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PORTFOLIO MANAGEMENT THEORY Question 1 Econometric approach is one of the most formal short-term forecasting approaches. This approach tries to describe the present economic condition as a function of certain policies and variables and the economic relationship attached to these variables. Explain the advantages and problems of using econometric models Answer 1 Advantages of using econometric Models Following are the main advantages of using models: Testing of hypothesis and idea of an economic indicator. Examples: Test to know how low interest rates stimulate growth and whether wages can be used as a predictor of inflation. Estimating sensitivities. Example: Would one percentage point rise in the US Consumer Price Index typically translate into I a-year bond yield? Developing internally consistent forecasts. Example: When researchers are using a judgmental approach, they may fail to see that something they are implying about income growth does not jibe with their assumption on employment growth. Running simulation of complex scenario. Example: A government economist may need to find out what happens if interest rates and government spending are both cut. Problems in the Use of Models The main problem in using the models is the lack of consistency of the data. Investment professionals should be aware of this before any decision is taken based on these models. Other problems that arise in these models are: Implausible Result: A number of variables used to isolate one may cause an implausible result. If any of the variables among them is working then the prediction might be quite unreliable. Statistical VS. Real World: The other problem is the difference in the statistical result and the result in the real world. Error in the Underlying Data: Past data used may be good predictors of some variable but in certain cases where variables are subject to huge revision they create problems when using models. Assumption: Assumption is the most vital problem in using models. It is not possible to predict every variable, so every model has some assumptions. So it is suggested to be careful while using assumptions. Structural Changes: Most of the models assume that past relationships have some, validity in predicting future relationships but this prediction may not be significant where fundamental structure changes due to rapidly changing economies. Simultaneity: Simultaneity is the term used to measure the influence of one variable on another when that second variable also influences the first one. These occurrences can create confusion in using statistical models.

zero investment portfolios with a positive net return. On the other hand. Along with the required rate of return. if the required return is less than the expected return the security is underpriced and one can go long on this stock. iii. One can increase your returns. Explain how it can be used for active and passive strategies. This is because there can be more than one source of return generation. a portfolio of stocks is created such that performance of this portfolio closely reflects the performance of the underlying index. This is because. the data that frequently changes due to some economic factors like population growth. Index fund is a widely used strategy of passive management of a portfolio. This way APT can be used to identify the mispriced securities and adopt a suitable strategy.e. then multi-index model is to . trend properties. the security is overpriced and one can go short on the stock. Answer 2 APT and Active Management i. which are important in determining the equilibrium return. two securities having same sensitivity to the market index (beta) might have different sensitivities to other factors. Such a portfolio can be created using the single-index model by finding a portfolio that has a beta of one with the index and that has minimum residual variance (risk) for a given portfolio size. This is nothing but the arbitrage mechanism illustrated above. One of the important uses of multi-index model in active management of portfolios is making factor bets. If the source of return is only one factor. APT is used to estimate the required return on a stock based on the various return generating factors and sensitivity of the security to these factors. ii. Under this strategy. The advantage of APT over CAPM is that the required return can be more accurately estimated with the APT model. APT and Passive Management i. one can take a position so as to benefit by one’s expectations. expected return on the stock is also estimated.have a number of problems. By using multi-index model the portfolio can be matched with the index in terms of all important sources of return movements. This is similar to the CAPM model. If you are able to correctly identify underpriced and overpriced assets using the APT you can construct zero risk.Time Series Data: The time series data i. That is. If the required return is greater than the expected return. If one’s expectations are against the market expectations with respect to some factor. the correlation between the returns on the portfolio and the index can be improved. Using a multi-index model rather than a single index model in construction of the index portfolio can help in better tracking the performance of the index. Finally. GDP growth sometimes.. These data may violate some assumptions due to their. thereby capturing the performance of the index through our portfolio. betting opportunities can be increased. Suppose inflation expected by the market is 6 percent but you believe it to be 8 percent. By increasing the number of factors in the model. Another application of APT is in identifying mispriced securities. By increasing your exposure to stocks/portfolios whose returns are positively related with inflation. multi-index model can be used in long-short investment strategy or risk neutral investment strategy. Question 2 Arbitrage pricing theory has wide applications in corporate finance and investment management. market factor.

