CONTENTS

ASSIGNMENT TOPIC: PORTFOLIO MANAGEMENT ................................2

INTRODUCTION ................................................................................................2
TRADITIONAL INVESTMENT MANAGEMENT ........................................2
INTRODUCTION TO MODERN PORTFOLIO MANAGEMENT ..............3
MARKOWITZ PORTFOLIO MODEL ............................................................5
CAPM ( CAPITAL ASSET PRICING MODEL):W.F. SHARPE ..................7
APT MODEL ........................................................................................................8
PORTFOLIO MANAGEMENT PROCESS....................................................10
PORTFOLIO MANAGEMENT STRATEGIES ............................................12
PORTFOLIO REVISION & EVALUATION .................................................14
PORTFOLIO PERFORMANCE EVALUATION .........................................15
BIBLIOGRAPHY ...............................................................................................17

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ASSIGNMENT TOPIC: PORTFOLIO MANAGEMENT

INTRODUCTION
Portfolio is a group of financial assets such as shares, stocks, bonds, debt instruments,
mutual funds, cash equivalents, etc. A portfolio is planned to stabilize the risk of non-
performance of various pools of investment.

Portfolio Management refers to the science of analyzing the strengths, weaknesses,

opportunities and threats for performing wide range of activities related to the one‘s
portfolio for maximizing the return at a given risk. It helps in making selection of Debt
Vs Equity, Growth Vs Safety, and various other tradeoffs.

TRADITIONAL INVESTMENT MANAGEMENT

In finance, the notion of traditional investments refers to putting money into well-known
assets (such as bonds, cash, real estate, and equity shares) with the expectation of capital
appreciation, dividends, and interest earnings.

Traditional Investment management is the professional asset management of various

traditional assets (shares, bonds and cash) and other assets (e.g., real estate) in order to
meet specified investment goals for the benefit of the investors.

Traditional investments have the advantage of being easily understood and easily
benchmarked. As a result, evaluating the performance of long-only investments is
relatively straightforward. Another benefit is liquidity: typical long-only equity funds
hold highly liquid securities and most allow for daily subscriptions and redemptions.
These funds also have the advantage of transparency, with reporting on the underlying
holdings of most funds readily available to investors. Since long-only investment funds
are largely commoditized and track their benchmarks closely, there is pressure to keep
their fees low. This explains the recent explosion of exchange traded funds (ETFs), which
provide clearly defined benchmark exposure (usually based on underlying indices) with
very low fees.

The key risks of traditional investment management are that they are highly volatile and,
in certain market environments (such as secular bear markets and crisis situations), they
have the potential for large drawdowns and low or negative returns for prolonged periods
of time. Most long-only investment funds are required to be fully invested at all times and
are very limited in the tools they can use to hedge risks and exposures. In situations
where assets become overvalued (such as asset bubbles or manias), managers are forced

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to remain fully invested despite risk/reward scenarios that become skewed to the
downside. Another disadvantage of traditional investments is that their fee structures
usually do not align managers‘ interests with their investors.

Traditional asset managers generally allocate capital on a ‗long-only' basis to stocks,

bonds and cash. Portfolios are managed against a passive benchmark which they aim to
outperform. The relative weighting of positions tend to have little deviation from the
benchmark itself, resulting in very similar return profiles. Consequently, this makes it
difficult for traditional managers to make money when markets are falling.

Investment management process is the process of managing money or funds. The

investment management process describes how an investor should go about making
decisions. Investment management process can be disclosed by five-step procedure,
which includes following stages:

1. Setting of investment policy.

2. Analysis and evaluation of investment vehicles.

3. Formation of diversified investment portfolio.

4. Portfolio revision

5. Measurement and evaluation of portfolio performance.

INTRODUCTION TO MODERN PORTFOLIO MANAGEMENT

Modern Portfolio Management provides a methodology for portfolio choice based upon
modern risk management techniques and a clearer definition of the investment risk/return
profile to feature goal-based investing and probabilistic scenario optimisation.

