MODULE-IV: Applied Portfolio Management

This subject is concerned with the process of constructing and managing a diversified institutional portfolio
comprising stocks, fixed-income securities, real and alternative assets, and derivatives. It begins by reviewing the
foundations of investment management before continuing to the topics of equity and fixed-income portfolio
management. Less traditional asset classes, such as investment companies, exchange-traded funds, real estate, hedge
funds and private equity, are also examined. Finally, considerable attention is given to the important issues of asset
allocation and performance measurement and attribution.

Portfolio Performance evaluation:

Portfolio evaluation refers to the evaluation of the performance of the portfolio. It is essentially the process
of comparing the return earned on a portfolio with the return earned on one or more other portfolios or on a
benchmark portfolio. Portfolio evaluation essentially comprises of two functions, performance measur ement and
performance evaluation. Performance measurement is an accounting function which measures the return earned on a
portfolio during the holding period or investment period. Performance evaluation, on the other hand, addresses such
issues as whether the performance was superior or inferior, whether the performance was due to expertise or fortune
etc.
While evaluating the performance of a portfolio, the return earned on the portfolio has to be evaluated in the context
of the risk associated with that portfolio. One approach would be to group portfolios into equivalent risk classes and
then compare returns of portfolios within each risk category. An alternative approach would be to specifically adjust
the return for the riskiness of the portfolio by developing risk adjusted return measures and use these for evaluating
portfolios across differing risk levels.

Performance Measurement for the Hedge funds

A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a
wider range of investment and trading activities than other investment funds. Hedge funds try to offset potential losses
in the principal market they invest in by hedging their investments using a variety of methods such as short selling.
Hedge funds concentrate on opportunities offered by temporarily mispriced securities. These funds are alpha driven
and are good candidates to add to core positions in more traditional portfolios established with concerns of
diversification.
Approaches of performance measurement of hedge funds
Sharpe Ratio:
It is the ratio of the reward or risk premium to the variability of return or risk as measured by the variance of the
return.
Treynor Ratio:
It is the ratio of reward to the volatility of return as measured by the portfolio beta.
Portfolio Evaluation completes the cycle of activities comprising portfolio management. It provides a mechanism
for identifying weakness in the investment process and for improving the deficient areas. Thus port folio evaluation
would serve as a feedback mechanism for improving the portfolio management process.
Omega ratio
Omega is a relative gain-to-loss function of using exogenously (and arbitrary) return threshold. The omega is than
defined as the quotient of the excess return over a threshold and the expected loss below the same threshold. Hence the
higher the Omega, the better. With the aim of creating a measure that combines the positive aspect of Omega ratio and
Sharpe ratio, a Sharpe-Omega ratio is created.
Beta or correlation analysis factor models
All previous indicators focus on measuring the risk-adjusted performance of hedge fund returns. However, they leave
aside the source of hedge fund returns and risks. Beta or correlation analysis aims to detect a fund’s underlying return
driving factors by explain hedge fund returns through the fund’s exposure to various risk factors. Factor analysis is
especially important for investors that consider hedge fund investment only as a part of their overall portfolio, such as
institutional investors.
Performance measurement with changing portfolio composition
Stock-selection techniques are generally used by fund managers in generating superior returns. In addition to using
stock-selection techniques, fund managers can also generate superior performance by timing the market correctly. This
means that they are capable of assessing correctly the direction of the market, either bull or bear. In case they do,
would be positioning their portfolio accordingly. For example, if managers are expecting a declining market, they can
change their portfolio properly by increasing the cash percentage of the portfolio or by decreasing the beta of the
equity portion of the portfolio. However, in case of rising market, fund managers could reduce the cash position or
increase the beta of the equity portion of their portfolios.
Market Timing
Market timing is the macro-forecasting ability of the fund manager in forecasting market wide movements (a shift
from bull to bear market). Market timing skills imply assessing correctly the direction of the market, whether bull or
bear and positioning the portfolios accordingly. Thus, market timing is defined as the strategy of changing a fund’s
allocation between stocks and cash to capture gains in up markets ad to avoid losses in down markets. In other words,
market timers are special breed of technicians who track the market to enhance the yield return on stock or bond by
investing during the periods of market upswing and switching into money market instruments when the market
conditions are unfavourable. In its pure form, market timing involves shifting funds between a market-index portfolio
and a safe asset, such as T-bills or a money market funds, depending on whether the market as a whole is expected to
outer form the safe asset.
Style Analysis
It was developed by William Sharpe and has become a popular methodology with several applications for analyzing
portfolios. Enhancement have been made to the basic methodology for the purpose of performance attribution.
Attribution using style analysis is sometimes used to isolate the effects of the manager’s security selection ability from
results attributed to the fund’s investment style over the period.
Style analysis is technique used to discover the management style of a portfolio, using an analysis of the fund’s
historical returns. The result of a style analysis are a list of market indices that best represent the historical
performance of a portfolio, weighted by their implied influence on the funds return.
Performance attribution procedures.
Rather than focus on risk adjusted returns, practitioners often want simply to ascertain which decisions resulted in
superior or inferior performance. Superior investment performance depends on an ability to be in the right securities at
the right time. Such timing and selection ability may be considered broadly, such as being in equities as opposed to
fixed-income securities when the stock market is performing well. Or it may be defined at a more detailed level, such
as choosing the relatively better-performing stocks within a particular industry.
Portfolio managers constantly make broad-brush asset allocation decisions as well as more detailed sector and security
allocation decisions within asset class. Performance attribution studies attempt to decompose overall performance into
discrete components that may be identified with a particular level of the portfolio selection process.
Attribution studies start from the broadest asset allocation choices and progressively focus on ever-finer details of
portfolio choice. The difference between a managed portfolio’s performance and that of a benchmark portfolio then
may be expressed as the sum of the contributions to performance of a series of decisions made at the various levels of
the portfolio construction process.

