IAPM - Unit - 4 & 5 (MBA-3)

Investment Analysis & Portfolio Management – MBA-3
UNIT – IV
CHAPTER- 01
PORTFOLIO CONSTRUCTION
Portfolio is group of financial / marketable assets such as shares, stock, bond, debt
instruments, cash equivalent etc. A portfolio is planned to stabilize the risk of non-
performance of various pools of investment.In other words, portfolio is a combination of
securities such as stocks, bonds and money market instruments. The process of blending
together to the assets so as to obtain optimum return with minimum risk is called portfolio
construction. Diversification of investment helps to spread risk over many assets. A
diversification of securities gives the assurance of obtaining the anticipated return on the
portfolio. Hence, it is a common practice to diversify securities in the portfolio. In a
diversified portfolio, some securities may not perform as expected but others may exceed the
expectation and making the actual return of the portfolio reasonably close to the anticipated
one.
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 vs. performance.It guides the investor in a method of selecting the best
available securities that will provide the expected rate of return for any given degree of risk
and also to mitigate the risk. It is a strategic decision which is addressed by top level
management.
Approaches in Portfolio Construction
Commonly, there are two approaches in the construction of the portfolio of securities –
Traditional Approach & Markowitz Efficient Frontier Approach (Modern Approach).
Traditional Approach – The simple fact that securities carry differing degrees of expected
risk leads most investors to the notion of holding more than one security at a time, in an
attempt to spread risks by not putting all their eggs into one basket. Most investor hope that if
they hold several assets, even if one goes bad, the others will provide some protection from
an extreme loss. Portfolio Management routed through diversification, it efforts to spread and
minimize risk take the form of diversification. The more traditional forms of diversification
have concentrated upon holding a number of security types. It is most valuable objective of
efficient portfolio would agree that a portfolio consisting of two stocks is probably less risk
than one holding either stock alone.Investor’s need in terms of income and capital
Dr.Meghashree A. Dadhich
appreciation are evaluated and appropriate securities are selected to meet the needs of the
investor. The traditional approach basically deals with following decisions –
a. Analysis of constraints- This involves determining investor’s financial position
objective and his attitude towards risk and return. Investor prepare a summary budget
for investment and investor also make a financial tool plan for investment by analysing
the constraints such as income needs, liquidity, time horizon, safety, tax consideration
etc. of the investor should be analysed.
b. Determining the objectives of the Investment – Portfolio have the common objective of
financing present and future expenditures from a large pool of assets. The return that the
investor requires and the degree of risk he is willing to take depend upon the
constraints. The objective of portfolio range from income to capital appreciation. If the
investor aims at capital appreciation then he should include risky securities in his
portfolio.
c. Selection of securities for the portfolio– The selection of securities is made with a view
to provide the investor the maximum yield for a given level of risk or ensure minimize
risk for a given level of return. However, selection of securities is based upon the
attitude of investor towards risk and objectives of the investor. The selection of
portfolio under different objectives is dealt subsequently – (i). If the main objective is
getting adequate amount regularly than 60% of the investment is made on debts and
40% on equities. (ii). If investor requires a certain percentage of growth in the income
received from his investment than portfolio may consist 60-100% equities and 40-0%
debt instruments. (iii). If the investor’s objective is capital appreciation than 90-100%
of his portfolio may consist equities or real estates and 10-0% of debts.
 Risk Averse: In this category we include those investor who demands maximum return a given for
risk and they will take calculated risk.
 Risk Seeking: In this category we include those investor who is willing to take more risk for given
return and they will take high risk and called risk owner.
 Risk Neutral: In this category we include those investor who is indifferent to risk and they will
unknown about risk.
d. Assessment of risk and return – The traditional approach for portfolio construction has
basic assumption i. e. the individual prefer larger to smaller returns from securities. To
achieve this goal, the investor has to take more risk. The ability to achieve higher return
is dependent upon his ability to judge risk and take risk. These risks may be interest rate
risk, purchasing power risk, financial risk and market risk.The investor analyses the
varying degree of risk and constructs his portfolio.
e. Diversification– Once the asset mix is determined and the risk-return is analysed, the
final step is the diversification of portfolio. The investor has to select the industries
appropriate to his investment objectives. Likewise, the investor has to select one or two
companies from each industry. The selection of the company depends upon its growth,
yield, expected earnings, past earnings, dividend and the amount spent on R & D. The
final step in this process is to determine the number of shares of each stock to be
purchased. Finally, portfolio weights are assigned to securities like bond, debentures,
preference & equity and diversification is carried out.