This objective can be achieved only through a multi-index model. Suppose. a roll over can be effected but this practice is costly. But it is safe to assume that returns are generated by more than one factor. If single index is used to construct the portfolio. Options on the exchanges are standardized: only a few exercise prices and maturities are used. After each 6-month period. Some times it may be desired by the fund manager to track the performance of the index and take position with respect to some additional risks. The effective cost of the protection is only known when the last premium is paid and it depends largely on the moves of the underlying asset until maturity of the protection (this is called a path dependent insurance and this property is clearly undesirable). Static portfolio insurance is a type of portfolio insurance. ii. for example. sensitivity of the portfolio to other important factors may be missed and multi-index model can improve tracking an index. Same is the case when a fund manager. the total risk is not the sum of the individual risks and it would be expensive and unnecessary to purchase puts for each individual risk. cash outflow also increases. Option on the underlying asset may not exist. In Switzerland. Sometimes only American options are available. This approach of portfolio protection is portfolio insurance. If inflation increases. In the case of a portfolio. Discuss the practical problems with static portfolio insurance. what is needed is in fact a put for the whole portfolio. . He could form a portfolio that has more or less same response to all the factors affecting the index except the inflation and had a minimal residual risk. as a matter of policy. He might wish to hold a portfolio that has a zero or preferably positive sensitivity to inflation. Question 3 The investor wants the asymmetric protection of his portfolio. the underlying asset used for the options may differ from the portfolio to be insured. For these reasons. which are not captured in the index. Manager of such a fund would like to have cash flows positively related to inflation. there is no liquidity on the desired option beyond 6 months. Suppose. other insurance strategies have been developed in a dynamic (rather than static) framework. Take the case of a pension fund whose cash outflows are indexed to inflation. must include certain stocks in the portfolio. Answer 3 Practical Problems with Static Portfolio Insurance: Static portfolio insurance suffers from a series of major problems: The maximum maturity quoted is often much shorter than the desired horizon for the protection and is also rarely liquid enough.better than the single index model. but the investor cares only about the value of his/her portfolio at expiration and would be happier with European options. Moreover. iii. listed puts do not exist for all securities. as a matter of policy a fund manager would like to avoid exposure to some sectors. Liquidity on the desired options may fall short. American options can be more expensive than the European ones. Another application where APT comes handy is construction of index-portfolios where some of the stocks in the index are deliberately kept out. so that its value will be guaranteed not to fall under a floor value when the market goes down while it will be free to appreciate when the market goes up.

In this regard. There is no other basis. This forces the portfolio manager to increase the weight of liquid investments in the asset mix. the risk taking ability of the investor increases with increase in wealth. As people get rich. some events may take place that may have an impact on the time horizon of the investor. after turning 55 years of age. According to this method. So. It says that people can afford to take more risk as they grow rich and benefit from its rewards. CHANGES IN LIQUIDITY NEEDS Investors very often ask the portfolio manager to keep enough scope in the portfolio to get some cash as and when they want. deaths. For example. In case three is a deficit. then you may go for conservative or safe investments. while they can afford. etc. 100% Common Stocks for Long Run This strategy involves placing all the long-term investments entirely in equity stocks. The happening or non happening of the events will naturally have its effect. the amount available for investment in fixed income and/or growth securities that actually help in achieving the goal of the investor. The fund manager should observe the changes in the attitude of the investor towards risk and try to understand them in a proper perspective.all have their own impact on the investment horizon. That is. for it. the portfolio manager should modify the portfolio accordingly. he may not take retirement.proceeds of properties. CHANGE IN THE TIME HORIZON As time passes. scientific or otherwise. investments will have to be made aggressive and the degree of aggressiveness depends on the amount of deficit and the amount now available for . sale of used vehicle. discuss the important factors affecting the client that make it necessary to change the portfolio composition. in practice. This method generally gets into popularity when stock markets are on a high and falls in popularity along with the markets. they may become conservative and more risk-averse. Births. gets reduced. He may extend the investment horizon. if his health improves. many other important events in a person's life that may force a change in the investment horizon. Question 5 The portfolio manager needs to be alert and sensitive to the changes in the requirements of the client. the money taken out today from the portfolio means that the . If the investor turns to be conservative after making huge gains. The outflows expected in future should then be reduced from the inflows. But. (need for portfolio revision) Answer 5 CHANGE IN WEALTH According to the utility theory. There are. they may not be willing. they become more concerned about losing the newly acquired riches than getting richer. of course. Risk Tolerance Method This method ignores the financials and focuses on the psychology of the individual. But. a risk-averse person should invest all or most of the money available in low risk investments and a risk-lover may invest in high risk instruments.-considering his delicate health. Due to this. inheritance of property. a person may have planned for an early retirement. marriages and divorces . If there is a surplus. as he does not need annuities until he retires.

