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PORTFOLIO MANAGEMENT

FRAMEWORK
The Grand Design
OUTLINE
• Phases of Portfolio Management
• Specification of Investment Objectives and Constraints
• Choice of Asset Mix
• Formulation of Portfolio Strategy
• Selection of Securities
• Portfolio Execution
• Portfolio Revision
• Portfolio Evaluation
PHASES OF PORTFOLIO MANAGEMENT
SPECIFICATION OF INVESTMENT
OBJECTIVES AND CONSTRAINTS

CHOICE OF ASSET MIX

FORMULATION OF PORTFOLIO
STRATEGY

SELECTION OF SECURITIES

PORTFOLIO EXECUTION

PORTFOLIO REVISION

PORTFOLIO EVALUAYION
Investment Policy Worksheet
1. Executive Summary
2. Investment Objectives
3. Investment Philosophy
4. Investment Selection Criteria
5. Monitoring Procedures
SPECIFICATION OF INVESTMENT OBJECTIVES
• The commonly stated investment goals are :
Income – To provide steady stream of income through
regular interest/dividend payment
Growth – To increase the value of the principal
amount through capital appreciation
Stability – To protect the principal amount invested
from the risk of loss.
• Since income and growth represent two ways by which
return is generated and stability implies containment of
risk, investment objectives may be expressed more
succinctly in terms of return and risk.
Investment Goals
 As in investor you would primarily be
interested in a higher return (in the form of
income and/or capital appreciation) and a
lower level of risk.
 How much risk you would be willing to
bear to seek a higher return, depends on
your risk disposition.
 Your investment objective should state your
preference for return relative to your
distaste for risk.
Specification of investment
objective
 Maximize the expected return, subject to the
risk exposure being held within a certain
limit (the risk tolerance level)
 Minimize the risk exposure, without
sacrificing a certain expected rate of return
(the target rate of return)

 One should generally start by defining the


risk tolerance.
Elaboration
 The risk one can bear depends on two key
factors:
 Financial Situation

 Temperament.

 What is the position of your wealth?


 What major expenses can be anticipated in near
future?
 What is your earning capacity?
 How much money can you lose without seriously
hurting your standard of living?
Temperament
 Even tough your financial situation may permit you to
absorb losses easily, you may become extremely upset
over small losses.
 On the other hand, despite a not-so-strong financial
position, you may not be easily ruffled by losses.
 Understand your financial temperament as objectively as
you can.
 Your risk tolerance level is set by either your financial
situation or your financial temperament.
 Risk tolerance cannot be or should not be defined to
precisely and rigorously.
 For practical purposes, it suffices if you define it as low,
medium or high.
Risk assessment
 Financial advisers, mutual funds, and
brokerage firms have developed risk
questionnaires to help investors determine
whether they are conservative, moderate, or
aggressive.
 Typically, such risk questionnaires have 7-
10 questions to gauge a person’s tendency
to make risky or conservative choices in
certain hypothetical situations.
A RISK TOLERANCE QUESTIONNAIRE
To assess your risk tolerance, seven questions are given below. Each question
is followed by three possible answers. Circle the letter that corresponds to
your answer.
1. Just six weeks after you invested in a stock, its price declines by 20
percent. If the fundamentals of the stock have not changed, what would
you do?
a. Sell
b. Do nothing
c. Buy more
2. Consider the previous question another way. Your stock dropped 20
percent, but it is part of a portfolio designed to meet investment goals with
three different time horizons.
(i) What would you do if your goal were five years away?
a. Sell
b. Do nothing
c. Buy more
(ii) What would you do if the goal were 15 years away?
a. Sell
b. Do nothing
c. Buy more
(iii) What would you do if the goal were 30 years away?
a. Sell
b. Do nothing
c. Buy more
3. You have bought a stock as part of your retirement portfolio. It price rises
by 25 percent after one month. If the fundamentals of the stock have not
changed, what would you do?
a. Sell
b. Do nothing
c. Buy more
4. You are investing for retirement which is 15 years away. What would you
do?
a. Invest in money market mutual fund or a guaranteed investment
contract
b. Invest in a balanced mutual fund that has a stock : bond mix of
50 : 50
c. Invest in an aggressive growth mutual fund
5. As a prize winner, you have been given some choice. Which one would you
choose?
a. Rs 50,000 in cash
b. A 50 percent chance to get Rs 125,000
c. A 20 percent chance to get Rs 375,000
6. A good investment opportunity has come your way. To participate in it
you have to borrow money. Would you take a loan?
a. No
b. Perhaps
c. Yes
7. Your company, which is planning to go public after three years, is offering
stock to its employees. Until it goes public, you can’t sell your shares. Your
investment, however, has the potential of multiplying 10 times when the
company goes public. How much money would you invest?
a. Nothing
b. Three months’ salary
c. Six months’ salary
Your risk tolerance score is:
Number of (a) answers x 1
+ Number of (b) answers x 2
+ Number of (c) answers x 3

