PROJECT REPORT ON
Portfolio construction
SUBMITTED TO
SUBMITTED BY
1
Preface The reforms, since 1991, have brought substantial deregulation to Indian capital market; today the markets are moving towards computerized, scrip less trading. In this process the market would become more efficient and the lessons of portfolio theory would assume increased relevance. About ten years ago, we often wondered whether many of the concepts that we are dealing with had any relevance to India. Terms like Mutual Funds, Portfolio Management, and Interest Rate Risk seemed alien to this land. The last few years have, however, changed everything. Today, when we talk of portfolio management in our classrooms or in seminars and conferences, we sense a tremendous excitement and interest among the audience. There is a little doubt that stock markets can be treacherous. But we have learnt that investing in shares need not be such a nerve-racking experience, provided the decisions are made on the basis of analysis and reasoning, and are not guided by whims, fancies and rumors. I have kept the use of mathematics to a minimum in the text as I believe that the principles and techniques of portfolio management can be understood and used without a rigorous knowledge of the mathematical foundations upon which they are based.
2
Contents Preface
2
Executive Summary
4-5
1. Introduction to Portfolio Management 2. Portfolio Construction
6-8 9-11
3. Steps to Stock Selection Process 4. Types of Assets
12 12-17
5. Phases of Portfolio Management
18
6. Security Analysis
19-26
7. Portfolio Analysis
27-28
8. Portfolio Selection
29-30
9. Portfolio Revision
31-32
10. Portfolio Evaluation
33-35
11.Conclusion
36
12.Bibliography
37
3
Executive Summary Investing is both Arts and Science. Every Individual has their own specific financial need and expectation based on their risk taking capabilities, whereas some needs and expectation are universal. Therefore, we find that the scenario of the Stock Market is changing day by day hours by hours and minute by minute. The evaluation of financial planning has been increased through decades, which can be best seen in customers. Now a day’s investments have become very important part of income saving. In order to keep the Investor safe from market fluctuation and make them profitable, Portfolio Management Services (PMS) is fast gaining Investment Option for the High Net worth Individual (HNI). There is growing competition between brokerage firms in post reform India. For investor it is always difficult to decide which brokerage firm to choose. At the time of investing money everyone look for the Risk factor involve in the Investment option.
The first of the two most consequential take-home messages that we want to convey is that good portfolio management practice is not a matter of establishing a discussion culture, but one of implementing sound, data driven, and transparent decision processes. The second message is that, even as seen in the light of the previous insight, portfolios and their constituent projects are ultimately managed by people, not by functions. Objections to portfolio management, or attempts to push it in a certain direction, frequently arise from less rational elements in the personalities of the acting people, even if they are driven by the best intentions. A good portfolio
4
manager will be aware of this and make use of these human features instead of attempting their suppression.
5
Introduction to Portfolio Management Investing in securities such as shares, debenture and bonds is profitable as well as exciting. Investing in financial securities is now considered to be one of the best avenues for investing one’s savings while it is acknowledged to be one of the most risky avenues of investment. It is rare to find investors investing their entire funds or savings in a single security. Instead, they tend to invest in a group of securities. Such a group of securities is called a portfolio. Creation of a portfolio helps to reduce risk without sacrificing returns. Portfolio Management deals with the analysis of individual securities as well as with the theory and practice of optimally combining securities into portfolios. An investor who understands the fundamental principles and analytical aspects of portfolio management has a better chance of success.
WHAT IS PORTFOLIO MANAGEMENT
An investor considering investment in securities is faced with the problem of choosing from among a large number of securities. His choice depends upon the risk-return characteristics of individual securities. He would attempt to choose the most desirable securities and like to allocate his funds over this group of securities. Again he is faced with the problem of deciding which securities to be held and how much to invest in each. The investor faces an infinite number of possible portfolios or group of securities.