The unexpected changes in the inflation rate are also significant to the stock market returns. So. CHANGING RETURN PROSPECTS It is assumed that other things being equal. CHANGES IN TAXES It is said that there are only two things certain in this world . unexpected changes in the rate of inflation may have its effect on pricing of stocks in either direction. the changes in prices accompany changes in the return prospects. The nominal yield then rises so as to counteract the loss. Further. As per the studies of Fama. With each negative fluctuation in the bond's price. and the bond prices fall. The above facts also apply to individual securities. It is to be noted here. that the simple measures of inflation. The disciplined investment decisions provide value by providing the objective basis to confidently pursue uncomfortable investments. Say. BULL AND THE BEAR MARKETS The fluctuations in the stock markets often provide opportunities for the investors in both positive as well as negative aspects. Let us consider the period one where stock return is more than bond in contrast to the period two where the bond has better return than the stock. portfolio managers have to constantly look out for changes in the tax structure and make suitable changes in the portfolio composition. This provides the opportunity to buy stock at period one and sell the stock in period two to shift to the bond market. It remains at the hands of the investors to protect themselves against discomforts that arise in the markets. Alternatively the rates of changes in producer prices. its yield rises but its total .death and taxes. the bond investors face a reduced real yield on the bonds. and the nature of other investments. though it has less effect on long-term bond yields. The stock market's demand for funds arises basically out of the money supply' growth and the underlying policy that determines it. which actually result in CPI inflation provides a better measure. when everything is going well.amount and the return that would have been earned on it are no longer available to achieve the investor's goal. but during downtrends in the economies. When the inflation rate increases beyond expectations. This is possible only when the investors have proper knowledge and discipline in the investment process. The specifics of tax planning depend on the nature of income of the investor. and signals for future returns. INFLATION RATE CHANGES Inflation has its unique way of affecting the stock markets. time. the stock prices fall. the monetary policy 'also has an immediate effect on the money markets. the markets also perform well. such as Consumer Price Index (CPI). The only uncertainties regarding them relate to thedate. If there is a change in the minimum holding period for long-term capital gains. The rate of tax under long-term capital gains is usually lower than the rate applicable to income. it may lead to revision. The monetary and liquidity constraints finally influence a toll on the stock markets. are not that reliable predictors of future returns on stocks and bonds. THE CENTRAL BANK POLICY It is to be always kept in mind that the central bank and the other banks enjoy a greater power in influencing liquidity in the capital markets. With taxes you have the additional aspect of the amount or rate. place and mode.

