portfolio management and analysis

1. Portfolio ConstructionPortfolio Construction

2. PortfolioPortfolio
 Portfolio is a combination of securities such asPortfolio is a combination of securities such as
stocks, bonds and money market instruments.stocks, bonds and money market instruments.
 The process of blending together the broad assetThe process of blending together the broad asset
classes so as to obtain optimum return with minimumclasses so as to obtain optimum return with minimum
risk is called portfolio construction.risk is called portfolio construction.
 Diversification of investments helps to spread riskDiversification of investments helps to spread risk
over many assets.over many assets.

3. Approaches inApproaches in
Portfolio ConstructionPortfolio Construction
 Traditional approach evaluates the entire financialTraditional approach evaluates the entire financial
plan of the individual.plan of the individual.
 In the modern approach, portfolios are constructed toIn the modern approach, portfolios are constructed to
maximise the expected return for a given level of risk.maximise the expected return for a given level of risk.

4. Traditional ApproachTraditional Approach
The traditional approach basically deals with twoThe traditional approach basically deals with two
major decisions:major decisions:
 Determining the objectives of the portfolioDetermining the objectives of the portfolio
 Selection of securities to be included in the portfolioSelection of securities to be included in the portfolio

5. Steps in Traditional ApproachSteps in Traditional Approach
A n a ly s is o f C o n s t r a in ts
D e t e r m in a t io n o f O b je c t iv e s
S e le c t io n o f P r o tf o lio
A s s e s s m e n t o f r is k a n d r e t u r n
D iv e r s if ic a t io n
B o n dB o n d a n d C o m m o n s t o c k C o m m o n s t o c k

6. Analysis of ConstraintsAnalysis of Constraints
Strong lyefficien tmarketAllinf ormation is
reflect edonpric es.
Weakly efficient market
Allhist oricalinf ormationisrefle ctedonse curity
Sem istronge fficientm arket
All publicinf ormation is
refl ectedons ecuritypr ices
 Income needsIncome needs
 Need for current incomeNeed for current income
 Need for constant incomeNeed for constant income
 LiquidityLiquidity
 Safety of the principalSafety of the principal
 Time horizonTime horizon
 Tax considerationTax consideration
 TemperamentTemperament

7. Determination of ObjectivesDetermination of Objectives
The common objectives are stated below:The common objectives are stated below:
 Current incomeCurrent income
 Growth in incomeGrowth in income
 Capital appreciationCapital appreciation
 Preservation of capitalPreservation of capital

8. Selection of PortfolioSelection of Portfolio
 Objectives and asset mixObjectives and asset mix
 Growth of income and asset mixGrowth of income and asset mix
 Capital appreciation and asset mixCapital appreciation and asset mix
 Safety of principal and asset mixSafety of principal and asset mix
 Risk and return analysisRisk and return analysis

9. DiversificationDiversification
 According to the investor’s need for income and riskAccording to the investor’s need for income and risk
tolerance level portfolio is diversified.tolerance level portfolio is diversified.
 In the bond portfolio, the investor has to strike aIn the bond portfolio, the investor has to strike a
balance between the short term and long term bonds.balance between the short term and long term bonds.

10. Stock PortfolioStock Portfolio
Following steps as shown in the figure are adoptedFollowing steps as shown in the figure are adopted
S e le c t io n o f I n d u s t r ie s
S e le c t io n o f C o m p a n ie s in t h e I n d u s t r y
D e t e r m in in g t h e s iz e o f p a r t ic ip a t io n

11. Modern ApproachModern Approach
 Modern approach gives more attention to the processModern approach gives more attention to the process
of selecting the portfolio.of selecting the portfolio.
 The selection is based on the risk and return analysis.The selection is based on the risk and return analysis.
 Return includes the market return and dividend.Return includes the market return and dividend.
 Investors are assumed to be indifferent towards theInvestors are assumed to be indifferent towards the
form of return.form of return.
 The final step is asset allocation process that is toThe final step is asset allocation process that is to
choose the portfolio that meets the requirement of thechoose the portfolio that meets the requirement of the
investor.investor.

