CH-7- Portfolio Management

Chapter 7: Portfolio Management

Portfolio management involves a series of decisions and actions that must be made by every investor
whether an individual or institution. Portfolios must be managed whether investors follow a passive
approach or active approach to selecting and holding their financial assets. The effective and efficient
management of portfolio enable investment of funds in such combination of different securities in
which the total risk of portfolio is minimized, and rate of returns is maximized.

7.1. What is Portfolio Management?

Portfolio management is the process of combining securities in a portfolio according to the investor’s
preferences and needs, monitoring that portfolio, and evaluating its performance.

In other word, portfolio management is the strategic decision guides the investor in a method of
selecting the best available securities that will provide the expected rate of return for a given degree of
risk and also to reduce the risk.

7.2. Objectives of Portfolio Management

The primary objective of portfolio management is to invest in securities in a way that it maximizes
one’s returns and minimizes risks in order to achieve one’s investment objective.

(i) Security of principal investment: Investment safety or minimization of risks is one of the important
objectives of portfolio management.
(ii) Consistency of return: Portfolio management also ensures to provide the stability of returns by
reinvesting the earned returns in profitable and good portfolio. Since returns of all securities do
not move exactly together, variability in one security will be offset by the reverse variability of
other securities; and ultimately the overall risk of the investor will be less affected. The earned
returns should compensate the opportunity costs of the funds invested.
A good portfolio should have multiple objectives and achieve a sound balance among:
i. Stable Return iv. Capital appreciation
ii. Safety of the investment v. Liquidity
iii. Tax Planning

In addition, the basic principles necessary for executing an investment program. These are known as
guiding principles in establishing an investment portfolio. They include: Safety of Funds, Consistency
of returns and Liquidity/Marketability
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7.3. Portfolio Management Process

In setting out to master the concepts and tools of portfolio management, we first need a coherent
description of the portfolio management process. The portfolio management process is an integrated
set of steps undertaken in a consistent manner to create and maintain an appropriate portfolio
(combination of assets) to meet clients’ stated goals.

The process of managing an investment portfolio never stops. Once the funds are initially invested
according to the plan, the real work begins in monitoring and updating the status of the portfolio and
the investor’s needs. Three elements in managing any business process are planning, execution, and
feedback.

Specification and
quantification of investor’s
objectives, constraints and Monitoring investor-
Portfolio Policies
preferences related input factors
& Strategies

Portfolio construction Attainment of

and revision investor’s
objectives
Asset allocation, portfolio
optimization, security Performance
selection,
evaluation
implementation, and
execution

Monitoring economic
Capital market and market input
Relevant economic, social, expectations factors
political, and sector
consideration
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Exhibit 7.1: Portfolio Construction, Monitoring and Revision Process

7.3.1. The Planning Step

The planning step is described in the four leftmost boxes in Exhibit 7.1. The top two boxes represent
investor-related input factors, while the bottom two factors represent economic and market input.

i) 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 mainly pertain to return and risk. Constraints
are limitations on the investor’s ability to take full or partial advantage of particular investments. For
example, an investor may face constraints related to the concentration of holdings as a result of
government regulation, or restrictions in a governing legal document. Constraints are either internal,
such as a client’s specific liquidity needs, time horizon, and unique circumstances, or external, such as
tax issues and legal and regulatory requirements.

ii) Creating the Investment Policy Statement (IPS): Once a client has specified a set of objectives and
constraints, the manager’s next task is to formulate the investment policy statement. The IPS serves as
the governing document for all investment decision making. In addition to objectives and constraints,
the IPS may also cover a variety of other issues.

For example, the IPS generally details reporting requirements, rebalancing guidelines, frequency and
format of investment communication, manager fees, investment strategy, and the desired investment
style or styles of investment managers. Atypical IPS includes the following elements:

 A brief client description.

 The purpose of establishing policies and guidelines.
 The duties and investment responsibilities of parties involved, particularly those relating to
fiduciary duties, communication, operational efficiency, and accountability. Parties
involved include the client, any investment committee, the investment manager, and the
bank custodian.
 The statement of investment goals, objectives, and constraints.
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 The schedule for review of investment performance as well as the IPS itself.
 Performance measures and benchmarks to be used in performance evaluation.
 Any considerations to be taken into account in developing the strategic asset allocation.
 Investment strategies and investment style(s).
 Guidelines for rebalancing the portfolio based on feedback.
The IPS forms the basis for the strategic asset allocation, which reflects the interaction of objectives and
constraints with the investor’s long-run capital market expectations. When experienced professionals
include the policy allocation as part of the IPS, they are implicitly forming capital market expectations
and also examining the interaction of objectives and constraints with long-run capital market
expectations. In practice, one may see IPSs that include strategic asset allocations, but we will maintain
a distinction between the two types.