It is a residual factor. The statistical significance of each of the factors is studied. Long-term interest rates: The change in the ten-year Treasury yields is taken. the residual market beta and other market factors. value lesser than –5 and greater than +5 are rejected. Identification of the factors The first step for estimating the parameters for the RAM model of Solomon Brothers is to run multiple regression for each stock of the universe being considered. the factors are standardized. Short-term interest rates: The change in the 1-month Treasury bill rate is taken. It means that. The dependent variable for the regression is the stock return and the independent variables are the above six factors. Similarly. all other things remaining the same. Value of the currency: The change in value of the domestic currency is taken. but also review of the .Business cycle: The factor representing the stage of the business cycle is taken as the difference between the yield on top rated corporate bonds of a 20-year maturity and the 20-year Treasury bonds. This represents the change in relative attractiveness of the financial assets and may cause investors to change the portfolio mix. This results in values that are too wide away from the mean being rejected. If the value of the regression coefficient of a stock for one of the factors is zero. there is another factor considered. Answer 7 The process of asset allocation described above is referred to as integrated asset allocation. The spread between the two falls during economic booms and rises during economic recessions. Question 7 Asset allocation is one of the crucial steps in the process of portfolio building. For example. then calculating the difference between the values of the factors obtained from the regression and the average. you will realize that the process involves not only integrating all the aspects. Discuss the different types of asset allocation. it means that the stock has average sensitivity to that factor. The name is justified. let us say that a stock has a positive value for change in the value of the domestic currency. the stock will under perform the market. Deviations from zero indicate higher sensitivity to that factor. all other things remaining constant. a negative value indicates that. If you recall the process explained once again. for all the stocks in the universe being considered. considering that all the major aspects of asset allocation have been included in the analysis. From the standardized values thus obtained. Inflation shock: The difference between the expected inflation and the actual inflation is taken. called `residual market beta’ by the proponents of this model. in a systematic manner. The factor is intended to capture the other macroeconomic factors remaining after considering the above six. Apart from these six main factors. The standardized multiple regression coefficient of a stock is then taken as the sensitivity of that stock to that macroeconomic factor. Standardization involves finding the average and the standard deviation of each of the factors. The expected inflation is estimated based on another model developed by the proponents of this model. and finally dividing the difference with the standard deviation. the stock will provide better returns than the market if the value of the domestic currency increases. Then. as measured by a trade-weighted basket of currencies.

we no longer have the step relating to prediction of future on an ongoing basis as. . Within equities and bonds. the allocation to risky assets is increased. Similarly. Generally. This type of asset allocation is based on the assumption that the risk tolerance of the investors is highly sensitive to the changes in their net worth. tactical asset allocation and insured asset allocation. Insured asset allocation is very similar to tactical asset allocation in that it is applied routinely as part of active asset management. Strategic asset allocation is generally undertaken periodically. Insured Asset Allocation Insured asset allocation is aimed at achieving the objectives of the investor without depending on market timing. These are assumed to be constant during the period of analysis (planning horizon).allocation. once predicted. Tactical Asset Allocation Tactical asset allocation is performed routinely. long run predictions regarding the capital markets are used. bonds and cash. This should not be confused with a buy-and-hold strategy. It is based on the implicit assumption that risk-return characteristics of the asset classes remain constant. It is aimed at benefitting from short run underpricing and overpricing of assets. based on the goal). For example. If the value of the assets or net worth crosses the floor. The asset mix thus chosen by the investor is taken as the long run or the policy asset mix. Such a strategy is referred to as constant asset mix strategy. the process is dynamic as well as integrated. In strategic asset allocation. lower the allocation to risky assets. In tactical asset allocation. Strategic Asset Allocation Strategic asset allocation is also referred to as long run asset allocation or policy asset allocation. but are also superior. the asset mix is made conservative. the conditions are taken to be constant. asset allocation can be of three types – strategic asset allocation. as already explained. as can now be seen. In a constant mix strategy. in the asset allocation process. Tactical asset allocation decisions are often contrarian. A minimum value of the net worth or asset value (as the case may be. In this type of asset allocation. it is ensured that the floor value is achieved. is called the floor. They are not. Sometimes it may be desirable to skip some of the steps in the allocation process. relatively few and broad categories of assets are considered. higher the value. 10% in bonds and 90% in stocks to 10% in stocks and 90% in bonds. This type of asset allocation does not. They are made with a view to benefit from a steep fall or rise in the market. Thus. as part of active asset management. the risk tolerance of the investor is also assumed to remain constant during this period. one may consider the mix of stocks and bonds in various proportions starting from say. At any rate. unlike tactical asset allocation. focus on the desirability of investing in more risky assets based on their risk-return characteristics. transactions are necessary to ensure that the mix remains constant. Similarly. The basic assumption in this type of asset allocation is that markets overreact to information. Depending on the steps that are skipped. Above the floor. That is. it does not mean that the risk characteristics of the investments are also ignored. changes in the risk tolerance of the investor are ignored. In this type of asset allocation. Implicit in this is the belief of the investors that make tactical allocation that their predictions regarding the movements of the market are not only different from the other investors. it is assumed that the risk tolerance of the investor is constant. lower the value. But. the likely range of outcomes from the investment are estimated. Tactical asset allocation may involve switching funds between equities. investments may also be switched from one category of equities to another and one category of bonds to another. higher the allocation to risky assets. Using these proportions. Thus. the asset mix is held constant.