If your score is … You may be a …


9–14 points Conservative investor
15–21 points Moderate investor
22–27 points Aggressive investor
Constraints
1. Liquidity
2. Investment Horizon
3. Taxes
4. Regulations
5. Unique Circumstances
1. Liquidity
 Liquidity refers to the speed with which an asset
can be sold, without suffering any discount to its
fair market price.
 For eg. Money market instruments are the most
liquid assets, whereas antiques are among the least
liquid ones.
 Taking into your cash requirements in the
foreseeable future, you must establish the
minimum level of “cash” you want in your
investment portfolio.
2. Investment Horizon
 Time when the investment or part thereof is
planned to be liquidated to meet a specific
need.
 For eg, the investment horizon may be ten
years to fund a child’s college education or
thirty years to meet retirement needs.
 The investment horizon has an important
bearing on the choice of assets.
3. Taxes
 What matters is the post-tax return?
 Tax considerations therefore have an
important bearing on investment decisions.
 So, carefully review the tax shelters
available to you and incorporate the same in
your investment decisions.
4. Regulations
 While individual investors are generally not
constrained much by law, institutional
investors have to confirm to various
regulations.
 For eg. Mutual funds in India are not
allowed to hold more than 10% of the
equity shares of a public company.
5. Unique circumstances
 Almost every investor faces unique
circumstances.
 For eg, an individual may have the
responsibility of looking after ageing
parents.
 Or an endowment fund may be precluded
from investing in the securities of
companies making alcoholic products and
tobacco products.
Selection of Asset Mix
 Based on the objectives and constraints, one
has to specify one’s asset allocation, i.e one
has to decide how much of your portfolio has
to be invested in each of the following assets:
 Cash

 Bonds

 Stocks

 Real Estate

 Precious Metals

 Others
Note the following:
 The first important investment decision for
most individual is concerned with their
education meant to build their human capital.

 The most significant asset that people


generally have during their early working years
is their earning power that stems from their
human capital. Purchase of life and disability
insurance becomes a pressing need to hedge
against loss of income on account of death or
disability.
……….

 The first major economic asset that individuals


plan to invest is in their own house. Before
they are ready to buy the house, their savings
are likely to be in the form of bank deposits
and money market mutual fund schemes.
Referred to broadly as “cash”, these
instruments have appeal because they are safe
and liquid.
………..
 Once the investment in house is made and
reasonable liquidity in the form of “cash” is
maintained to meet expected and unexpected
expenses in the short run, the focus shifts to
planning for the education of children,
providing financial security to family, saving
for retirement, bequeathing wealth to heirs, and
contributing to charitable activities.

 In this context, “stocks” and “bonds” become


important.
Stocks
 Equity shares
 Income Shares

 Growth Shares

 Blue-chip Shares

 Cyclical Shares

 Speculative Shares……etc

 And units/shares of equity schemes of


mutual funds.
Bonds
 Fixed income securities:
 Non convertible debentures of private companies