International diversification:
International diversification is the process of a company or investor beginning to do business with or invest in other
countries or regions. One reason for international diversification is risk management, because this enables the investor
or business to make the best of each area’s financial swings. While both an investor and a business can make money
from this approach, they do it in different ways. This diversification can be beneficial when the domestic currency is
weakening, but it loses its advantages when the domestic currency strengthens.

International investing:
The strategy of selecting globally-based investment instruments as part of an investment portfolio. International
investing includes such investment vehicles as mutual funds, American Depository Receipts, exchange-traded funds
(ETFs) or direct investments in foreign markets. People often invest internationally for diversification, to spread the
investment risk among foreign companies and markets; and for growth, to take advantage of emerging markets.
International investments can be included in an investment portfolio to provide diversification and growth
opportunities. All types of investments involve risk, and international investing may present special risks, including:
-Fluctuations in currency exchange rates
-Changes in market value
-Significant political, economic and social events
-Low liquidity
-Less access to important information
-Foreign legal remedies
-Varying market operations and procedures

Risk and return

International investing offers potential return opportunities and potential reduction in risk through diversification.
Based on the historical record, investments in certain foreign market would have increased investor returns during
certain periods of time. However, investors need to understand how these returns are calculated, and the risk they are
taking.
Investing in a foreign security involves all the risks associated with investing in a domestic security plus some
additional risks. The investor expects to receive cash flows in the future from the foreign security. However, these
cash flows will be in a foreign currency and thus will be of little use to the investor if they cannot be converted into the
investor’s domestic currency. The additional risks associated with foreign investing arise from uncertainties associated
with converting these foreign cash flows into domestic currency.
Risks in international investing
1. Political risk
Many national markets, particularly emerging markets, are vulnerable to political risk that may stem from
coups, elimination, social unrest, and so on. This can lead to an unexpected change in the policies of the govt.
toward foreign investors. In the extreme case, it may result in expropriation of the assets owned by foreigners.
2. Currency risk
Exchange rates change over time. So global investors have to live with currency risk. For example, an Indian
investor who invests in the U.S. equities will have to bear the risk of dollar declining against the rupee.
3. Custody risk
In many countries, domestic investors enjoy a certain degree of protection against frauds, bankruptcies, and
broker misdeeds. This protection may not be available to foreign investors. So, when you invest in foreign
market you may be exposed to such risks. You must understand the investment protection norms in the country
where you propose to invest to ascertain the custodial risks involved.
4. Liquidity risk
In many emerging markets trading is concentrated on a small proportion of listed securities. Other securities
are not traded frequently and hence somewhat illiquid.
5. Market volatility
Emerging markets are, in general, more volatile than developed markets. So, global investors who have
exposure to emerging markets have to bear higher market volatility.