Fund Size Generally. The information on fund costs can be obtained from the quarterly or annual reports of the fund. it is most important to people looking for a monthly cash flow. The past performance can be evaluated in terms of variation of returns. Portfolio Turnover As with stock funds. They could take meaningful positions in smaller junk issues without having to worry about affecting prices as such. since they are fare more irregular and unpredictable than income. Since the yields show the kind of return one can expect. higher turnover translates into increased transaction costs. This analysis makes sense for highly quality fixed-income portfolios. Good bond managers can produce incrementally superior results and will keep their funds at the top of the pack. even with an actively traded portfolio. Explain the factors that an investor should keep in mind while selecting a bond fund. Compare the fees and expenses of several funds having same investment philosophy. But. By studying the past volatility of a portfolio's total returns one can gain a pretty good feel for its likely future course. Capital gains are not included. Fund Costs They are especially important for bond fund investors because fixed-income portfolios generally produce lower long run returns than stock products. which are shouldered by fund investors. Bond Fund Yields A fund’s yield or. he/she might want to limit his/her analysis to long-term bond funds in the hope of earning the relatively higher returns from such investment. which can be measured by standard deviation. it is important to know who the manager is. In addition. and what philosophy he or she follows. The reason being that these portfolios may be able to maneuver more easily. Answer 8 Management And Performance Good management is certainly crucial for stock funds.Question 8 If one wants to save to build capital for his or her retirement. but some people do not think so. how long that individual has been at the helm. high turnover can be a problem. it is believed that bigger bond funds are better because they benefit from economies of scale and should have lower expense ratios. examine the portfolio's expense ratio over the past several years and choose that fu_d having the least cost. It is based on the interest on interest or dividends paid. more precisely its net income distribution rate is similar to the current yield on a stock or bond. transaction expenses will tend to be relatively low. PORTFOLIO CHARACTERISTICS Portfolio Composition . But smaller or medium sized fund may be suitable when investing in less liquid junkbond securities. These individuals should remember that a mutual fund’s yield fluctuat. expressed as a percent of the net asset value. Thus. Standard deviations can be used to make comparisons with other bond portfolios. if the fund holds positions in lower quality debt. In the case of treasury and high-grade corporate bond products. their managers may be able to make better deals since they trade in larger block of funds. One can get a good feel for the past range of a fund’s yield by looking at several years’ worth of information.

as outlined in the prospectus. Thus. Since each drop in quality entails a commensurate increase in yield. the S&P 500 or any index comparable to the NYSE composite. purchasing the lower quality portfolio does not always translate into higher income to the investor. Investors should be careful of long maturities during periods of low interest rates. when fund expenses and any sales charges are taken into account. gaining extra yield is relatively easy.Every prospectus mentions the investment objective and the type of securities that will form the portfolio composition of a particular fund. In India. but only by assuming higher credit risk. one should also look at the quality of securities constituting a portfolio of the fund. The credit rating of the securities should not be less than ‘A’. Empirical studies conducted in the US market have also revealed that when commonly used NYSE based surrogates are involved suchas the Dow-Jones Industrial Average. examine the fund’s holdings as listed in the annual and quarterly reports. Discuss briefly some important criticism leveled against these measures. Investors should ensure that the target bond portfolio is being run in accordance with its investment policy. Answer 9 Risk-Adjusted Performance Measures: Some Issues Let us conclude our discussion on performance measures with a discussion on the criticism leveled against the use ofthese measures. Question 9 Risk-adjusted performance measures are always criticized for their inability to analyze properly the performance of portfolios. However. he/ she should go for that bond fund whose portfolio consists of securities of short maturities. it should be found out if the manager hedges with futures or options. credit rating is generally done by CARE. Quality Rating Besides the portfolio composition. They will fall the farthest if rates move upward. Many bond funds are reaching out for yield. The situation will reverse if the investor expects the interest rate to move downwards. Funds with the longest maturities have the greatest interest rate risk. Average Maturity This is an important indicator of volatility. The quality can be determined by looking at the credit rating of individual securities and especially those forming the bulk of the portfolio. ICRA and CRISIL. if an investor expects the interest rate to move upwards. This can help lessen the fund’s exposure to interest rate risk. in part to offset their higher expenses. The portfolio composition should be looked in general terms. To do this. Use of Market Surrogate All measures other than Sharpe’s measure require the identification ofa market portfolio. the performance ranking of the common (equity) stock portfolios are quite different. While investigating maturities. Hence the performance is highly dependent on theselection of . without trying to analyze each issue’s investment potential.

