’s Measure
 p= rp - [ rf + ßp ( rm - rf) ]
 p = Alpha for the portfolio
rp = Average return on the portfolio
ßp = Weighted average Beta
rf = Average risk free rate
rm = Avg. return on market index port.
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 Appraisal Ratio
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Appraisal / Information Ratio =

p / (ep)

Appraisal Ratio divides the alpha of the portfolio by

the nonsystematic risk
Nonsystematic risk (tracking error )could, in theory,
be eliminated by diversification

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 Tracking error
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 standard deviation of the difference between returns of the portfolio and

the returns of the index
 A high IR can be achieved by having a high return in the portfolio, a low
return of the index and a low tracking error.
For example:
Manager A might have returns of 13% and a tracking error of 8%
Manager B has returns of 8% and tracking error of 4.5%
The index has returns of -1.5%
Manager A's IR = [13-(-1.5)]/8 = 1.81
Manager B's IR = [8-(-1.5)]/4.5 = 2.11
Manager B had lower returns but a better IR. A high ratio means a
manager can achieve higher returns more efficiently than one with a low
ratio by taking on additional risk. Additional risk could be achieved
through leveraging.

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Quiz
Portfolio P Portfolio M

Avg . Return 35% 28%

Beta 1.2 1

SD 42% 30%

TE 18% 0

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 Solution
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 SR
1. Sp= 0.69
2. Sm=0.733
 TR
1. Tp= 24.2
2. Tm=22
 Alpha
1. Ap= 2.6
2. Am=0
 IR
1. IRp= 0.144
2. IRm=0

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 Asset Allocation
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1. Strategic AA
2. Tactical AA
3. Drifting AA
4. Balanced AA
5. Dynamic ( insured ) AA

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 Asset Allocation
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1. Strategic AA :-
 Forecast r , SD , betas etc
 Draw Efficient Frontier
 Draw ID curves
 Choose Optimal Portfolio

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 Asset Allocation
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2. Tactical AA :-
 The objective of TAA is to enhance the performance of
the portfolio through an opportunistic shift in the asset
mix in response to changing patterns of reward in the
capital market .
 TAA entails market timing .
 The only difference between traditional market timing
an TAA ( it’s modern version ) is that the later is
supposed to be analytically disciplined and based on
objective measures of value.

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 Asset Allocation
30

3.Drifting AA :-
 DAA advocates that initial portfolio be left

undisturbed.
 It is essentially a “buy and hold” policy.

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 Asset Allocation
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4. Balanced AA
 BAA calls for a periodical rebalancing of the

portfolio to ensure that the stock – bond mix

remains same .
 It does relatively poor in up markets.

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 Asset Allocation
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5.Dynamic ( insured ) AA
 It involves shifting the asset mix mechanically in response
to changing market conditions .
 e. g Constant Proportion Portfolio Insurance (CPPI ) policy.

Here ,
Investment in stock = m (Portfolio value – Floor )
where , m > 1
 Provides good down side protection & performs well in up
markets.

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 Portfolio composition and payoffs of the three
policies
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 Assumptions :-
1. Stock Bond Mix = 50 : 50
2. Total Portfolio = Rs.1,00,000 /-
3. CPPI
Investment in stock = 2 (Portfolio value – 75,000 )

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Portfolio composition and payoffs of the three
policies
Market Level is 100
Portfolio

Stocks Bonds Total

Buy and Hold 50,000 50,000 1,00,000

Constant Mix 50,000 50,000 1,00,000

CPPI 50,000 50,000 1,00,000

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Portfolio composition and payoffs of the three
policies
Markets fall to 80

Before Rebalancing After Rebalancing

Stocks Bonds Total Stocks Bonds Total

Buy and 40000 50000 90000 40000 50000 90000

Hold
Constant 40000 50000 90000 45000 45000 90000
Mix

CPPI 40000 50000 90000 30000 60000 90000

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Portfolio composition and payoffs of the three
policies
Markets rises to 100

Before Rebalancing After Rebalancing

Stocks Bonds Total Stocks Bonds Total

Buy 50000 50000 100000 50000 50000 100000

and
Hold
Constant 56250 45000 101250 50625 50625 101250
Mix

CPPI 37500 60000 97500 45000 52500 97500

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37

“Thy who knows himself conquers the world”

Dhanyawad

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