The planning process involves the concrete elaboration of an investment strategy; that is, the
manager’s approach to investment analysis and security selection. A clearly formulated investment
strategy organizes and clarifies the basis for investment decisions. It also guides those decisions toward
achieving investment objectives. In the broadest sense, investment strategies are passive, active, or
semi-active.

In a passive investment approach, portfolio composition does not react to changes in capital market
expectations (passive means ‘‘not reacting’’). For example, a portfolio indexed to the Morgan Stanley
Capital International (MSCI)-Europe Index, an index representing European equity markets, might
add or drop a holding in response to a change in the index composition but not in response to changes
in capital market expectations concerning the security’s investment value. Indexing, a common passive
approach to investing, refers to holding a portfolio of securities designed to replicate the returns on a
specified index of securities. A second type of passive investing is a strict buy-and-hold strategy, such
as a fixed, but non-indexed, portfolio of bonds to be held to maturity.

In contrast, with an active investment approach, a portfolio manager will respond to changing capital
market expectations. Active management of a portfolio means that its holdings differ from the
portfolio’s benchmark or comparison portfolio in an attempt to produce positive excess risk-adjusted
returns, also known as positive alpha. Securities held in different-from-benchmark weights reflect
expectations of the portfolio manager that differ from consensus expectations. If the portfolio
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manager’s differential expectations are also on average correct, active portfolio management may add
value.

A third category, the semi-active, risk-controlled active or enhanced index approach, seeks positive
alpha while keeping tight control over risk relative to the portfolio’s benchmark. As an example, an
index-tilt strategy seeks to track closely the risk of a securities index while adding a targeted amount
of incremental value by tilting portfolio weightings in some direction that the manager expects to be
profitable.

Active investment approaches encompass a very wide range of disciplines. To organize this diversity,
investment analysts appeal to the concept of investment style. We can define an investment style (such
as an emphasis on growth stocks or value stocks) as a natural grouping of investment disciplines that
has some predictive power in explaining the future dispersion in returns across portfolios. We will
take up the discussion of investment strategies and styles in greater detail in subsequent chapters.

iii) Forming Capital Market Expectations: The manager’s third task in the planning process is to form
capital market expectations. Long-run forecasts of risk and return characteristics for various asset
classes form the basis for choosing portfolios that maximize expected return for given levels of risk, or
minimize risk for given levels of expected return.

iv) Creating the Strategic Asset Allocation: The fourth and final task in the planning process is
determining the strategic asset allocation. Here, the manager combines the IPS and capital market
expectations to determine target asset class weights; maximum and minimum permissible asset class
weights are often also specified as a risk-control mechanism. The investor may seek both single-period
and multi-period perspectives in the return and risk characteristics of asset allocations under
consideration. A single-period perspective has the advantage of simplicity. A multi-period perspective
can address the liquidity and tax considerations that arise from rebalancing portfolios over time, as
well as serial correlation (long- and short-term dependencies) in returns, but is more costly to
implement.

The execution and feedback steps in the portfolio management process are as important as the
planning step and will receive more attention in subsequent chapters. For now, we merely outline how
these steps fit in the portfolio management process.

7.3.2. The Execution Step

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The execution step is represented by the ‘‘portfolio construction and revision’’. 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 is 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 7.1 in the portfolio construction and revision box.

At times, a portfolio’s actual asset allocation may purposefully and temporarily differ from the
strategic asset allocation. For example, the asset allocation might change to reflect an investor’s current
circumstances that are different from normal. The temporary allocation may remain in place until
circumstances return to those described in the IPS and reflected in the strategic asset allocation. If the
changed circumstances become permanent, the manager must update the investor’s IPS, and the
temporary asset allocation plan will effectively become the new strategic asset allocation. A strategy
known as tactical asset allocation also results in differences from the strategic asset allocation. Tactical
asset allocation responds to changes in short-term capital market expectations rather than to investor
circumstances.

The portfolio implementation decision is as important as the portfolio selection/ composition decision.
Poorly managed executions result in transaction costs that reduce performance. Transaction costs
include all costs of trading, including explicit transaction costs, implicit transaction costs, and missed
trade opportunity costs. Explicit transaction costs include commissions paid to brokers, fees paid to
exchanges, and taxes. Implicit transaction costs include bid-ask spreads, the market price impacts of
large trades, missed trade opportunity costs arising from price changes that prevent trades from being
filled, and delay costs arising from the inability to complete desired trades immediately due to order
size or market liquidity.
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In sum, in the execution step, plans are turned into reality with all the attendant real-world
challenges.