 Public sector bonds

 Gilt edged securities

 Savings Bonds

 Units/Shares of debt oriented schemes of mutual funds

 National Savings Certificates

 Bank Deposits

 Post office savings deposits

 Fixed deposits with companies

 Deposits in provident fund and PPF schemes

 Deposits in the Senior Citizen’s Savings

Schemes…………etc
ENDURING RELATION

J.H.LORIE : “THE MOST ENDURING RELATION IN ALL


FINANCE PERHAPS IS THE RELATIONSHIP BETWEEN
RETURNS ON EQUITIES (OR STOCKS) AND RETURNS
ON BONDS. IN ALL PERIODS OF AMERICAN HISTORY,
BRITISH HISTORY, AND GERMAN HISTORY, EQUITIES
(STOCKS) HAVE PROVIDED HIGHER RETURNS THAN
BONDS” A SIMILAR OBSERV’N CAN BE MADE WHEN
WE LOOK AT THE RETURNS ON STOCKS AND BONDS IN
INDIA FOR THE LAST TWO DECADES”
SELECTION OF ASSET MIX

• Should the long-term stock-bond mix be 50 : 50 or


75 : 25 or 25 : 75 or any other ?

• Referred to as the strategic asset-mix decision (or


policy asset-mix decision), this is by far the most
important decision by the investor.

• Empirical studies have shown that nearly 90 percent of


the variance of the portfolio return is explained by its
asset mix.
CONVENTIONAL WISDOM
1.GREATER RISK TOLERANCE STOCKS (higher proportion)
2.LONGER INVESTMENT HORIZON STOCKS (higher proportion)

RISK-RETURN RELATIONSHIP FOR VARIOUS TYPES


OF BONDS AND STOCKS
RETURN SPECULATIVE
SHARES
BLUE CHIP
SHARES
CDs OF PRIVATE
PUBLIC SECTOR
SECTOR
BONDS GROWTH
SHARES
DEFENSIVE
SHARES
INCOME/GROWTH
BANK
ORIENTED UNITS
DEPOSITS
RISK
RANGE OF RETURN ON COMMON STOCKS FOR VARIOUS TIME PERIODS
(US- 1950-80)
60%

50%

40%

30%

20%

10%

0%

-10%

-20%

-30%

1-year 5-year 10-year 15-year 20-year 25-year


periods periods periods periods periods periods

High +52.6% +23.9% +19.3% +16.4% +13.4% +10.3%


Average +13.0% +10.4% + 9.5% + 9.3% + 9.4% + 9.4%
Low -26.5% - 2.4% + 1.2% + 4.3% + 6.5% + 8.4%

Source : Vanguard Group


Rationale
 Why does the risk of stocks diminish as the
investment period lengthens?
 As the investment period lengthens, the
average yearly return over the period is subject
to lesser volatility because lower returns in
some years may offset by high returns in other
years and vice versa.
 Put differently, there is the benefit of “time
diversification” which is distinct from
“portfolio diversification”
APPROPRIATE PERCENTAGE ALLOCATION

• How the appropriate percentage allocation to the stock


component of the portfolio is influenced by the two basic
factors, viz. Risk Tolerance and Investment Horizon.

RISK TOLERANCE
TIME HORIZON
LOW MODERATE HIGH

SHORT 0 25 50
MEDIUM 25 50 75
LONG 50 75 100

A popular rule of thumb for asset allocation says that the percentage allocation to
debt must be equal to the age of the individual.
Contd…
 For the sake of simplicity, we assumed that there is single
investment horizon.
 In reality, an investor may have multiple investment horizons
corresponding to varied needs.
 For eg, the investment horizons corresponding to various goals
sought by an investor may be as follows:

Investment Goal Investment Horizon


Buying a car Two years
Constructing a house Ten years
Achieving financial independence Twenty years
Establishing a charitable institution Thirty years
Benjamin Graham on Asset Allocation

 The investor should never have less than 25%


or more than 75% of his funds in common
stocks, with a consequent inverse range of
between 75% and 25% in bonds.
 According to him, standard distribution should
be 50:50 between stocks and bonds.