The financial markets have undergone a period of distress that has strained the trusted
relationship between investors and financial advisors; new regulation has been forged to
push for higher levels of transparency and risk-based communication as part of
investment decision-making. This has ignited the quest for better portfolio optimization
techniques that can combine the added-value asymmetry of real products (as they
strongly contributed to pre-crisis budgets) with the life-cycle requirements of investors,
supported by intuitive graphical representation of seemingly complex mathematical
relationships between real portfolios and products as required by regulation. Modern
portfolio management tells us the importance of simulating real securities (especially

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fixed income and structured products) during the making of optimal portfolios, as well as
the importance of simulating financial investments over time to match in a transparent
way actual goals and constraints instead of relying solely upon past performance or
personal judgment.

Portfolio Management (PM) guides the investor in a method of selecting the best
available securities that will provide the expected rate of return for any given degree of
risk and also to mitigate (reduce) the risks. It is a strategic decision which is addressed by
the top-level managers.

The main objectives of portfolio management in finance are as follows:-

1) Security of Principal Investment : Investment safety or minimization of risks is one

of the most important objectives of portfolio management. Portfolio management not
only involves keeping the investment intact but also contributes towards the growth of its
purchasing power over the period. The motive of a financial portfolio management is to
ensure that the investment is absolutely safe. Other factors such as income, growth, etc.,
are considered only after the safety of investment is ensured.

2) Consistency of Returns : Portfolio management also ensures to provide the stability

of returns by reinvesting the same earned returns in profitable and good portfolios. The
portfolio helps to yield steady returns. The earned returns should compensate the
opportunity cost of the funds invested.

3) Capital Growth : Portfolio management guarantees the growth of capital by

reinvesting in growth securities or by the purchase of the growth securities. A portfolio
shall appreciate in value, in order to safeguard the investor from any erosion in
purchasing power due to inflation and other economic factors. A portfolio must consist of
those investments, which tend to appreciate in real value after adjusting for inflation.

4) Marketability : Portfolio management ensures the flexibility to the investment

portfolio. A portfolio consists of such investment, which can be marketed and traded.
Suppose, if your portfolio contains too many unlisted or inactive shares, then there would
be problems to do trading like switching from one investment to another. It is always
recommended to invest only in those shares and securities which are listed on major stock
exchanges, and also, which are actively traded.

5) Liquidity : Portfolio management is planned in such a way that it facilitates to take

maximum advantage of various good opportunities upcoming in the market. The portfolio

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should always ensure that there are enough funds available at short notice to take care of
the investor‘s liquidity requirements.

6) Diversification of Portfolio : Portfolio management is purposely designed to reduce

the risk of loss of capital and/or income by investing in different types of securities
available in a wide range of industries. The investors shall be aware of the fact that there
is no such thing as a zero risk investment. More over relatively low risk investment give
correspondingly a lower return to their financial portfolio.

7) Favorable Tax Status : Portfolio management is planned in such a way to increase

the effective yield an investor gets from his surplus invested funds. By minimizing the
tax burden, yield can be effectively improved. A good portfolio should give a favorable
tax shelter to the investors. The portfolio should be evaluated after considering income
tax, capital gains tax, and other taxes.

The objectives of portfolio management are applicable to all financial portfolios. These
objectives, if considered, results in a proper analytical approach towards the growth of
the portfolio. Furthermore, overall risk needs to be maintained at the acceptable level by
developing a balanced and efficient portfolio. Finally, a good portfolio of growth stocks
often satisfies all objectives of portfolio management.