Modern Approach–Modern approach gives more attention to the process of selecting the
portfolio. The selection is based on the risk and return analysis. Returns includes the market
return and dividend. Investor are assumed to be indifferent towards the form of return. The
final steps is asset allocation process that is to choose the portfolio that meets the requirement
of the investor. Investor can adopt passive approach or active approach towards the
management of the portfolio. In the passive approach the investor would maintain the
percentage allocation of the asset classes and keep the security holding within its place over
the established holding period. In the active approach the investor continuously assess the
risk and return of the securities within the assets classes and changes them accordingly.
Portfolio risk can be reduced by the simplest kind of diversification. In the case of common
stocks diversification reduces the unsystematic risk or unique risk. Analysts says that if 15
stocks are added in a portfolio of the investor, the unsystematic risk can be reduced to zero.
But at the same time if the number exceed 15, additional risk reduction cannot be gained. But
diversification cannot reduced systematic or undiversifiable risk.
Modern portfolio theory (MPT) is a theory of finance that attempts to maximize portfolio
expected return for a given amount of portfolio risk, or equivalently minimize risk for a given
level of expected return, by carefully choosing the proportions of various assets. Markowitz
gives more attention to the process of selecting the common stock’s portfolio than the bond’s
portfolio. The stocks are not selected on the basis of need for income or appreciation. But the
selection is based on the risk-return analysis. Return includes the market return and dividend.
The investor needs return either in the form of market return or dividend.
It views portfolio construction in terms of the expected return and the risk associated with
obtaining the expected return.MPT is a mathematical formulation of the concept
of diversification in investing, with the aim of selecting a collection of investment assets that
has lower overall risk than any other combination of assets with the same expected
return. Investor selects roughly some group of shares say 10 or 15 stocks. For these stocks’
expected return and risk would be calculated. The investor is assumed to have the objective
of maximizing the expected return and minimizing the risk. Further, it is assumed that
investors would take up risk in a situation when adequately rewarded for it. This implies that
individuals would prefer the portfolio of highest expected return for a given level of risk.
In the modern approach, the risk taker i.e. who are willing to accept a higher probability of
risk for getting the expected return would choose highly risky portfolio. The risk averser i.e.
who would like to tolerate risk will choose less risky portfolio. The risk neutral investor
would choose the medium risky portfolio.
Managing the Portfolio
After establishing the asset allocation, the investor has to decide how to manage the portfolio
over time. He can adopt passive approach or active approach towards the management of the
portfolio. In the passive approach, the investor would maintain the percentage allocation for
assets and keep the security holding within its place over the established holding period. In
the active approach, the investor continuously assesses the risk and return of the securities
within the assets and changes them according to the risk variations which meet his objective.
 Planning – How much to save & invest monthly / quarterly / half yearly / annually
 Organizing – Deciding the investible proportion for various investment avenues
 Staffing – Investment in selected invested avenues / securities as per predefined
proportion
 Directing – Regular monitoring on investment(s) to achieve the investment objectives
 Controlling – Divesting from the high risk - low return securities to minimize the total
risk & maximise the total return of investment
Types of Portfolio
Stock investors constantly hear the wisdom of diversification. The concept is to simply not
put all of your eggs in one basket, which in turn helps mitigate risk, and generally leads to
better performance or return on investment. Diversifying your hard-earned dollars does make
sense, but there are different ways of diversifying, and there are different portfolio types. The
following are the portfolios -
1. The Aggressive Portfolio: An aggressive portfolio or basket of stocks includes those
stocks with high risk/high reward proposition. Stocks in the category typically have a
high beta, or sensitivity to the overall market. Higher beta stocks experience larger
fluctuations relative to the overall market on a consistent basis. If your individual stock
has a beta of 2.0, it will typically move twice as much in either direction to the overall
market - hence, the high-risk, high-reward description. Most aggressive stocks are in the
early stages of growth, and have a unique value proposition. Building an aggressive
portfolio requires an investor who is willing to seek out such companies, because most of
these names, with a few exceptions, are not going to be common household companies.
Look online for companies with earnings growth that is rapidly accelerating, and have
not been discovered by Wall Street. The most common sectors to scrutinize would be
technology, but many other firms in various sectors that are pursuing an aggressive
growth strategy can be considered. As you might have gathered, risk management
becomes very important when building and maintaining an aggressive portfolio. Keeping
losses to a minimum and taking profit are keys to success in this type of portfolio.