Benefits from diversification

1. International diversification provides the potential for firms to achieve greater returns on their innovations and
reduces the often substantial risks of R&D investments. Therefore, International diversification provides
incentives for firms to innovate. Additionally, the firm uses its primary resources and capabilities to diversify
internationally and thus earn further returns on these capabilities.
2. International diversification helps to generate the resources required to sustain a large-scale R&D operation.
An environment of rapid technological obsolescence makes it difficult to invest in new technology and the
capital-intensive operations necessary to compete in this environment. Firms operating solely in domestic
markets may find such investments difficult because of the length of time required to recoup the original
investment. If the time is extended, it may not be possible to recover the investment before the technology
becomes obsolete.
3. International diversification improves a firm’s ability to appropriate additional returns from innovation before
competitors can overcome the initial competitive advantage created by the innovation.
4. Firms moving into international markets are exposed to new products and processes. If they learn about those
products and processes and integrates this knowledge into their operations, further innovation can be
developed. To incorporate the learning into their own R&D processes, firms must manage those processes
effectively in order to absorb and use the new knowledge to create further innovations.
5. Because of the potential positive effects of International diversification on performance and innovation, such
diversification may even enhance returns in product-diversified firms. International diversification increases
market potential in each of these firms product-lines, but the complexity of managing a firm that is both
product diversified and internationally diversified is significant.
Assessing the potential of international diversification
Firstly, focus on investors who wish to hold largely passive portfolios. Their objectives is to maximize diversification
with limited expense and effort. Passive investment is simple-rely on market efficiency to guarantee that a broad stock
portfolio will yield the best possible Sharpe ratio. Estimate the mean and standard deviation of the optimal risky
portfolio, and select a capital allocation to achieve the highest expected return at a level of risk investors are willing to
bear. But now, a passive investor must also decide whether to add an international component to the more convenient
home-country index portfolio.
Suppose the passive investor could rely on efficient markets as well as a world CAPM. Then the world capitalization-
weighted portfolio would be optimum. Abiding by this theoretically simple solution is also practical.
Investors usually prefer the domestic securities in their portfolios and this is called home bias.
–Why it exists?
Investor consumption consists in large part of goods and services produced in the home country and prices of these
goods and services may be correlated with home country stock prices.
–How is it measured?

Home bias is the excess weight of domestic country of the investor relative to its weight in the otherwise efficient
portfolio.
Problem: What is the efficient portfolio?
•In order to be able to invest internationally specialization in some fields such as currency, country, and worldwide
industry may be necessary. Furthermore, there is a greater universe for security selection.
•Constructing a benchmark portfolio (bogey) of foreign assets:
–There are indexes of non-US stocks such as European, Australian, Far East (EAFA) index (Morgan Stanley Capital
International)
–Portfolios can be designed to replicate the country, currency, and company representation of these indexes.

International investing and performance attribution.

–The indexes are constructed by using market capitalization as the weight.
•Problem: Different countries have differing proportions of their corporate sector organised as publicly traded firms.
•Suggestion: Weighting international indexes by GDP.
•Performance Attribution
–Currency selection: measures the contribution to total portfolio performance attributable to exchange rate fluctuations
relative to the investor’s benchmark currency.
–Country selection: measures the contribution of performance attributable to investing in the better-performing stock
markets of the world.
–Stock selection: measured as the weighted average of equity returns in excess of the equity index in each country.
–Cash/bond selection: measured as the excess return derived from weighting bonds and bills differently from some
benchmark weight