“…..it gives the investor the feeling that he is at least making some moves in
response to market developments; more important of all, it will restrain
him from being drawn more and more heavily into common stocks as the
market rises to more and more dizzy heights!”
John Bogle on Asset Allocation
Balanced Asset Allocation Model

Older 70:30 50:50


Age Younger 80:20 60:40
Accumulation Distribution

Investment Goal
FORMULATION OF PORTFOLIO
STRATEGY

1. Active Portfolio Strategy


2. Passive Portfolio Strategy
Active Portfolio Strategy
 An active portfolio strategy is followed by most
investment professionals and aggressive
investors who strive to earn superior risk
adjusted returns.
 The four principal vectors of an active strategy
are:
 Market Timing

 Sector Rotation

 Security Selection

 Use of a specialized concept


PORTFOLIO STRATEGY

• ACTIVE
• PASSIVE

HIGHLY ACTIVE HIGHLY PASSIVE


MARKET TIMING | …………………………………………… |

SECTOR ROTATION | …………………………………………… |

SECURITY SELECTION | …………………………………………… |

USE OF A SPECIALISED | …………………………………………… |


CONCEPT
Market Timing
 This involves departing from the normal (or
strategic or long run) asset mix to reflect one’s
assessment of the prospects of various assets in
the near future.
 Suppose your investible resources is divided
between stocks and bonds in proportion of
50:50.
 In the short and intermediate run, however,
you may be inclined to deviate from your long
run asset mix (increasing and lowering the
beta of your portfolio)
……..
 Market timing is based on an explicit or implicit
forecast of general market movements.
 The advocates of market timing employ a variety of
tools like business cycle analysis, moving average
analysis, advance-decline analysis, and econometric
models.
 The forecast of the general market movement derived
with the help of one or more of these tools is
tempered by the subjective judgment of the investor.
 Often, of course, the investor may go largely by his
market sense.
……..
 Anyone who reviews the fluctuations in the market
may be tempted to play the game of market timing.

 Yet, very few seem to succeed in this game.

 A careful study on market timing argues that an


investment manager must forecast the market
correctly 75% of the time just to break-even, after
taking into account the costs of errors and the costs of
transactions.
“The market does just as well, on average when the
investor is out of the market as it does when he is in. So he
looses money, relative to simply buy and hold strategy, by
being out of the market part of the time.” – Fischer Black

“In 30 years in this business, I don’t know anybody who


has done it successfully and consistently, nor anybody who
knows anybody who has done it successfully and
consistently” – John Bogle (Vanguard Group of
Investments
Sector Rotation
 It can be applied to stocks as well as bonds.
 Generally used with stock component
 Involves shifting and weightings for various industrial
sectors based on their assessed outlook.
 Weighing stocks of certain sectors more that what is in
the market portfolio.
 With respect to bonds, sector rotation implies a shift in
the composition of the bond portfolio in terms of
quality (credit rating), coupon rate, term to maturity
and so on.
 For eg……you anticipate rise in interest rates and
hence you may shift from long-term bonds to medium-
term or even short-term bonds.
Security Selection
 Most commonly used vector
 Involves a search for under-priced securities.
 You may employ fundamental and/or technical analysis to
identify stocks which seem to promise superior returns and
concentrate the stock component of your portfolio to them.
 Such stocks will be over-weighted in portfolio relative to
market portfolio.
 Likewise, stocks which are perceived to be unattractive will
be underweighted relative to their position in the market
portfolio.
 As far as bonds are concerned, security selection calls for
choosing bonds which offer the highest YTM at a given level
of risk.
Use of a Specialized Investment Concept
 Employ a specialized concept or philosophy,
particularly with respect to investment in
stocks.

 A possible way to enhance returns is “to


develop a profound and valid insight into the
forces that drive a particular sector of market
or a particular group of companies or
industries and systematically exploit that
investment insight or concept”
……….
 Some of the concepts that have been exploited
successfully by investment practitioners are:
 Growth stocks

 Value stocks

 Asset Rich Stocks

 Technology Stocks

 Cyclical stocks etc….


Advantages of specialized concept:
a) Focus your efforts on a certain kind of
investment that reflect your abilities and
talents
b) Avoid the distractions of pursuing other
alternatives
c) Master an approach or style through sustained
practice and continual self-critique
Disadvantage

 It may become obsolete.