2. The Defensive Portfolio: Defensive stocks do not usually carry a high beta, and usually
are fairly isolated from broad market movements. Cyclical stocks, on the other hand, are
those that are most sensitive to the underlying economic "business cycle." For example,
during recessionary times, companies that make the "basics" tend to do better than those
that are focused on fads or luxuries. Despite how bad the economy is, companies that
make products essential to everyday life will survive. Think of the essentials in your
everyday life, and then find the companies that make these consumer staple products.
The opportunity of buying cyclical stocks is that they offer an extra level of protection
against detrimental events. Just listen to the business stations and you will hear portfolios
managers talking about "drugs," "defence" and "tobacco." These really are just baskets of
stocks that these managers are recommending based upon where the business cycle is
and where they think it is going. However, the products and services of these companies
are in constant demand. A defensive portfolio is prudent for most investors. A lot of
these companies offer a dividend as well which helps minimize downside capital losses.
3. The Income Portfolio: An income portfolio focuses on making money through
dividends or other types of distributions to stakeholders. These companies are somewhat
like the safe defensive stocks but should offer higher yields. An income portfolio should
generate positive cash flow. Real estate investment trusts (REITs) and master limited
partnerships (MLP) are excellent sources of income producing investments. These
companies return a great majority of their profits back to shareholders in exchange for
favourable tax status. REITs are an easy way to invest in real estate without the hassles
of owning real property. Keep in mind, however, that these stocks are also subject to the
economic climate. REITs are groups of stocks that take a beating during an economic
downturn, as building and buying activity dries up. An income portfolio is a nice
complement to most people's pay check or other retirement income. Investors should be
on the lookout for stocks that have fallen out of favour and have still maintained a high
dividend policy. These are the companies that can not only supplement income but also
provide capital gains. Utilities and other slow growth industries are an ideal place to start
your search.
4. The Speculative Portfolio: A speculative portfolio is the closest to a pure gamble. A
speculative portfolio presents more risk than any others discussed here. Finance gurus
suggest that a maximum of 10% of one's investable assets be used to fund a speculative
portfolio. Speculative "plays" could be initial public offerings (IPOs) or stocks that are
rumoured to be takeover targets. Technology or health care firms that are in the process
of researching a breakthrough product, or a junior oil company which is about to release
its initial production results, would also fall into this category. Another classic
speculative play is to make an investment decision based upon a rumour that the
company is subject to a takeover. One could argue that the widespread popularity of
leveraged ETFs in today's markets represent speculation. Again, these types of
investments are alluring: picking the right one could lead to huge profits in a short
amount of time. Speculation may be the one portfolio that, if done correctly, requires the
most homework. Speculative stocks are typically trades, and not your classic "buy and
hold" investment.
5. The Hybrid Portfolio: Building a hybrid type of portfolio means venturing into other
investments, such as bonds, commodities, real estate and even art. Basically, there is a lot
of flexibility in the hybrid portfolio approach. Traditionally, this type of portfolio would
contain blue chip stocks and some high grade government or corporate bonds. REITs and
MLPs may also be an investable theme for the balanced portfolio. A common fixed
income investment strategy approach advocates buying bonds with various maturity
dates, and is essentially a diversification approach within the bond asset class itself.
Basically, a hybrid portfolio would include a mix of stocks and bonds in a relatively
fixed allocation proportions. This type of approach offers diversification benefits across
multiple asset classes as equities and fixed income securities tend to have a negative
correlation with one another.
Simple Diversification
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio means the
group of assets an investor owns. The assets may vary from stocks to different types of
bonds. Sometimes the portfolio may consist of securities of different industries. When
different assets are added to the portfolio, the total risk tends to decrease. In the case of
common stock, diversification reduces the unsystematic risk or unique risk. Analysts opine
that if 15 stocks are added in a portfolio of the investor, the unsystematic risk can be reduced
to zero. But at the same time, if the number exceeds 15, additional risk will be added. But the
diversification cannot reduce systematic or undiversifiable risk. In the case of simple
diversification, securities are selected at random and no analytical procedure is used.
Example–Suppose an investor is having Rs. 10000 to invest. He has kept separate to Rs. 6000
for the investment in financial assets (FD / PF / Insurance / APY / NPS etc.) and he wants to
invest remaining Rs. 4000 in stock market (Diversification). Here, he can invest it in
defensive stocks (Govt. Securities / Gilt Edged Securities) to have a defensive portfolio (low
risk – low return) or in aggressive stocks (Private Companies Shares which are frequently
tradeable) to have an aggressive portfolio (high risk – high return) or in income stocks
(Companies which pay interim or special dividend) to maintain income portfolio (Profit =
Dividend + Capital Appreciation) or in the shares whose risk – return is uncertain to have a
speculative portfolio (Companies whose future prices are not so predictable) or in hybrid
securities (Companies who belongs from various industries) to maintain hybrid portfolio
(high risk to maximize the return).