MARKOWITZ PORTFOLIO MODEL

The author of the modern portfolio theory is Harry Markowitz who introduced the
analysis of the portfolios of investments in his article ―Portfolio Selection‖ published in
the Journal of Finance in 1952. The new approach presented in this article included
portfolio formation by considering the expected rate of return and risk of individual
stocks and, crucially, their interrelationship as measured by correlation. Prior to this
investors would examine investments individually, build up portfolios of attractive
stocks, and not consider how they related to each other. Markowitz showed how it might
be possible to better of these simplistic portfolios by taking into account the correlation
between the returns on these stocks.

The diversification plays a very important role in the modern portfolio theory. Markowitz
approach is viewed as a single period approach: at the beginning of the period the
investor must make a decision in what particular securities to invest and hold these
securities until the end of the period. Because a portfolio is a collection of securities, this
decision is equivalent to selecting an optimal portfolio from a set of possible portfolios.

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Essentiality of the Markowitz portfolio theory is the problem of optimal portfolio
selection.

Harry M. Morkowitz is credited with introducing new concepts of risk measurement and
their application to the selection of portfolios. He started with the idea of risk aversion‘ of
average investors and their desire to maximise the expected return with the least risk.
Morkowitz model is thus a theoretical framework for analysis of risk and return and their
inter-relationships.

He used the statistical analysis for measurement of risk and mathematical programming
for selection of assets in a portfolio in an efficient manner. His framework led to the
.concept of efficient portfolios. An efficient portfolio is expected to yield the highest
return for a given level of risk or lowest risk for a given level of return.

Markowitz generated a number of portfolios within a given amount of money or wealth

and given preferences .of investors for risk and return. Individuals vary widely in their
risk tolerance and asset preferences. Their means, expenditures and investment
requirements vary from individual to individual. Given the preferences, the portfolio
selection is not a simple choice of anyone security or securities, but a right combination
of securities.

Markowitz emphasised that quality of a portfolio will be different from the quality of
individual assets within it. Thus, the combined risk of two assets taken separately is not
the same risk of two assets together. Thus, two securities of TIS CO do not have the same
risk as one security of TIS CO and one of Reliance.

Risk and Reward are two aspects of investment considered by investors. The expected
return may vary depending on the assumptions. Risk index is measured by the variance or
the distribution around the mean, its range etc., which are in statistical terms called
variance and covariance.

The qualification of risk and the need for optimisation of return with lowest risk are the
contributions of Markowitz. This led to what is called the Modern Portfolio Theory,
which emphasises the trade off between risk and return. If the investor wants a higher
return, he has to take higher risk. But he prefers a high return but a low risk and hence the
need for a trade off.

Assumptions of Markowitz Theory The Modern Portfolio Theory of Markowitz is based

on the following assumptions:

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1. Investors are rational and behave in a manner as to maximise their. utility with a given
level of income or money.

2. Investors have free access to fair and correct information on the returns and risk.

3. The markets are efficient and absorb the information quickly and perfectly.

4. Investors are risk averse and try to minimise the risk and maximise return.

5. Investors base decisions on expected returns and variance or standard deviation of

these returns from the mean.

6. Investors prefer higher returns to lower returns for a given level of risk.

CAPM ( CAPITAL ASSET PRICING MODEL):W.F. SHARPE

CAPM was developed by W. F. Sharpe. CAPM simplified Markowitz‗s Modern Portfolio

theory, made it more practical. Markowitz showed that for a given level of expected
return and for a given feasible set of securities, finding the optimal portfolio with the
lowest total risk, measured as variance or standard deviation of portfolio returns, requires
knowledge of the covariance or correlation between all possible security combinations
(see formula 3.3).

When forming the diversified portfolios consisting large number of securities investors
found the calculation of the portfolio risk using standard deviation technically
complicated. Measuring Risk in CAPM is based on the identification of two key
components of total risk (as measured by variance or standard deviation of return):
Systematic risk

Unsystematic risk Systematic risk is that associated with the market (purchasing power
risk, interest rate risk, liquidity risk, etc.). Unsystematic risk is unique to an individual
asset (business risk, financial risk, other risks, related to investment into particular asset).
In CAPM investors are compensated for taking only systematic risk. Though, CAPM
only links investments via the market as a whole.

