PORTFOLIO MANAGEMENT What is Portfolio? A portfolio is a grouping of financial assets such as stocks, bonds and cash equi i e- (1 quivalents, as well as their funds counterparts, including mutual, exchange-traded and close funds, Simply put, portfolio is the collection of assets or different investments under one ownership. The general principle of portfolio construction is that an investor should Construct an investment portfolio, in accordance with risk tolerance and investment objectives. Types of Portfolio * Securities only portfolio e.g. bonds only, bank shares only, stocks etc, + Mixed asset portfolio without real estate ie. combination of securities, investing in paper assets, * Real estate only portfolio ie. investing in brick and mortars “residential commercial industry” Management The act of supervising, coordinating, organising, planning, staffing, regulating and controlling all available resources so as to achieve the objectives of an organisation or the stated goal. Portfolio Management Portfolio Management is the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk against performance. Portfolio Management is all about SWOT analysis i.e. S — Strengths ‘ W — Weaknesses O + Opportunities T = Threats ¥ In the choice of debt and equity, domestic and international, growth and safety, and many other trades-off encountered in the attempt to maximise return at a given appetite for risk. jmum portfolio. risk, Different there is need to ‘The whol ee eae Of portfolio management is to achieve an opti crs arias offers maximum return for a given level of ‘nts react directly to the same economic condition and thus, construct an efficient portfolio. _Key Elements of Portfolio Management (\) (14 Asset Allocation Asset allocation is based on the understanding that different investment tyPes of assets do not move in concert, and some are more volatile than others. profile of an investor by investing Asset allocation seeks to optimise the risk/return. ith a more in a mix of assets that have low correlation to each other. Investors wil aggressive profile can weigh their portfolio toward more volatile investment, while investors with a more conservative profile can weigh their portfolio toward more stable investments. TY @) Diversification This is the spreading of risk and reward within an a 0 maximise return and minimise risk through collectio! ple is not to put all eggs .sset. The whole essence of diversification ist n of different investment class to make up a portfolio. The princi ina basket. a 3) Rebalancing This is a method used to return a portfolio to its original target allocation at annual intervals It is important for returning the asset mix that best reflects an investor's risk/retumn profile. Otherwise, the movements of the markets could expose the portfolio to greater risk or reduced return opportunities. () Dynamic Asset Allocation This is a portfolio management strategy that involves rebalancing a portfolio so as to bring the asset mix back to its long-term target. Such rebalancing would generally involve reducing positions in the best-performing asset class, while adding to positions in underperforming assets. Management of Portfolio 1, Directly by investor —> self management 2, By financial professionals — external agentPortfolio Problems 1 Proble : " ‘roblem of identification and selection of investment [individual portfolio} Problem of allocation of resources “quantum of fund to invest” Portfolio Management Theory Portfolio management theory is about finding the balance between maximising Your return and minimising your risk, The objective isto select your investments in such a way that your risks will be diversified while not reducing your expected portfolio return, The approaches to portfolio management include: 1, Traditional Approach 2. Modern Portfolio Theory Tray roach This is the approach to portfolio diversification. The traditional approach recognises the need of portfolio constructed to meet the investors’ overall investment objectives without looking at the correlation of the asset class. ‘This approach encourage the investors to select assets of different class so far they will meet investment objectives and it may include selection of assets that are positively correlated i.e. assets that react in the same manner under the same economic condition. Thus, an investor when using this approach may put all his eggs in a basket. This approach neglects interrelationship of asset. It is sometimes called Naive Diversification. Modern Portfolio Theory (MPT) S This theory was developed by Harry Markowitz. It is a theory on how risk-averse can construct portfolios to optimise or maximise expected return based on a given level of market risk, emphasising that risk is on inherent pat of higher reward. ‘A major insight provided by the MPT is that an investment’s risk and