Example. Your investment account of $100,000 consists of three stocks: 200 shares of stock A, 1,000
shares of stock B, and 750 shares of stock C. Your portfolio is summarized by the following weights:
Asset Shares Share Price Dollar Weight
Investment
A 200 50 10000 10%
B 1000 60 60000 60%
C 750 40 30000 30%
Total 100000 100%
UNIT – IV
CHAPTER- 02
PORTFOLIO CONSTRUCTION: MARKOWITZ MODEL
The Markowitz Model
Harry Markowitz considered father of modern portfolio theory, mainly because he was the
first person who gave a mathematical model for portfolio optimization & diversification. He
published an article on portfolio selection in the journal of finance in March 1952& indicated
the importance of correlation among the different stocks return in the construction of a stock
portfolio. After the publication of this paper, numerous investment firms and portfolio
managers developed ‘Markowitz algorithms’ to minimize risk.
Markowitz has given up the single stock portfolio and introduced diversification. The single
stock portfolio would be preferable if the investor is perfectly certain that his expectation of
higher return would turn out to be real. But in this era of uncertainty, most people agree that
holding two stocks is less risky than holding one stock.
For example, holding stocks from textile, banking and electrical companies is better than
investing all money in textile company’s stock. But building up the optimal portfolio is very
difficult. Markowitz provides an answer to it with the help of risk-return relationship. This
model assists in the selection of the most efficient combination by analysing various possible
set of portfolios of the given securities
Assumptions-
 Investors are rational (they seek to maximize returns while minimizing risk).
 Investors will accept increased risk only if compensated with higher expected returns.
 Investors receive all pertinent information regarding their investment decision in a timely
manner.
 Investors can borrow or lend an unlimited amount of capital at a risk-free rate of interest.
 An investor either maximizes their portfolio return for a given level of risk or minimizes
their risk for a given level of return.
In the world of uncertainty, most of the risk averse investors would like to join Markowitz
rather than keeping a single stock, because diversification reduces the risk. Holding two
securities may reduce the portfolio’s risk. The level of risk exposure is measured with the
help of standard deviation of the return. The expected return is the weighted sum of the
expected returns of the portfolio, the weights being the probability of their occurrence. The
portfolio risk can be calculated-
σp = √σ2w2 + σ2w2 + 2 w1w2σ1σ2 r12
The risk would be nil, if two securities have perfect negative correlation. Risk cannot be
reduced if the securities have perfect positive correlation.
Markowitz Efficient Frontier
A portfolio is efficient when it is expected to yield higher level of return at the level of risk or
alternatively the lower level of risk for a specified level of expected return. To build an
efficient portfolio an expected return’s level is chosen and assets are substituted. Until, the
portfolio’s combination with the smallest risk at the best return is found.
Now, the question is raised that which portfolio the investor should choose? He would choose
a portfolio that maximizes his utility. For that utility analysis has to be done. ‘Utility is the
satisfaction the investor enjoys from the portfolio’s return’. If investor is allowed to choose
between two certain investments, he would always like to take the one with larger outcome.
Thus, utility increases with increase in return. Diversification consist following cases –
 When diversification does not help;
 When diversification can eliminate risk;
 When diversification always help;
Numerical portion has covered in lectures only!!!
UNIT – IV
CHAPTER - 3
THE SHARPE INDEX MODEL
The Sharpe Index Model
The investor always like to purchase a combination of stocks that provides the highest return
and has lowest risk. Investor wants to maintain a satisfactory reward to risk ratio. The
Markowitz model is adequate and conceptually sound in analysing the risk and return of the
portfolio. The problem with Markowitz model is that a number of co-variances have to be
estimated.
The model has been developed by William F. Sharpe in 1963 and is commonly used in the
finance industry to understand the return of an investment compared to its risk.Shape has
developed a simplified model to analyse the portfolio. He assumed that the return of the
security is linearly related to a single index like the market index. Strictly speaking, the
market index should consist of all the securities trading on the exchange. In the absence of it,
a popular index can be surrogate for the market index.
According to William Sharpe, portfolio risk is the aggregate of systematic and unsystematic
risk. For determining portfolio risk using Sharpe’s approach, first determine systematic risk
of portfolio, using variance approach.