The essence of the CAPM: the more systematic risk the investor carry, the greater is his /
her expected return. The CAPM being theoretical model is based on some important
assumptions:

• All investors look only one-period expectations about the future;

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• Investors are price takers and they cant influence the market individually;

• There is risk free rate at which an investors may either lend (invest) or borrow money.

• Investors are risk-averse, • Taxes and transaction costs are irrelevant.

• Information is freely and instantly available to all investors. Following these

assumptions, the CAPM predicts what an expected rate of return for the investor should
be, given other statistics about the expected rate of return in the market and market risk
(systematic risk):

Several of the assumptions of CAPM seem unrealistic. Investors really are concerned
about taxes and are paying the commissions to the broker when buying or selling their
securities. And the investors usually do look ahead more than one period. Large
institutional investors managing their portfolios sometimes can influence market by
buying or selling big amounts of the securities. All things considered, the assumptions of
the CAPM constitute only a modest gap between the theory and reality. But the empirical
studies and especially wide use of the CAPM by practitioners show that it is useful
instrument for investment analysis and decision making in reality.

APT MODEL

Arbitrage Pricing Theory (APT) APT was proposed ed by Stephen S.Rose and presented
in his article „The arbitrage theory of Capital Asset Pricing―, published in Journal of
Economic Theory in 1976. Still there is a potential for it and it may sometimes displace
the CAPM. In the CAPM returns on individual assets are related to returns on the market
as a whole. The key point behind APT is the rational statement that the market return is
determined by a number of different factors.

These factors can be fundamental factors or statistical. If these factors are essential, there
to be no arbitrage opportunities there must be restrictions on the investment process. Here
arbitrage we understand as the earning of riskless profit by taking advantage of
differential pricing for the same assets or security. Arbitrage is is widely applied
investment tactic.

APT states, that the expected rate of return of security J is the linear function from the
complex economic factors common to all securities and can be estimated using formula:

E(rJ) = E(ŕJ) + β1J I1J + β2J I2J + ... + βnJ InJ + εJ , (3.6)

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here: E(rJ) - expected return on stock J;

E(ŕJ) - expected rate of return for security J, if the influence of all factors is 0;

IiJ - the change in the rate of return for security J, influenced by economic factor i (i = 1,
..., n);

βiJ - coefficient Beta, showing sensitivity of security‘s J rate of return upon the factor i
(this influence could be both positive or negative);

εJ - error of rounding for the security J (expected value – 0).

It is important to note that the arbitrage in the APT is only approximate, relating
diversified portfolios, on assumption that the asset unsystematic (specific) risks are
negligable compared with the factor risks. There could presumably be an infinitive
number of factors, although the empirical research done by S.Ross together with R. Roll
(1984) identified four factors – economic variables, to which assets having even the same
CAPM Beta, are differently sensitive:

• inflation;

• industrial production;

• risk premiums;

• slope of the term structure in interst rates.

In practice an investor can choose the macroeconomic factors which seems important
and related with the expected returns of the particular asset. The examples of possible
macroeconomic factors which could be included in using APT model :

• GDP growth;

• an interest rate;

• an exchange rate;

• a defaul spread on corporate bonds, etc.

Including more factors in APT model seems logical. The institutional investors and
analysts closely watch macroeconomic statistics such as the money supply, inflation,
interest rates, unemployment, changes in GDP, political events and many others.

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PORTFOLIO MANAGEMENT PROCESS

Three elements in managing any business process are planning, execution, and feedback.
These same elements form the basis for the portfolio management process as depicted in
the figure below.
1. The Planning Step :The planning step is described in the four leftmost boxes in
Exhibit 1-1. The top two boxes represent investor-related input factors, while the bottom
two factors represent economic and market input.