several problems should be addressed. Performance evaluation of a portfolio is in other words. provided the basic goal of comparison is to assess the expertise of the investment manager. While making manager universe comparisons. if assets are priced according to some other model. Bond managers practice a large number of techniques which creates a big problem. Skill or Luck Obviously. an investor would like to know whether an apparently successful investment manager was skilled or justlucky. Limitation in Using Market Index as a Benchmark Portfolio It has been argued that a market index should not be used as a benchmark portfolio because it is nearly impossible foran investor to construct a portfolio whose returns replicate these on the index. This is because of the transaction costsinvolved in initially forming the portfolio. the return on the index overstate the returns of that a passive investor can earn. The analyst should first decide about the fact that the available universe matches the selected universe. Hence. Portfolios can be classified as style universes with broad strategy guidelines. because the managers facethe fundamental problem of how to narrowly define the styles. This suggests that styles should be outlined along with broad policy framework. which maynot be the correct asset pricing model. in restructuring the portfolio when stocks are replaced in the index. Put differently. and inpurchasing more shares of the stocks comprising the index when the cash dividends are received. use of the beta based performance measure will be inappropriate. the evaluation of performance of portfolio manager. It must be noted that the Sharpe’s measure(reward-to-variability ratio) is immune to this criticism because it uses standard deviation as a measure of risk anddoes not rely on the validity or on the identification of a market portfolio. a separate style can be formed for every manager making it very difficult to compare their styles. A universe is suitable for comparison with a given manager only when the . Since no two managers are similar. say the APTmodel. Validity of CAPM The measure of portfolio performance (Jensen’s measure and Treynor’s measure) are based on the CAPM. Unfortunately a very long time interval is needed to distinguish skill from luck on the part of the investmentmanager. Manager universe comparisons are a part of evaluating the performance of a portfolio manager? How do you make manager universe comparisons? Answer 10 Manager Universe Comparisons The obvious way of evaluating a portfolio manager's performance is to compare it with other portfolio managers.market portfolio. Question 10 One of the important steps in portfolio management process is to evaluate the performance of portfolios during the time horizon concerned. Identifying a suitable universe is the first problem.

For example.selection of that manager implies a good alternative for the investors. Universe manager developers are those persons who select and help investment managers in successfully understanding the investment management process for both domestic and international investment. a consistent inferior performance for a given period of time should not be attributed to bad skills. The absence of long performing years states that new performers may not have a long record of actual performance. In addition to this. The comparison process will be very difficult if the comparison portfolios are not customized properly for the same liability stream. comparison of the dedicated portfolio with immunized portfolio will not be appropriate for a traditional style universe. unless a detailed study upholds that conclusion. and philosophy. However. . which may be thought of as an extension of the first problem. the old performers may sometimes undergo a change in personnel or investment outlook. one should not expect this to continue for longer periods of time and hence actual performance over a long phase may not always be accessible. This clearly suggests that some subjective resolution should be made in positioning a manager within a universe. relates to the difficulty attached in exactly categorizing managers into styles. Superior or inferior kind of performance for a fixed period can be attributed to good or bad luck of the investment manager rather than his superior or inferior skills. objectives. The target returns fixed to these strategies are generally stated in absolute terms and are customized to suit specific investors with specified liability stream. In spite of these difficulties attached to such manager universe comparison. They can demand comprehensive information about investment process. it is very likelythat an investor will ask how his manager's performance differs from that of others. immunization and other combinations. constraints. While evaluating the new strategies such as dedication. this concern becomes more important. The second problem. If this is the case. A constant superior performance over a long period of time enhances the investor's confidence that excess returns are a result of good skill rather than sheer luck. The amount of time that is available for performance with the manager is another problem.