Single Index Model
Casual observation of the stock prices over a period of time reveals that most of the stock
prices move with the market index. When the Sensex increases, stock prices also tend to
increase and vice-versa. This indicates that some underlying factors affect the market index
as well as the stock prices. Sharpe Model has simplified the selection process by relating the
return in a security to a single market index.
 Firstly, this will theoretically reflect all well traded securities in the market.
 Secondly, it will reduce and simplify the work involved in compiling elaborate matrices
of variances as between individual securities.
Towards this purpose, the following equation can be used –
Ri = αi+ βi Rm + ei
According to the equation, the return of a stock can be divided into two components, the
return due to the market and the return independent of the market. βiindicates the
sensitiveness (systematic risk) of the stock return to the changes in the market return. For
example, βiof 1.5 means that the stock return is expected to increase by 1.5% when the
market index return increases by 1% and vice-versa. The single index model is based on the
assumption that stocks vary together because of the common movement in the stock market
and there are no effects beyond the market.
Alpha is the vertical intercept on y-axis representing the return on the security when only
unsystematic risk is considered and systematic risk is measured by Beta. C i is the residual
component, not captured by the above variables.
Sharpe’s Optimal Portfolio
This optimal portfolio of Sharpe is called the Single Index Model. The optimal portfolio is
directly related to the Beta. If Ri is expected return on stock i and Rf is Risk free Rate, then
the excess return = Ri – Rf This has to be adjusted to Bi, namely,
Sharpe had provided a model for the selection of appropriate securities in a portfolio. The
selection of any stock is directly related to its excess return- beta ratio. The excess return is
the difference between the expected return on the stock and the risk less rate of interest such
as the rate offered on the government security or Treasury bill. This ratio provides a
relationship between potential risk and reward.
Return Beta Ratio = Ri – Rf/βiwhich is the equation for ranking Stocks in the order of their
return adjusted for risk.
Ranking of the stocks are done on the basis of their excess return to beta. Portfolio managers
would like to include stocks with higher ratios. The selection of the stocks depends on a
unique cut-off rate such that all stocks with higher ratios of Ri – Rf/βiare included and the
stock with lower ratio s are left off. The cut-off point is denoted by C*.
The method involves selecting a cut-off rate for inclusion of securities in a portfolio. For this
purpose, excess return to Beta ratio given above has to be calculated for each stock and rank
them from highest to lowest. Then only those securities which have Ri – Rf/βi, greater than
cut-off point, fixed in advance can be selected.
Rf = Risk free Return = 5%
Based on the above data, we have to calculate the ‘C’ values for each security for inclusion in
the optimum portfolio.
The following table gives the example:
All securities with excess return to Beta ratio above the cut-off rate C*, say 3.0 in the above
table will be chosen in the portfolio. The calculation of cut-off point is also explained. In
arriving at the optimal portfolio, the emphasis of Sharpe Model is on Beta and on the Market
Index. Sharpe’s optimal portfolio would thus consist of those securities only which have
excess return to Beta ratio above a cut-off point.
By this method, selection of the portfolio has become easier due to the ranking of the
securities in the order of their excess return and applying the yardstick of a required cut-off
point for selection of securities.
Distribution of Investments:
Once the choice of securities is made then one has to decide the proportion of his funds to be
invested in each security.
The percentage to be invested in each security is-
The second expression in the bracket will determine the proportion of funds to be invested in
each security. The first expression simply scales the weight on each security, so that the total
is summing up to 1.
Numerical portion has covered in lectures only!!!
UNIT –V
CHAPTER- 01
PORTFOLIO EVALUATION
Many investors mistakenly base the success of their portfolios on returns alone. Few consider
the risk that they took to achieve those returns. Since the 1960s, investors have known how to
quantify and measure risk with the variability of returns, but no single measure actually
looked at both risk and return together. The evaluation of the portfolio provides a feedback
about the performance to evolve better management strategy.
Although portfolio evaluation is the last step in the portfolio management process, it is by no
means the least important. On the contrary, proper performance measurement, attribution,
and appraisal can enhance the probability of success for the entire investment process.
Improper evaluation, on the other hand, can directly create some of the often-criticized
issues in the investment industry.
Here, we have three sets of performance measurement tools to assist us with our portfolio
evaluations. The Sharpe, Treynor and Jensen performance indexes combine risk and return
performance into a single value, but each is slightly different.