1.1. Identifying and Specifying the Investor’s Objectives and Constraints :The first
task in investment planning is to identify and specify the investor‘s objectives and
constraints. Investment objectives are desired investment outcomes. In investments,
objectives chiefly pertain to return and risk. Constraints are limitations on the investor‘s
ability to take full or partial advantage of particular investments.

1.2. Creating the Investment Policy Statement: Once a client has specified a set of
objectives and constraints, the manager‘s next task is to formulate the investment policy
statement

2. The Execution Step The execution step is represented by the ‗‗portfolio construction
and revision‘‘ box in Exhibit 1-1. In the execution step, the manager integrates
investment strategies with capital market expectations to select the specific assets for the
portfolio (the portfolio selection/composition decision).

Portfolio managers initiate portfolio decisions based on analysts‘ inputs, and trading
desks then implement these decisions (portfolio implementation decision).

Subsequently, the portfolio is revised as investor circumstances or capital market

expectations change; thus, the execution step interacts constantly with the feedback step.
In making the portfolio selection/composition decision, portfolio managers may use the
techniques of portfolio optimization. Portfolio optimization—quantitative tools for
combining assets efficiently to achieve a set of return and risk objectives—plays a key
role in the integration of strategies with expectations and appears in Exhibit 1-1 in the
portfolio construction and revision box.

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3. The Feedback Step In any business endeavor, feedback and control are essential
elements in reaching a goal. In portfolio management, this step has two components:
monitoring and rebalancing, and performance evaluation.

3.1. Monitoring and Rebalancing Monitoring and rebalancing involve the use of
feedback to manage ongoing exposures to available investment opportunities so that
the client’s current objectives and constraints continue to be satisfied. Two types of
factors are monitored: investor-related factors such as the investor’s circumstances, and
economic and market input factors.

3.2 Performance Evaluation: Investment performance must periodically be evaluated

by the investor to assess progress toward the achievement of investment objectives as
well as to assess portfolio management skill. The assessment of portfolio management
skill has three components. Performance measurement involves the calculation the
portfolio’s rate of return. Performance attribution examines why the portfolio
performed as it did and involves determining the sources of a portfolio’s performance.
Performance appraisal is the evaluation of whether the manager is doing a good job
based on how the portfolio did relative to a benchmark (a comparison portfolio).

PORTFOLIO MANAGEMENT STRATEGIES

Portfolio Management Strategies refer to the approaches that are applied for the efficient
portfolio management in order to generate the highest possible returns at lowest possible
risks. There are two basic approaches for portfolio management including Active
Portfolio Management Strategy and Passive Portfolio Management Strategy.
Active Portfolio Management Strategy
The Active portfolio management relies on the fact that particular style of analysis or
management can generate returns that can beat the market. It involves higher than
average costs and it stresses on taking advantage of market inefficiencies. It is
implemented by the advices of analysts and managers who analyze and evaluate market
for the presence of inefficiencies.
The active management approach of the portfolio management involves the following
styles of the stock selection.
Top-down Approach: In this approach, managers observe the market as a whole and
decide about the industries and sectors that are expected to perform well in the ongoing

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economic cycle. After the decision is made on the sectors, the specific stocks are selected
on the basis of companies that are expected to perform well in that particular sector.

Bottom-up: In this approach, the market conditions and expected trends are ignored and
the evaluations of the companies are based on the strength of their product pipeline,
financial statements, or any other criteria. It stresses the fact that strong companies
perform well irrespective of the prevailing market or economic conditions.

Passive Portfolio Management Strategy

Passive asset management relies on the fact that markets are efficient and it is not
possible to beat the market returns regularly over time and best returns are obtained from
the low cost investments kept for the long term.
The passive management approach of the portfolio management involves the following
styles of the stock selection.
Efficient market theory: This theory relies on the fact that the information that affects
the markets is immediately available and processed by all investors. Thus, such
information is always considered in evaluation of the market prices. The portfolio
managers who follows this theory, firmly believes that market averages cannot be beaten
consistently.