 The changes in the market place may cast a


shadow over the validity of the basis premise
underlying the investment philosophy.
Two popular management styles
 Two management styles popularly used by active
portfolio managers are:
 Value Management

 Growth Management

 Value managers typically buy stocks that have low P-


E ratios, low P-B ratio, below average earnings
growth and high dividend yields
 Such stocks are referred to as value stocks.
 Value managers are sometimes called contrarian
managers as they often buy “out-of-favor” stocks.
……….
 Growth managers buy stocks that currently
enjoy high rates of earnings growth and are
expected to experience high rates of earnings
growth in future as well

 These stocks, called “growth stocks” or


“glamour stocks”, typically have high P-E
ratios, high P-B ratios, above average earnings
growth and low dividend yields.
General Characteristics
Value Stocks Growth Stocks
Low EPS growth High EPS growth
Low P-E ratio High P-E ratio
Low P-B ratio High P-B ratio
High dividend yield Low dividend yield
Betas tend to be less than one Betas tend to be more than one
Out of favor Popular

Empirical evidence suggests that, in general, value stocks


have outperformed growth stocks, in terms of both raw
and risk-adjusted returns.
PASSIVE STRATEGY

ACTIVE STRATEGY … PREMISE . . INEFFICIENCIES …


EXPLOITED

PASSIVE STRATEGY … TENET…….MARKET EFFICIENT


. ……. AVAILABLE INFOR’N

1. CREATE A WELL-DIVERSIFIED PORTFOLIO AT A


PRE-DETERMINED LEVEL OF RISK

2. HOLD THE PORTFOLIO RELATIVELY UNCHANGED


OVER TIME, UNLESS IT BECOMES INADEQUATELY
DIVERSIFIED OR INCONSISTENT WITH THE
INVESTOR’S RISK-RETURN PREFERENCES
Ability to select Ability to forecast overall market
undervalued securities
Good Poor
1. Concentrate holding in 1. Concentrate holding in
selected undervalued selected undervalued
securities rather than securities rather than
diversify broadly diversify broadly
Good 2. Shift beta above and 2. Keep beta stable at the
below the desired long- desired long-term
term average based on average
market forecasts

1. Hold a broadly 1. Hold a broadly


diversified list of diversified list of
securities securities
Poor 2. Shift beta above and 2. Keep beta stable at
below desired long- desired long-term
term average, based on average
market forecasts
SELECTION OF SECURITIES

SELECTION OF BONDS
• YTM
• DEFAULT RISK
• TAX SHIELD
• LIQUIDITY
• DURATION

SELECTION OF STOCKS
• TECHNICAL ANALYSIS
• FUNDAMENTAL ANALYSIS
• RANDOM ANALYSIS
MARKET EFFICIENCY AND
SECURITY SELECTION

LEVEL OF APPROACH TECHNICAL FUNDAMENTAL RANDOM


EFFICIENCY ANALYSIS ANALYSIS SELECTION

INEFFICIENCY BEST POOR POOR

WEAK-FORM POOR BEST POOR


EFFICIENCY

SEMI-STRONG-FORM
EFFICIENCY POOR GOOD FAIR

STRONG-FORM
EFFICIENCY POOR FAIR BEST
PORTFOLIO EXECUTION
TRADING GAME

BUSINESS TRANSACTION SECURITY TRANSACTION

• MOTIVE AND IDENTITY OF • MOTIVE AND IDENTITY


THE COUNTERPARTY OF THE COUNTERPARTY
KNOWN NOT KNOWN
• CONSTRUCTIVE MOTIVES • ZERO SUM GAME
+ SUM GAME
Motives for Trade
 Cognitive:
 People trade because they think they have
superior information or better methods of
analyzing information
 However, most traders tend to confuse
noise or randomness for information.
……..
 Emotional:

 Trading can be a source of pride.