Sharpe’s Performance Index
Sharpe’s performance index gives a single value to be used for the performance ranking of
various funds or portfolios. Sharpe index measures the risk premium of the portfolio relative
to the total amount of risk in the portfolio. This risk premium is the difference between the
portfolio’s average rate of return and the risk-less rate of return. The index assigns the highest
values to asset that have best risk-adjusted rate of return.
Sharpe Index (St) = Portfolio’s Return – Risk Free Rate of Interest / Standard Deviation
of the Portfolio
Sharpe index can be used to rank the desirability of funds or portfolios, but not the individual
assets. The individual asset contains its diversifiable risk.
Treynor’s Performance Index
To understand the Treynor index, an investor should know the concept of characteristic line.
The relationship between a given market return and the fund’s return is given by the
characteristic line. The fund’s performance is measured in relation to the market
performance. The ideal fund’s return rises at a faster rate than the general market
performance when the market is moving upwards and its rate of return declines slowly than
the market return in the decline phase.
The relationship between the market return and fund’s return is assumed to be linear. This
linear relationship can show by the characteristic line. Each fund establishes a performance
relationship with the market. The characteristic line can be drawn by plotting the fund’s rate
of return for a given period against the market’s rate of return for the same period. The slope
of the line reflects the volatility of the fund’s return. A steep slope would indicate that the
fund is very sensitive to the market performance. If the fund is not so sensitive then the slope
would be a slope of less inclination.
With the help of characteristic line Treynor measures the performance of the fund. The slope
of the line is estimated by Rp= α + β Rm + e p
Treynor Index (Tn) = Portfolio’s Return – Risk Free Rate of Return / Beta co-efficient of
Portfolio
Beta co-efficient is treated as a measure of undiversifiable systematic risk.
Jensen’s Performance Index
The absolute risk adjusted return measure was developed by Michael Jensen and commonly
known as Jensen’s measure. It is mentioned as a measure of absolute performance because a
definite standard is set and against that the performance is measured. The standard is based
on the portfolio manager’s predictive ability. Successful prediction of security price would
enable the manager to earn higher returns than the ordinary investor expects to earn in a given
level of risk.
Jensen index compares the actual or realized return of the portfolio with the calculated or
predicted return. Better performance of the fund depends on the predictive ability of the
managerial personnel of the fund. The basic model of Jensen is given below –
Rp = α + Rf + β (Rm – Rf)
The return of the portfolio varies in the same proportion of β to the difference between the
market return and Riskless rate of interest. Beta is assumed to reflect the systematic risk. The
fund’s portfolio beta would be equal to one if it takes a portfolio of all market securities. The
beta would be greater than one if the fund’s portfolio consists of securities that are riskier
than a portfolio of all market securities.
Any professional manager would be expected to earn average portfolio return of R p = α + Rf
+ β (Rm – Rf). If his prediction ability is superior, he should earn more than other funds at
each level of risk.
Fama Net Selectivity

Difference between expected and actual risk adjusted return is taken as a measure of
performance of the portfolio and is called ‘Fama Net Selectivity’. Net selectivity presents
stock selection skill of the portfolio manager, as it is the excess return over and above the
return required to compensate for the total risk taken by the portfolio manager. Higher value
of the net selectivity indicates that the fund manager has earned returns well above the return
for the level of risk inherent in the portfolio. Required return can be calculated using CAPM
Model: Ri = Rf + σi / σm (Rm – Rf)
Net selectivity is then calculated by subtracting this required return from the actual return of
the fund. Fama’s performance measure attributes the difference between computed and actual
returns as to the stock selection ability of the portfolio manager. Positive net selectivity
values indicate superior performing portfolios and negative net selectivity values indicate
inferior performing scores.
Fama’s Net Selectivity = (Rp – Rf) – [(σi / σm) (Rm – Rf)]
Q1. An investor has invested in 3 mutual fund schemes and willing to do portfolio’s
evaluation with the aim to ensure receipt of expected return on maturity. You are requested to
apply Fama’s Net Selectivity for portfolio evaluation & ranking. It is projected that Rf is
7.50%, market return is 18% and market risk is 14.75%.