7.3.3. 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.

i) 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.
One impetus for portfolio revision is a change in investment objectives or constraints because of
changes in investor circumstances. Portfolio managers need a process in place to stay informed of
changes in clients’ circumstances. The termination of a pension plan or death of a spouse may trigger
an abrupt change in a client’s time horizon and tax concerns, and the IPS should list the occurrence of
such changes as a basis for appropriate portfolio revision.

More predictably, changes in economic and market input factors give rise to the regular need for
portfolio revision. Again, portfolio managers need to systematically review the risk attributes of assets
as well as economic and capital market factors. A change in expectations may trigger portfolio
revision. When asset price changes occur, however, revisions can be required even without changes in
expectations. The actual timing and magnitude of rebalancing may be triggered by review periods or
by specific rules governing the management of the portfolio and deviation from the tolerances or
ranges specified in the strategic asset allocation, or the timing and magnitude may be at the discretion
of the manager.

For example, suppose the policy allocation calls for an initial portfolio with a 70 percent weighting to
stocks and a 30 percent weighting to bonds. Suppose the value of the stock holdings then grows by 40
percent, while the value of the bond holdings grows by 10 percent. The new weighting is roughly 75
percent in stocks and 25 percent in bonds. To bring the portfolio back into compliance with
investment policy, it must be rebalanced back to the long-term policy weights. In any event, the
rebalancing decision is a crucial one that must take into account many factors, such as transaction
costs and taxes (for taxable investors). Disciplined rebalancing will have a major impact on the
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attainment of investment objectives. Rebalancing takes us back to the issues of execution, as is

appropriate in a feedback process.

ii) 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.
7.4. Portfolio Management Policies
Policies followed in management of portfolio differ from investor to investor. The following are the
basic policies which are most commonly followed in the portfolio management.
1) Aggressive Policy: is a policy that assumes the market is strong and rising. Common stock is the
best alternative investment for the portfolio in rising market.
2) Defensive Policy: According to this policy, the securities which resist a decline in price are chosen
for investment. Since common shares are more risky (because it’s residual claim), bonds and
preferred shares are defensive type securities.
3) Aggressive-Defensive Policy: This type of policy safeguards the investor against any possible rise
or fall in the stock market. If the market is in rising trend, equity stock would bring a large income.
If the market is affected by recession, preferred stocks, bonds, debentures will protect the investor.
4) Income vs. Growth Policy: The income policy focuses on maximization of current income, but
does not consider capital gains. This policy suggests bonds and debentures. The growth policy gives
priority to capital appreciation of the portfolio. It is followed by the investors who favor stocks,
promising substantial capital appreciation.
In general, the income Vs growth policy emphasizes that both income and growth factors should be
given due importance while constructing investment portfolio which will assure the investor current
income as well as increase in its capital value.

7.5. Portfolio Evaluation: Risk-Adjusted Portfolio Performance Measures

Portfolio evaluation is the stage where we examine to what extent the objective has been achieved.
Through portfolio evaluation the investor tries to find out how well the portfolio has performed. The
portfolio evaluation is really a study of the impact/result of previous decisions. Without portfolio
evaluation, portfolio management would be incomplete.

Investment analysts and portfolio managers continuously monitor and evaluate the outcome of their
performance. The basic features of good portfolio managers are their ability to perceive the market
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trends correctly and make correct expectations & estimates regarding risk, return, ability to make
proper diversification, to reduce the company related risk. In addition, portfolio performance also
depends on the timing of investments, superior investment analysis and security selection. For
evaluating the performance of a portfolio it is necessary to consider both risk and return.

Measuring the risk associated with a portfolio is one important aspect of measuring portfolio
performance. Portfolio returns must be adjusted for risk before they can be compared meaningfully.
The easiest way to adjust returns for portfolio risk is to compare rates of return amongst portfolios
with similar risk profiles. This process may be misleading, however, for some managers may
concentrate on particular subgroups, so that the portfolio profiles are not actually that comparable.
More accurate measures of portfolio returns have come into vogue to calculate risk-adjusted returns
using mean-variance criteria and measuring both risk and return. Risk-adjusted returns are not
necessarily perfect measurements, as they do not take into account transaction costs. They are,
however, important tools for providing information about portfolios. Three of the most popular risk-
adjusted measures will now be examined. These are: Sharpe measure, Treynor measure and the Jensen
measure. They differ from one another according to the risk measure used.