12. Managing the PortfolioManaging the Portfolio
 Investor can adopt passive approach or activeInvestor can adopt passive approach or active
approach towards the management of the portfolio.approach towards the management of the portfolio.
 In the passive approach the investor would maintainIn the passive approach the investor would maintain
the percentage allocation of asset classes and keep thethe percentage allocation of asset classes and keep the
security holdings within its place over the establishedsecurity holdings within its place over the established
holding period.holding period.
 In the active approach the investor continuouslyIn the active approach the investor continuously
assess the risk and return of the securities within theassess the risk and return of the securities within the
asset classes and changes them accordingly.asset classes and changes them accordingly.

13. Portfolio EvaluationPortfolio Evaluation

14. The ConceptThe Concept
 Portfolio manager evaluates his portfolioPortfolio manager evaluates his portfolio
performance and identifies the sources of strengthperformance and identifies the sources of strength
and weakness.and weakness.
 The evaluation of the portfolio provides a feed backThe evaluation of the portfolio provides a feed back
about the performance to evolve better managementabout the performance to evolve better management
strategy.strategy.
 Evaluation of portfolio performance is considered toEvaluation of portfolio performance is considered to
be the last stage of investment process.be the last stage of investment process.

15. Sharpe’s Performance IndexSharpe’s Performance Index
 Sharpe index measures the risk premium of theSharpe index measures the risk premium of the
portfolio relative to the total amount of risk in theportfolio relative to the total amount of risk in the
portfolio.portfolio.
 Risk premium is the difference between theRisk premium is the difference between the
portfolio’s average rate of return and the riskless rateportfolio’s average rate of return and the riskless rate
of return.of return.

16. Sharpe IndexSharpe Index
Formula forFormula for
Sharpe’s Performance IndexSharpe’s Performance Index
p f
t
p
R – R
S =
σ
Portfolio average return – Risk free rate of interest
=
Standard deviation of the portfolio return

17. Treynor’s Performance IndexTreynor’s Performance Index
Strong lyefficien tmarketAllinf ormation is
reflect edonpric es.
Weakly efficient market
Allhist oricalinf ormationisrefle ctedonse curity
Sem istronge fficientm arket
All publicinf ormation is
refl ectedons ecuritypr ices
 The relationship between a given market return andThe relationship between a given market return and
the fund’s return is given by the characteristic line.the fund’s return is given by the characteristic line.
 The fund’s performance is measured in relation to theThe fund’s performance is measured in relation to the
market performance.market performance.
 The ideal fund’s return rises at a faster rate than theThe ideal fund’s return rises at a faster rate than the
general market performance when the market isgeneral market performance when the market is
moving upwards.moving upwards.
 Its rate of return declines slowly than the marketIts rate of return declines slowly than the market
return, in the decline.return, in the decline.

18. n
Portfolio average return – Riskless rate of interest
T =
Beta co-efficient of portfolio
p f
n
p
R – R
T =
β
Treynor’s Index FormulaTreynor’s Index Formula

19. Jensen’s Performance IndexJensen’s Performance Index
 The absolute risk adjusted return measure wasThe absolute risk adjusted return measure was
developed by Michael Jensen.developed by Michael Jensen.
 The standard is based on the manager’s predictiveThe standard is based on the manager’s predictive
abilityability..

20. Jensen ModelJensen Model
The basic model of Jensen is:The basic model of Jensen is:
RRpp == αα ++ ββ (R(Rmm – R– Rff))
 RRpp = average return of portfolio= average return of portfolio
 RRff = riskless rate of interest= riskless rate of interest
 αα = the intercept= the intercept
 ββ = a measure of systematic risk= a measure of systematic risk
 RRmm = average market return= average market return

21.  ααpp represents the forecasting ability of the manager.represents the forecasting ability of the manager.
Then the equation becomesThen the equation becomes
RRpp – R– Rff == ααpp ++ ββ(R(Rmm – R– Rff))
oror
RRpp == ααpp + R+ Rff ++ ββ(R(Rmm – R– Rff))

22. Exercise
With the given details, evaluate the performances of the
different funds using Sharpe, Treynor and Jensen
performance evaluation techniques.
Portfolio A B C D
Average
Return
12% 12% 8% 9%
Standard
Deviation
20 18 22 24
Beta 0.97 1.17 1.22
Risk free rate of return is 4 per cent. Market return is 10 %.