Portfolios Expected Return of Risk of Portfolio
Portfolio Rp (%) (σp)
Equity Linked Scheme 24 16
Balanced Fund 12.50 7
Growth Fund 16.75 10
Fama’s Net Selectivity = (Rp – Rf) – [(σi / σm) (Rm – Rf)]

ELC = (24-7.5) – [(16-14.75) * (18 – 7.50) = 16.5 – (1.25 * 10.5) = 3.375
BF = (12.5-7.5) – [(7-14.75) * (18 – 7.50) = 5 – (-7.75 * 10.5) = (-) 86.375
GF = (16.75 - 7.5) – [(10-14.75) * (18 – 7.50) = 9.25 – (-4.75 * 10.5) = (-)59.125
UNIT – IV
CHAPTER- 02
PORTFOLIO REVISION
The care taken in the construction of the portfolio should be extended to the revision of the
portfolio. Fluctuations that occur in the equity prices cause substantial gain or loss to the
investors. The investor should have competence and skill in the revision of the portfolio.
Normally, the average investor dislikes to sell in the bull market with the anticipation of
further rise. Likewise, he is reluctant to buy in the bear market with the anticipation of further
fall.
The portfolio management process needs frequent changes in the composition of stocks and
bonds. In securities, the type of securities to be held should be revised according to the
portfolio policy. If the policy of investor shifts from earnings to capital appreciation, the
stocks should be revised accordingly. An investor can sell his shares if the price of shares
reaches the historical high price. Likewise, if the security does not fulfil the investor’s
expectation regarding return and growth, it is better to get rid of it.
Portfolio revision is one of the pillars of the overall process of portfolio management. It
entails assessing the change in portfolio composition over a period of time and taking steps, if
required, to get it back in line with the investment objective and risk tolerance framework
with which the portfolio was initially constructed. Portfolio revision also helps investors in
keeping their investments relevant to changing times and trends. The primary intention
behind portfolio revision is to achieve an optimal amount of returns for a given level of risk.
Types of Portfolio Management
1. Passive Management – It is a process of holding a well-diversified portfolio for a long
term with the buy and hold approach. Passive management refers to the investor’s attempt
to construct a portfolio that resembles the overall market returns. The simplest form of
passive management is holding the index fund that is designed to replicate a good and
well defined index of the common stock such as BSE-Sensex or NSE-Nifty. The fund
manager buys every stock in the index in exact proportion of the stock in that index.In
passive portfolio revision, the primary aim is to keep earning market returns by executing
a buy-and-hold strategy for the most part. This is not to say that changes are not made to
the portfolio at all throughout the investment horizon, just the portfolio changes are less
in number compared to the active strategy and portfolio managers do not react to every
change in the direction of markets. The believers in passive portfolio revision subscribe to
Efficient Market Hypothesis which holds that financial markets are efficient as all
available information about a security is available throughout the market and is priced
into the security. Due to this belief, this technique finds it futile to try to beat market
returns, and thus, tries to equal them.For example - If Reliance Industry’s stock
constitutes 5% of the index; the fund also invests 5% of its money in Reliance Industry.
2. Active Management –Active management is holding securities based on the forecast
about the future. The portfolio managers who pursue active strategy with respect to
market components are called ‘market timers’. The portfolio managers vary their cash
position or beta of the equity portion of the portfolio based on the market forecast. The
manager’s may indulge in group rotations. Here, the group rotation means changing the
investment in different industries’ stocks depending on the assessed expectations
regarding their future performance. Stocks that seem to be best or attractive are given
more weights in the portfolio than their weights in the index. At the same time, stocks that
are considered to be less attractive are given lower weights compared to their weights in
the index. As the name of the strategy suggests, an investor or professional portfolio
manager is quite hands on with making changes to the portfolio. The underlying
philosophy behind active portfolio revision is that in-depth securities research and
analysis can reveal investments which can beat market returns as markets are inefficient.
Subscribers of this strategy don’t find the idea of market returns appealing and react to
changes in market situations in order to gain an advantage over others. However, in order
to try to generate greater than market returns and the relatively frequent churning of
portfolios, this strategy is costly due to the cost associated with research as well as higher
trading costs that a passive strategy.For example – IT & FMCG industry stocks may be
given more weights than their respective weights in the NSE-50.
Portfolio Revision or Formula Plan
The formula plan provides the basic rules and regulations for the purchase and sale of
securities. The amount to be invested on the different types of securities is fixed. The amount
may be fixed either in constant or variable ratio. This depends on the investor’s attitude
towards risk and return. The formula plan helps to divide the investible fund between the
aggressive and conservative portfolios.
The aggressive portfolio consist more of common stock which yield high return with high
risk. The aggressive portfolio’s return is volatile because the share prices generally fluctuate.
The conservative portfolio consists of more bonds that have fixed rate of returns. It is called
conservative portfolio because the return is certain and the risk is less. The capital
appreciation in the conservative portfolio is rather slow and the fall in price of the bond or
debenture is also alike.