return ‘characteristics should not be viewed alone, but should be evaluated by how the investment affect the overall portfolio's risk and return. MPT shows that an investor can construct a portfolio of multiple assets that will maximise returns for a given level of risk. Likewise, given a desired level of expected return, an investor can construct a portfolio with lowest possible risk This approach looks at the inter-relationship between assets to make up a portfolio and ensures they are not positively correlated but rather negatively correlated.7 05 0 os The closer the relationship between an asst ina portfolio to -1, the better the asset combinations. And the closer to +1, the higher the possibility of a crash. This approach can also be called Efficient Diversification and the theory brought the concept of “Efficient Frontier”. Difference between Traditional and Modern Portfolio Theory Traditional Ttis based on the fact that risk could be measured on each individual security through the process of finding out the standard deviation and that security should be chosen where the deviation was the lowest. Traditional theory believes that the market is inefficient and that the fundamental analyst can take advantage of the situation. It does not look at interrelationship of asset but rather how the objectives of the investment will be met. It involves naive diversification. Modern Tt is based on the view that by diversification, risk can be reduced. Diversification can be made by the investor either by having a large number of shares of companies in different regions, industries etc. MPT brought out by Markowitz and Sharpe, is the combination of securities to get the most efficient portfolio. It looks at the relationship between asset class and how possible economic change can affect the rate of return and tisk of the portfolio It involves efficient diversification. Diversification wn is a risk management technique that mixes a wide variety of Diversificatio investments within a portfolio. The rationale between these techniques contend that different kinds of investments will, on average, yield a portfolio constructed of lower risk than any individual investment found within higher returns and pose a the portfolio.Seller (1999) det decrbtali the fines diversification as the complete removal of specific risk by tH fluctuation of a portfolio return in excess of what the market will in terms of risk premium, Thus, diversification is a way to generate similar returns but at a reduced exposure to risk. It involves investing capital in different asset class to reduce the overall risk and thus maximising return. Diversification strives to smooth out unsystematic risk events in a portfolio 50 the Positive performance of some investments neutralises the negative performance of others. Therefore, the benefits of diversification hold only if securities in the portfolio are not perfectly correlated (+1). 1. Naive Diversification 2. — Efficient Diversification Naive Diversification Naive diversification is best described as a rough and more or less, instinctive common sense division of a portfolio, without bothering with sophisticated mathematical models. It entails the use of role of thump and intuitive approach to selection of asset to make up a portfolio. Efficient diversification is a way for a risk-adverse investor to achieve the highest expected return for any level of portfolio risk. A good portfolio has to be well diversified to give the investor both protections and opportunities to earn money. ‘According to Markowitz, the goal is to craft an “efficient portfolio”. An efficient portfolio is either a portfolio that offers the highest expected return for a given level of risk, or one with the lowest level of risk for a given expected return. The line that connects all these efficient portfolios is the “Efficient Frontier”. Efficient diversification involves the use of sophisticated mathematical tools for selection of different assets to make up a portfolio. It examines the interrelationship between different asset class that makes up the portfolio and ensures perfectly correlated assets are not combined. Diversification in Real Estate (Ways of Diversifying with Real Estate Investment) 1. Diversification by property type 2. Diversification by geographical area (internationally or locally) 3. Diversification by management4. Diversification by life-cycle costing 5. Diversification by ownership type Diversification isthe act of spreading one’s investment over a number of Investment vehices, These vehicles diffor with respect to other risk lovel, whereas some vehicles are very risky and others are much more conservative, ‘The objective of diversifying is to mitigate your risk, As such, If one of your investments underperform, you will have other investments that will be performing better and thus compensating for the underperforming asset.TA 230 nveon L{ wensas >aan an LL si Lf tiem bferowereunl artes, ayouen Hf aysuns 303 aH em oshl 128 Efe HL een HY tomes Hf deus Hers s0 x00 [were proveasy | [ omen apie puewu3 | | etnay e750 soe | [ teusnpu | fieasouwos) [renvapisay _— ees rene quaunsanuy 226353 jeoy juaunso aur 976389 eax unAIM BuLAssraaIp Jo skem SuLMOys EYfication 1. Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. 2 It helps to maximise returns by investing in different asset or investment vehicles, and thus spreading risk e.g. railway stocks, bank shares, direct and indirect real estate investment etc. 3. Ithelps to quantify risk and returns from an investment, 4. It helps to prevent total crash of an investment portfolio e.g. when your portfolios are not perfectly correlated i.e. your investment reacts differently to the same economic condition and thus the possibility of a total crash is eliminated. For instance, investing only in bank shares e.g, oceanic bank, when oceanic bank was bought over, oceanic bank shares crashed and those people that invested in it lost their investments. But however, where you have bank shares, gilt edge, real estate shares, airline shares, and say railway shares, the possibility of a total crash has been eliminated and there is high tendency of compensation if a crash occurs to one of the investments. 5. Ithelps to management specific (the asset class) and systematic risk (economic tisk, political risk etc). (Read up on diversification needs) RISK Risk involves the chance an investments actual return will differ from the expected return, Risk includes the possibility of losing some or all of the original investment. Risk is the probability or threat of damage, injury, liability loss or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through pre-emptive action, Risk is also the probability that an actual return on an investment will be lower than the expected return. Financial risk is divided into the following categories: Basic risk, capital risk, country risk, deposit risk, delivery risk, economic risk, operations risk, payment system risk, political risk, refinancing risk, reinvestment risk, sovereign risk, and underrating risk. Category of Risk © Systematic risk or market risk © Unsystematic or specific riskSystematic/Market Risk This type of risk affects all securities in the same class and itis linked to the overall capital market system and therefore cannot be eliminated by diversification. Systematic risk is associated with market risk eg. politcal risk, locational risky environmental risk etc. It is beyond the power or control ofthe investor, as they 3° external to the investment. E.g. change of government cannot be controlled by the investor; environmental hazards cannot be predicted or controlled. But however 9 investor can only minimise it by investing in different regions (both internally and locally), This risk is usually emanated from external agents Specific/Unsystematic Risk This is the risk that is not market related. It is also called non-market risk, ext73° market risk or diversifiable risk. inherent in each investment and emanated from the investment characteristic eg, real estate investment “possibility of a tenant defaulting rent payment, depreciation etc”. The risk that airline industry employees will go om strike, and airline stock prices will suffer as a result, is considered to be unsystematic risk, This tisk primarily affects the airline industry, airline companies and the companies with whom the airlines do business. It does not affect the entire market system, so itis an “unsystematic or non-market related risk. ‘a rent default, breach of covenant, Investment in real estate brings such risk affect the depreciation etc. This type of risk is inherent in real estate and does not whole market. Measurement of Risk At individual level + Risk is measured by using variance At portfolio level -» Risk measured by using standard deviation (Read Up) Sources of Risk 1. Interest rate risk:- The variability in a security's return resulting from changes in the level of interest rate referred to as interest rate risk e.g. change in bank interest rate from 7%-12%. 2. Market risk:- The variability in returns resulting from fluctuation in the overall market. That is, the aggregate stock market. 