Indexing: According to this theory, the index funds are used for taking the advantages of
efficient market theory and for creating a portfolio that impersonate a specific index. The
index funds can offer benefits over the actively managed funds because they have lower
than average expense ratios and transaction costs.
Apart from Active and Passive Portfolio Management Strategies, there are three more
kinds of portfolios including Patient Portfolio, Aggressive Portfolio and Conservative
Portfolio.
Patient Portfolio: This type of portfolio involves making investments in well-known
stocks. The investors buy and hold stocks for longer periods. In this portfolio, the
majority of the stocks represent companies that have classic growth and those expected to
generate higher earnings on a regular basis irrespective of financial conditions.

Aggressive Portfolio: This type of portfolio involves making investments in ―expensive

stocks‖ that provide good returns and big rewards along with carrying big risks. This
portfolio is a collection of stocks of companies of different sizes that are rapidly growing
and expected to generate rapid annual earnings growth over the next few years.

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Conservative Portfolio: This type of portfolio involves the collection of stocks after
carefully observing the market returns, earnings growth and consistent dividend history.

PORTFOLIO REVISION & EVALUATION

Portfolio revision is the process of selling certain issues in portfolio and purchasing new
ones to replace them. The main reasons for the necessity of the investment 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 securities in the
portfolio often change in risk-return characteristics and their diversification 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 decisions are made in
dynamic investment environment, where changes occur permanently. The key
macroeconomic indicators (such as GDP growth, inflation rate, interest rates, others), as
well as the new information about industries and companies should be observed by
investor on the regular basis, because these changes can influence the returns and risk of
the investments in the portfolio. Investor can monitor these changes using various sources
of information, especially specialized websites (most frequently used are presented in
relevant websites). It is important to identify he major changes in the investment
environment and to assess whether these changes should negatively influence 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, following
aspects must be taken into account:

• Change in wealth
• Change in time horizon

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• 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 they generally are
related with the noticeable changes in investor‘s portfolio.

Rebalancing a portfolio is the process of periodically adjusting it to maintain certain

original conditions. Rebalancing reduces the risks of losses – in general, a rebalanced
portfolio is less volatile than one that is not rebalanced. Several methods of rebalancing
portfolios are used:

1) Constant proportion portfolio;

2) Constant Beta portfolio;

3) Indexing.

PORTFOLIO PERFORMANCE EVALUATION

Portfolio performance evaluation involves determining periodically how the portfolio

performed in terms of not only the return earned, but also the risk experienced by the
investor. For portfolio evaluation appropriate measures of return and 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 by adding the
markets value of all the securities held at that particular time. The market value 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.

In selecting benchmark portfolios investor should be certain that they are relevant,
feasible and known in advance. The benchmark should reflect the objectives of the
investor.

The portfolio performance evaluation involves the determination of how a managed

portfolio has performed relative to some comparison benchmark. Performance evaluation
methods generally fall into two categories, namely conventional and risk-adjusted

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methods. The most widely used conventional methods include benchmark comparison
and style comparison. The risk-adjusted methods adjust returns in order to take account
of differences in risk levels between the managed portfolio and the benchmark portfolio.
The major methods are the Sharpe ratio, Treynor ratio, Jensen‘s alpha, Modigliani and
Modigliani, and Treynor Squared. The risk-adjusted methods are preferred to the
conventional methods.

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 BIBLIOGRAPHY

I am very thankful to all my friends and our teachers who have guided me a lot
and helped me in completing this assignment .The data and information which I
have used as reference in completing my assignment have been taken from the
following sources as stated below -:

REFERENCES

1) TEXT BOOK: Investment Analysis and Portfolio Management

By Prasanna Chandra

2) www.nptel.ac.in

3) www.cfainstitute.org

4) Business Standard

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