Assumptions of the Formula Plan
1. Certain percentage of the investor’s fund is allocated to fixed income securities and
common stocks (risky securities). The proportion of money invested in each component
depends on the prevailing market condition.
2. If the market moves higher, the proportion of stocks in the portfolio may either decline or
remain constant. The proportion is low aggressive in the low market and defensive when
the market is on the rise.
3. The stocks are bought and sold whenever there is a significant change in the price.
4. The investor should strictly follow the formula plan once he chooses it.
5. The investor should select good stock that move along with the market. The stock price
movement should be closely correlated with the market movement and the beta value
should be around 1. The stocks of the fundamentally strong companies have to be
included in the portfolio.
Advantages of the Formula Plan
 The investor can earn higher profit by adopting the plan;
 A course of action is formulated according to the investor’s objectives;
 It controls the buying and selling of securities by the investor;
Disadvantages of the Formula Plan
 The formula plan does not help the selection of security. The selection of security has to
be done either on the basis of the fundamental or technical analysis;
 The formula plan should be applied for long periods, otherwise the transaction cost may
be high;
 Even if the investor adopts the formula plan, he needs forecasting. Market forecasting
helps him to identify the best stocks.
Portfolio Revision Method
1. Constant Rupee Plan – This plan force the investor to sell when the prices rise and
purchase as prices fall. The essential feature of this plan is that the portfolio is divided
into two parts, which consists of aggressive and defensive (conservative) portfolio. The
constant rupee plan enables the shift of investment from bonds to stocks and vice-versa
by maintaining a constant amount invested in the stock portion of the portfolio. The
constant rupee plan starts with a fixed amount of money invested in selected stocks and
bonds. When the price of the stocks increases, the investor sells sufficient amount of
stocks to return to the original amount of the investment in stocks. By keeping the value
of aggressive portfolio constant, remainder is invested in the defensive portfolio. The
objective of the constant rupee plan is to balance the division between the conservative
and aggressive components of a portfolio in terms of the target value. The target value
could be fixed initially by the investor in a desirable proportion. For example, a constant
rupee plan could consider the initial value of 10000 each between conservative and
aggressive portfolios. There can also be an initial value of 15000 and 5000 in the
aggressive and conservative portfolio components respectively.
2. Constant Ratio Plan – It attempts to maintain a constant ratio between the aggressive
and conservative portfolios. The ratio is fixed by the investor. The investor’s attitude
towards risk and return plays a major role in fixing the ratio. The conservative investor
may like to have more of bond and the aggressive investor may like to have more of
stocks. Once, the ratio is fixed, it is maintained as the market moves up and down. As
usual, action points may be fixed by the investor. Here investors are buyers in the market.
Irrespective of a fall or rise in prices, the investors intend to purchase the shares. This
plan is used most often for portfolio building. The intention is to increase the wealth of
the investors rather than secure returns for the investors. For enlarging this portfolio,
investors may identify a certain percentage of increment or decrement.
3. Variable Ratio Method – According to this plan, the proportion of stocks and bonds
change. Whenever the price of stock increases, the stocks are sold and new ratio is
adopted by increasing the proportion of defensive portfolio. To adopt this plan, the
investor is required to estimate a long term trend in the price of the stocks. Forecasting is
very essential to this plan. When there is wide fluctuation in the prices of stocks than
variable ratio plan is useful. The variable-ratio plan gives more flexibility to the investor
to revise the portfolio components. When the share price falls, the investor may shift a
major component of the conservative portfolio to the aggressive component. The desired
ratio of investment holding between conservative and aggressive components of a
portfolio hence may vary according to the flexibility that the investor wishes to
incorporate in the portfolio revision decisions. When the share price rises back, then the
investor may shift funds back to maintain a stabilized portfolio.
With the passage of time the stocks which were attractive once may turn out to be less
attractive in terms of return. The investor’s attitude towards risk and return also may change
and the forecast regarding the market also may undergo change. In this context, the necessary
revision is thought of by the portfolio manager.

IAPM - Unit - 4 & 5 (MBA-3)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

IAPM - Unit - 4 & 5 (MBA-3)

Uploaded by

Copyright:

Available Formats

Investment Analysis & Portfolio Management – MBA-3

Rf = Risk free Return = 5%

Numerical portion has covered in lectures only!!!

Fama Net Selectivity

Fama’s Net Selectivity = (Rp – Rf) – [(σi / σm) (Rm – Rf)]

You might also like