1) Sharpe Measure: The performance measure developed by William Sharpe is referred to as the
reward-to-variability ratio or Sharpe ratio. It is the ratio of reward or risk premium to the
variability of return which measured by the standard deviation of return. The formula for
calculating Sharpe ratio may be stated as:
Sharpe ratio (SR) = (rp - rf ) / sp

Where, rp = Realized return on the Portfolio

rf = Risk free rate of return
sp = Standard deviation of portfolio return
The higher the value of this measure the better value the portfolio represents, since as p gets smaller
the total risk of the portfolio gets smaller. If the Sharpe ratio is negative the portfolio’s performance is
less than the risk-free rate and the negative figure itself cannot be compared to other negative figures.

2) Treynor Measure: The performance measure developed by Jack Treynoris referred to as Treynor
ratio or reward to variability ratio like Sharpe. However, Treynor, distinguished between total risk and
systematic risk, implicitly assuming that portfolios are well diversified; that is, he ignored any diversifiable
risk. It is the ratio of the reward or risk premium to the volatility of return as measured by the portfolio Beta.
The formula for calculating Treynor ratio is stated as follows:
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Treynor ratio (TR) = (rp - rf ) / bp

Where, rp = Realized return on the Portfolio

rf = Risk free rate of return
bp = Portfolio beta
The higher the value of the Treynor measure the better the value represented by the portfolio, since a
higher beta represents higher systematic risk. The Treynor measure may be preferred by investors who
are running highly diversified portfolios, as the measure does not consider unsystematic risk. A
portfolio holding a large number of investments should see the unsystematic risk diversified away. The
Sharpe measure, which considers total risk, may be preferred by investors with less diversified
portfolios.

3) Jensen Measure: This performance measure has been developed by Michael Jensen and is referred
to as the Jensen ratio. This ratio attempts to measure the difference between the actual return
earned on a portfolio and the expected return from the portfolio given its level of risk. Jensen's
measure of performance is based on the capital asset pricing model (CAPM). The expected return
for any security (i) or, in this case, portfolio (p) is given as; E(rp) = rf+ bp(rm - rf )

Jensen ratio (JR) = rp - E(rp)

Where: E(rp) = Expected return of portfolio

rp = Realized return on the Portfolio
rf = Risk free rate of return
bp = Portfolio beta
rm = Return on market index
To summarize:
 The Sharpe ratio looks at total risk
 The Treynor ratio takes into account systematic risk
 The Jensen measure looks at the performance of the portfolio over and above that of a
benchmark.
If an investor has limited holdings, then standard deviation may provide a more accurate measure of
risk. Likewise, if an investor holds a wide variety of holdings outside of one particular mutual fund,
then beta may be a more accurate measure of risk.
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For example, two fund managers are employed to manage two portfolios with identical objectives.
Details of their portfolios are as follow:

Fund Return Beta (p) Total risk (p)

A 10% 1.03 10%
B 14% 1.25 20%

Using the Sharpe measure, where:

Sharpe measure = Rp – Rf (assume Rf = 4.5%)
p
Fund A = (10 – 4.5)/10 = 0.55
Fund B = (14 – 4.5)/20 = 0.48

It can be concluded that, on a risk-adjusted basis considering total risk, fund manager A has
outperformed fund manager B.

Using the Treynor measure, where:

Treynor measure =(Rp – Rf)/p
Fund A = (10 – 4.5)/1.03 = 5.34%
Fund B = (14 – 4.5)/1.25 = 7.6%

It can be concluded that, on a risk-adjusted basis taking into account systematic risk, fund manager B
has outperformed fund manager A.

Using the Jensen measure, where:

Jensen measure == Rp – Rb
Rb = Rf + b (Rm – Rf ) (assume Rm = 8%)
Ra = 4.5 + 1.03(8 – 4.5) = 8.1%
Rb = 4.5 + 1.25(8 – 4.5) = 8.9%
a = Ra = 10.0 – 8.1 = 1.9%
b = Rb = 14.0 – 8.9 = 5.1%

It can be concluded that on a risk-adjusted basis (systematic risk), fund manager B has performed
better than fund manager A.

One more point to note is that returns will be affected by tax rates, inflation over time, and foreign
exchange rates when applicable
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7.6. Portfolio Revision

In portfolio management, the maximum emphasis is placed on portfolio analysis and selection which
leads to the construction of the optimal portfolio. But, the financial markets are continually changing.
In this dynamic environment, a portfolio that was optimal when constructed may not continue to be
optimal with the passage of time. The portfolio management process needs frequent changes in the
composition of stocks and bonds. If the policy of the investor shifts from earnings to capital
appreciation, the stocks should be revised accordingly. Likewise, if the security does not fulfill the
investor’s expectation regarding return and growth, it is better to get rid of it. If another stock offers a
competitive edge over the present stock, investment should be shifted to the other stock. Many
investors find themselves inadequate in their ability to trade and earn profit.