Key Players
 Value Based Transactors (VBT)
 Information Based Transactors (IBT)
 Liquidity Based Transactors (LBT)
 Pseudo-Information Based Transactors
(PIBT)
 Dealers
Value Based Transactors (VBT)
 Carries out extensive fundamental analysis of
publicly available information to establish values.
 He trades when the difference between the value
assessed by him and the prevailing market price so
warrants.
 Typically he places limit orders to buy and sell with a
spread that is large enough to provide a cushion
against errors of judgment and informational lacunae.
 VBTs generally serves as the anchor for the trading
system and establish the framework for the operations
of dealers.
 VBT typically don’t place much importance on time.
Information Based Transactors
 Transacts on the basis of information which is not in
public domain, and therefore, not reflected in security
prices.
 He places importance on time, as he expects his
information to have a significant impact on prices.
 IBT is bothered about how soon the market price will
move up or down in response to new information.
 IBT generally employs “incremental” fundamental
analysis.
 In addition, he uses technical analysis because timing
is crucial to his operations.
 Unlike VBT he rarely tries to establish the absolute
value of a security.
Liquidity Based Transactors
 Trades primarily due to liquidity
considerations.
 He trades to deploy surplus funds or to obtain
funds or to rebalance portfolio.
 His trades are not based on a detailed valuation
exercise or access to some information.
 Hence, he may be regarded as an information
less trader who is driven mainly by liquidity
considerations.
Pseudo-information Based Transactors
 Believes that he possesses information that can
be a source of gain, even though that
information is already captured or impounded
in the price of the security.
 He exaggerates the value of new information
that he may come across and forms unrealistic
expectations.
 Essentially, the PIBT, like LBT, is an
information-less trader.
Dealers
 Intermediates between buyers and sellers eager to
transact.
 Dealer is ready to buy or sell with a spread which is
fairly small for actively traded securities.
 The dealer’s quotations may move swiftly in response
to changes in the demand and supply forces in the
market.
 Typically, the dealer’s bid-ask price band lies well
within the bid-ask price band set by the VBT.
 This means that the bid price of the dealer is higher
than the bid price of the VBT and the ask price of the
dealer is lower than the ask price of the VBT.
……….
 The dealer’s function is such that he is not
required to take a view on whether a security is
worth buying or worth selling.
 He simply plays role of an intermediary and he
does not plan to hold the position he acquires
in accommodating a transaction.
 Hence, the dealer is remarkably innocuous
person.
 Lurking behind the dealer, of course, is the
transactor's real adversary, whose identity and
motive are often unknown.
TRADING MOTIVATIONS, TIME HORIZONS,
AND TIME VS PRICE PREFERENCES

TRANSACTOR MOTIVATION TIME TIME VS PRICE


HORIZON PREFERENCE

VBT DISCREPANCY WEEKS TO PRICE


BETWEEN VALUE MONTHS
AND PRICE

IBT NEW INFORMATION HOURS TO TIME


DAYS

LBT RELEASE OR ABSORB HOURS TO TIME


CASH DAYS

PIBT APPARENTLY NEW HOURS TO TIME


INFORMATION DAYS

DEALER ACCOMODATION MINUTES TO INDIFFERENT


HOURS
Who wins, Who loses
 It appears that the IBT’s odds of wining are the
highest, assuming that his information is
substantiated by the market.
 He is followed by the VBT, LBT and PIBT in
that order.
 The IBT seems to have a distinct edge over
others.
 The VBT tends to lose against the IBT but
gains against the LBT and PIBT.
 The LBT may have some advantage over the
PIBT.
Guidelines
 Maintain a dialogue with the broker
 Sensitivity of the stock to buying and selling

pressure
 Volume that can be traded without pushing

the price out of the desirable range.


 Manipulative games, if any being played by

operators
 Degree of market resilience.

 Place an order which serves your interest best


 Avoid Serious Trading Errors
Types of orders
1. The market order:
 Instructs the broker to execute the transaction promptly at
the best available price.
 This leaves little discretion to the broker.
2. The best efforts order:
 Order to execute transaction when he considers market
condition more favorable.
3. The market-on-open order:
 Instructs the broker to execute the transaction no sooner the
market opens.
4. The limit order:
 Instructs the broker to execute the transaction only which the
price limits specified in the order.
……..appropriate orders
 IBT – market order or market-to-open order
 VBT – limit order
 LBT and PIBT – Best efforts order.
Serious Trading Errors
i. VBT selling time too cheaply
ii. IBT buys time too expensively
iii. LBT, by, appearing motivated by information,
evokes very defensive responses from dealers
and other market participants.

GUARD YOURSELF AGAINST THESE ERRORS.


Portfolio Revision
 Irrespective of how well you have constructed
your portfolio, it soon tends to become
inefficient and hence needs to be monitored
and revised periodically.

 “Portfolio do not manage themselves. With


each passing day, portfolios that we carefully
crafted yesterday become very less-than-
optimal. Change is the investor’s only
constant”
……..
 Over time:
 Asset allocation in the portfolio may have
drifted away from its target
 The risk return characteristics of various

securities may have altered


 The objectives and preferences of the

investor may have changed.