3, Inflation risk/ purchasing power risk 4, Business risk associated with class of investmentFinancial risk Liquidity risk Country risk Political risk . Tenant risk 10. Planning/taxation risk ete. wena RETURN Return is the gain or loss of a security in a particular period. The return consists of the income and the capital gains relative to an investment, and it is usually quoted as a percentage. The general rule is that the more risk you take, the greater the potential for higher returns and losses. Return in Real Estate Investment can be: 1. Income return — Rent 2. Capital return + Lump sum amount received from sale 3. Total return —+ Income + Capital return ‘Measurement of Return ‘Atindividual level + Arithmetic Mean / Geometric Mean At portfolio level —> Weighted Average Calculation for Return (Simple Illustration) Ifan investment produces the following return in 7years. Say 2010 8% 2011 + 6% 2012+ 12% 2013 + 6% 2014 + 9% 2015 + 3% 2016 25% Find the average mean of the investment. Solution Returns = 8 +6+12+6+9+3+425 = 46.5% “Average return = “5 = 6.64% 10Uncertainty Uncertainty is a situation which involves imperfect and/or unknown information. State of having limited knowledge where it is impossible to exactly describe the existing state, a future outcome, or more than one possible outcome. Uncertainty cannot be measured because the probability of such event occurring is not known. For instance, the probability of Jesus coming to Nigeria is unknown. The probability that snow will fall in Lagos tomorrow is not known. Thus, uncertainty cannot be quantified, while risk can be quantified. SIMPLE MEASURES OF PERFORMANCE * Net Present Value (NPV) * Internal Rate of Return (IRR) NET PRESENT VALUE Net Present Value is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyse the profitability of a projected investment or project. It involves discounting future incomes into present worth. NPV gives either + or — sign. If positive, the project is viable and when negative, the project is not viable. Simple Illustration If Mr. Ayo is to purchase a plot of land at the cost of 84,000 and cost of construction is put at 420,000 only. The expected income from the property is put at N5,000 (Year 1); 97,000 (Year 2); $410,000 (Year 3); 112,000 (Year 4). Taking return on investment to be 7%, calculate the NPV and advice on the viability of the investment. Year | Cash Outflow | Cash Inflow| PV @7% | Discounted Cash Flow 0 7 2 3 4 PV NI =Total Inflow — Total Outflow = 28,105 — 24,000 = +4,105 Advice: The project is viable and thus the investor can go ahead with the investment. 11INTERNAL RATE OF RETURN Internal Rate of Return ( a (IRR) is a metric in capi ing for measuring rote mn ( pital budgeting for Profitability of potential investments, Internal rate of return is a discount rate that makes the NPV of all cash flows from a particular project to zero. Using Illustration 1 above, Year | Cash Outflow | Cash Inflow [Pv @7% | Discounted Cash Flow 0 (24,000) - 1.0000 (24,000) 1 - 5,000 | 0.9346 4,673 2 3 7,000 | 0.8734 6114 3 a 10,000 | 0.8163 8,163 4 . 12,000 | 0.7629 9,155 NPV = Total Inflow — Total Outflow = 28,105 — 24,000 = +4,105 Calculation of IRR (Gince the NPV is positive, we need to increase the rate to get a negative (~) NPV. Then, take yield at say, 14%. Year_| Cash Outflow |Cash Inflow | PV @ 14% | Discounted Cash Flow 0 (24,000) = 1.0000 (24,000) 1 - 5,000 | 0.8772 4,386 2 - 7,000 | 0.7695 5387 3 - 10,000 | 0.6750 6,750 4 - 12,000 | 0.5921 7,105 NPV = Total Inflow — Total Outflow } 13,628 — 24,000 372 Therefore: ! Interpolation - ener = IRR= be + Wa bn) oe 27404 0B os erent (This will make NPV equal to 0 if ° =7+ On calculated. Thus, that is the break- =7+(7)0.9169 even point). 12Read Up: 1) Types of : ) Types of Investor: Retail/Individual Investor Portfolio/Instituti 2) Types of Risk takers / Institutional Investor Risk averse Risk indifferent 3) Advantages and di mete isadvantages of investment in indirect real estate (© 722 estate stocks and shares), Questions 1) Without portfolio, there cannot be diversification. Discuss 2) Succinctly discuss the key elements of portfolio management ortfolio management 3) Discuss portfolio problems as a good student of p io and clearly differentiate 4) Discuss the 2 major ways of constructing a portfoli between both 5) _ Differentiate between the following: Naive & Efficient diversification Traditional & Modern portfolio theory Identification of investment and Allocation of resources Sources of risk ‘Asset allocation and Dynamic asset allocation ‘Systematic and specific risk NPV and IRR Risk and Uncertainty Property type and Geographical area diversification Discuss diversification in relation to real estate investment room mp ae se 6) 7) Discuss the sources of risk in relation to property investment and management 8) Given the following for available investment options: PROJECIS: Project A Project B Project C CAPITAL OUTLAY: — 150,000 150,000 150,000 INFLOW: Year 1 — 30,000 Year 1 — 25,000 Year 1 —» 25,000 Year 2+ 52,000 Year 2 25,000 Year 2 —+ 25,000 Year 3 — 41,050 Year 3 + 80,000 Year 3 — 25,000 Year 4 — 21,000 ‘Year 4 — 65,000 Year 4 — 20,000 Year 5 — 65,000 Year 5 — 150,000 Year 5 — 20,000 Take yiel!/ddiscounting factor to be 7.5% a. Calculate the NPV and IRR of the investments b. Rank the investments according to their viability ¢. Give reasons for your ranking 13