7.6.1. Need for Revision

The primary factor necessitating portfolio revision is changes in the financial markets since the
creation of the portfolio. The need for portfolio revision may arise because some investor related
factors also. These factors may be listed as:
 Ability of additional funds for investment
 Change in risk tolerance
 Change in the investment goals
 Need to liquidate a part of the portfolio to provide funds for some alternative use.
The portfolio needs to be revised to accommodate the changes in the investor’s position. Thus, the need
for portfolio revision may arise from changes in the financial market or changes in the investor’s
position, namely his status and preferences.

7.6.2. Portfolio Revision Strategies

Two different strategies may be adopted for portfolio revision, namely
a) Active Revision Strategy
b) Passive Revision Strategy
The choice of the strategy would depend on the investor’s objectives, skill, resources and time.

Active Revision Strategy: Active revision strategy involves frequent and sometimes substantial
adjustments to the portfolio. The effectiveness of an actively-managed investment portfolio obviously
depends on the skill of the manager and research staff but also on how the term active is defined.
Investors who undertake active revision strategy believe that security markets are not continuously
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efficient. They believe that securities can be mispriced at times giving an opportunity for earning
excess returns through trading in them. Active portfolio revision is essentially carrying out portfolio
analysis and portfolio selection all over again. It is based on an analysis of the fundamental factors
affecting the economy, industry and company as also the technical factors like demand and supply.

Consequently, the time, skill and resources required for implementing active revision strategy will be
much higher. The frequency of trading is likely to be much higher under active revision strategy
resulting in higher transaction costs.

Passive Revision Strategy: Passive portfolio strategy, in contrast, involves only minor and infrequent
adjustment to the portfolio over time. The practitioner of passive revision strategy believes in market
efficiency and homogeneity of expectation among investors. They find little incentive for actively
trading and revising portfolios periodically.

Under passive revision strategy, adjustment to the portfolio is carried out according to certain
predetermined rules and procedures designated as formula plans. These formula plans help the
investor to adjust his portfolio according to changes in the securities market.

7.7. Formula Plans

Formula plans represent an attempt to exploit the price fluctuations in the market and make them a
source of profit to the investor. They make the decisions on timings of buying and selling securities
automatic and eliminate the emotions surroundings the timing decisions. Formula plans consist of
predetermined rules regarding when to buy or sell and how much to buy or sell. These predetermined
rules call for specified actions when there are changes in the securities market.

The use of formula plans demands that the investor divide his investment funds into two portfolios,
one aggressive and the other conservative or defensive. The aggressive policy usually consists of equity
shares while the defensive portfolio consists of bonds and debentures. The formula plans specify
predetermined rules for the transfer of funds from the aggressive portfolio to the defensive portfolio.
These rules enable the investor to automatically sell shares when their prices are rising and buy shares
when their prices are falling.

Assumptions of the Formula Plan

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(i) Assumption I: Certain percentage of the investor’s fund is allocated to fixed income securities and
common stocks. The proportion of the money invested in each component depends on the
prevailing market condition. If the stock market is in the boom condition lesser funds are allotted
to stocks. If the market is low, the proportion may reverse.
(ii) Assumption II: If the market moves higher, the proportion of stocks in the portfolio may either
decline or remain constant. The portfolio is more aggressive in the low market and defensive when
the market is on the rise.
(iii) Assumption III: The stocks are bought and sold whenever there is a significant change in the
price. The changes in the level of market could be measured with the help of indices.
(iv)Assumption IV: The investor should strictly follow the formula plan once he chooses it. He should
not abandon the plan but continue to act on the plan.
(v) Assumption V: The investor should select good stocks that move along with the market. They
should reflect the risk and return features of the market.

Advantages of the Formula Plan

(i) Basic rules and regulations for the purchase and sale of securities are provided.
(ii) The rules and regulations are rigid and help to overcome human emotion.
(iii) The investor can earn higher profits by adopting the plans.
(iv) A course of action is formulated according to the investor’s objectives
(v) It controls the buying and selling of securities by the investor.
(vi) It is useful for taking decisions on the timing of investments.

Disadvantages of the Formula Plan

(i) The formula plan doesn’t help the selection of security.
(ii) The selection of the security has to be done either on the basis of the fundamental or technical
analysis.
(iii) The formula plan should be applied for long periods; otherwise the transaction cost may be
high.
(iv) Even if the investor adopts the formula plan, he needs forecasting. Market forecasting helps
him to identify the best stock.