 Given the dynamic developments in the capital
market and changes in your circumstances, you
have to periodically monitor and revise your
portfolio.
Portfolio Rebalancing
 Involves reviewing and revising portfolio
composition (stock bond mix)

 There are three basic policies with respect to


portfolio rebalancing:
1. Buy and Hold Policy

2. Constant mix Policy

3. Portfolio Insurance Policy


1. Buy and Hold Policy
 The initial portfolio is left undisturbed
 Irrespective of what happens to the relative
values, no rebalancing is done.
 For eg, initial portfolio has stock-bond mix of
50:50 and after six month, stock-bond mix
happens to be, say 70:30 because the stock
component has appreciated and the bond
component has stagnated, the portfolio mix is
allowed to drift.
 Put differently, no changes are affected.
2. Constant Mix Policy

 Calls for maintaining the proportions of stocks


and bonds in line with their target value.

 Calls for rebalancing the portfolio when the


relative values of its components changes, so
that the target proportions are maintained.
3. Portfolio Insurance Policy
 Calls for increasing the exposure to stocks
when the portfolio appreciates in value and
decreasing the exposure to stocks when the
portfolio depreciates in value.

 The basic idea is to ensure that the portfolio


value does not fall below a floor level.
Portfolio Upgrading
 Calls for re-assessing the risk-return
characteristics of various securities (stocks as
well as bonds), selling over-priced securities,
and buying under-pricing securities.
 It may also entail other changes the investor
may consider necessary to enhance the
performance of the portfolio.
Portfolio Revision (contd..)
 You may hesitate to revise your portfolio or be too
slow in doing so.
 You may not like to incur costs of trading.
 However, there are costs of non-trading which, though
subtle, may be significant.
 Your portfolio may drift into an asset mix that may no
longer be appropriate to your needs;
 You may hold over-priced investments, offering

inferior returns
 You may forego opportunities of making promising
investments.
……….
 Learn to weight the opportunity cost of non-
trading against the explicit costs of trading.

 In essence, portfolio revision calls for


developing the appropriate response to the
tension between the “apparent” cost of
trading the “subtle” cost of inaction.
Performance Evaluation

Key Dimensions
PERFORMANCE EVALUATION RATE OF RETURN
1. ARITHMETIC MEAN 2. IRR 3. GEOMETRIC MEAN
RATE OF RETURN DATA
Year Market value of Dividend and Rate of return
the portfolio interest income
(Rs) (Rs)
0 100,000

1 105,000 10,000 10,000 + (105,000 – 100,000)


= 15%
100,000
2 95,000 10,000 10,000 + (95,000 – 105,000)
= 0.0%
105,000
3 120,000 10,000 10,000 + (120,000 – 95,000)
= 36.8%
95,000
4 140,000 12,000 12,000 + (140,000 – 120,000)
= 26.7%
120,000
5 150,000 12,000 12,000 + (130,000 – 140,000)
= 15.7%
140,000
A.M : (15.0 + 0.0 + 36.8 + 26.7 + 15.7) / 5 = 18.8%
10,000 10,000 10,000 12,000 12,000 + 150,000
IRR :100000 = + + + +
(1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5
r ≃ 17.65%
GM : [ (1.15) (1.00) (1.368) (1.267) (1.157)] 1/5 - 1 ≃ 18.2%
IRR (Money Weighted Rate of Return)
PERIOD
1 2 3 4
RATE OF RETURN EARNED 10% 30% 20% -
PORTFOLIO A
1. BEGINNING VALUE BEFORE
INFLOW OR OUTFLOW 10,000 11,000 14,300 17,160
2. INFLOW (OUTFLOW) - - - (17,160)
3. AMOUNT INVESTED 10,000 11,000 14,300 -
4. ENDING VALUE 11,000 14,300 17,160 -
PORTFOLIO B
1. BEGINNING VALUE BEFORE
INFLOW OR OUTFLOW 10,000 11,000 3,900 4,680
2. INFLOW (OUTFLOW) - (8,000) - (4,680)
3. AMOUNT INVESTED 10,000 3,000 3,900 -
4. ENDING VALUE 11,000 3,900 4,680 -

17,160
A : 10,000 = r = 19.72%
(1+r)3
8,000 0 4680
B : 10,000 = + + r = 15.27%
(1+r) (1+r)2 (1+r)3
IRR REFLECTS INVESTMENT PERFORMANCE AS WELL AS THE EFFECT OF CONTRIBUTIONS AND
WITHDRAWALS .. TOTAL EXPERIENCE OF A FUND (a) INVESTMENET PERFORMANCE & (b) CASH
FLOWS.
G.M : [(1.10) (1.30) (1.20)] 1/3 - 1 = 0.1972 OR 19.72%
RISK

• Mean Absolute Deviation

 d n

• Standard Deviation

• Beta
PERFORMANCE MEASURE

Rp - Rf
TREYNOR MEASURE :
p

Rp - Rf
SHARPE MEASURE :
p

JENSEN MEASURE : Rp - [Rf + p (RM - Rf)]


Few comments on Measures…..
 Treynor measure reflects the excess return earned
per unit of systematic risk (beta)
 Treynor measure implicitly assumes that the
portfolio is well diversified.
 Sharpe measure reflects the excess return earned
on a portfolio per unit of total risk (std. deviation)
 Both Treynor and Sharpe measure, postulate a
linear relationship between risk and return
 For a perfectly diversified portfolio, both the
measure give identical rankings.
ANNUAL RETURNS FOR THREE MUTUAL FUNDS
AND A MARKET INDEX

PERIOD FUND A FUND B FUND C RETURN ON RISK-FREE


MARKET RETURN

1 - 38.7 -16 -33 -26 7.9


2 39.6 39.4 30 36.9 5.8
3 11.1 34.3 18.2 23.6 5.0
4 12.7 -6.9 -7.3 -7.2 5.3
5 20.9 3.2 4.9 6.4 7.2
6 35.5 28.9 30.9 18.2 10
7 57.6 24.1 34.7 31.5 11.5
8 -7.8 0.0 6.0 -4.8 14.1
9 22.8 23.4 33.0 20.4 10.7

Mean: Rp 17.1 14.5 13.0 11 8.6


Standard 28.1 19.7 22.8 20.5 _
Deviation: σp
Beta: βp 1.20 0.92 1.04 1.00 _
PERFORMANCE EVALUATION OF
THE THREE FUNDS
Rp - Rf
TREYNOR MEASURE :
p
17.1 - 8.6
FUND A : = 7.1
1.20
14.5 - 8.6
FUND B : = 4.9
0.92
13.0 - 8.6
FUND C : = 4.8
1.04
11.0 - 8.6
MARKET INDEX : = 2.4
1.0
Rp - Rf
SHARPE MEASURE :
p
17.1 - 8.6
FUND A : = 0.302
28.1
14.5 - 8.6
FUND B : = 0.299
19.7
13.0 - 8.6
FUND C : = 0.193
22.8
11.0 - 8.6
MARKET INDEX : = 0.117
20.5
JENSEN MEASURE : Rp - [Rf + p (RM - Rf )]
FUND A : 17.1 - [8.6 + 1.20 (2.4)] = 5.62
FUND B : 14.5 - [8.6 + 0.92 (2.4)] = 3.69
FUND C : 13.0 - [8.6 + 1.04 (2.4)] = 1.90
MARKET INDEX : O (BY DEFINITION)
Problems with Performance Measurement

 In practice, it is often not applied properly.


 Performance is measured too frequently and
judgments are formed on the basis of very
short time frames.
 Such an approach has certain negative or
dysfunctional consequences:
 It has attempted to quantify a function that is only
partly amenable to quantification.
 It has let to “short-termism” in investment

decision.
 It has promoted the cult of market timing.
……..
 It must be recognized that it is not feasible
to evaluate the ability of a money manager
over a short period of one to three years
when it should be appraised over a period of
five to seven years.
“For accuracy of computations,
performance should be computed as
often as practical, but results should not
be taken as significant by the investor or
the investment manager until a
reasonable period of time, such as a
market cycle for equities or an interest
rate cycle for fixed income securities,
has elapsed”
THE END