6
As the economic and financial environment keeps changing, the risk-return characteristics of individual securities as well as portfolios also change. This calls for periodic review and revision of investment portfolios of investors. An investor invests his funds in a portfolio expecting to get a good return consistent with the risk that he has to bear. The return realized from the portfolio has to be measured and the performance of the portfolio has to be evaluated. Portfolio Management comprises all the processes in the creation and maintenance of an investment portfolio. It deals specifically with security analysis, portfolio analysis, portfolio selection, portfolio revision, and portfolio evaluation. Portfolio Management is a complex process which tries to make investment activity more rewarding and less risky.
A person making an investment expects to get some return from the investment in the future. But, as the future is uncertain, so is the future expected return. It is this uncertainty associated with the returns from an investment that reduces risk into an investment. The total variability in returns of a security represents the total risk of that security. Systematic and Unsystematic Risk are the two components of total risk. Thus, Total Risk = Systematic Risk + Unsystematic Risk The impact of economic, political and social changes on the performance of companies and thereby on their stock prices caused by such system wide factors is referred to as systematic risk. Systematic Risk is further subdivided into interest rate risk, market risk, and purchasing power risk.
7
When variability of returns occurs because of company issuing factors such as raw material scarcity, labour strike, management inefficiency, it is known as Unsystematic Risk. The systematic risk of a security is measured by a statistical measure called Beta. The input data required for the calculation of beta are the historical data of returns of the individual security as well as the returns of a representive stock market index.
8
PORTFOLIO CONSTRUCTION
The Portfolio Construction of Rational investors wish to maximize the returns on their funds for a given level of risk. All investments possess varying degrees of risk. Returns come in the form of income, such as interest or dividends, or through growth in capital values (i.e. capital gains). The portfolio construction process can be broadly characterized as comprising the following steps:
1. Setting objectives: The first step in building a portfolio is to determine the main objectives of the fund given the constraints (i.e. tax and liquidity requirements) that may apply. Each investor has different objectives, time horizons and attitude towards risk. Pension funds have long-term obligations and, as a result, invest for the long term. Their objective may be to maximize total returns in excess of the inflation rate. A charity might wish to generate the highest level of income whilst maintaining the value of its capital received from bequests. An individual may have certain liabilities and wish to match them at a future date. Assessing a client’s risk tolerance can be difficult. The concepts of efficient portfolios and diversification must also be considered when setting up the investment objectives.
2. Defining Policy: Once the objectives have been set, a suitable investment policy must be established. The standard procedure is for the money manager to ask clients to select their preferred mix of assets, for example equities and bonds, to provide an idea of the normal mix desired. Clients are then asked to specify 9
limits or maximum and minimum amounts they will allow to be invested in the different assets available. The main asset classes are cash, equities, gilts/bonds and other debt instruments, derivatives, property and overseas assets. Alternative investments, such as private equity, are also growing in popularity, and will be discussed in a later chapter. Attaining the optimal asset mix over time is one of the key factors of successful investing.
3. Applying portfolio strategy: At either end of the portfolio management spectrum of strategies are active and passive strategies. An active strategy involves predicting trends and changing expectations about the likely future performance of the various asset classes and actively dealing in and out of investments to seek a better performance. For example, if the manager expects interest rates to rise, bond prices are likely to fall and so bonds should be sold, unless this expectation is already factored into bond prices. At this stage, the active fund manager should also determine the style of the portfolio. For example, will the fund invest primarily in companies with large market capitalizations, in shares of companies expected to generate high growth rates, or in companies whose valuations are low? A passive strategy usually involves buying securities to match a preselected market index. Alternatively, a portfolio can be set up to match the investor’s choice of tailor-made index. Passive strategies rely on diversification to reduce risk. Outperformance versus the chosen index is not expected. This strategy requires minimum input from the portfolio manager. In practice, many active funds are managed somewhere between the active and passive extremes, the core holdings of the fund being passively managed and the balance being actively managed.
10
4. Asset selections: Once the strategy is decided, the fund manager must select individual assets in which to invest. Usually a systematic procedure known as an investment process is established, which sets guidelines or criteria for asset selection. Active strategies require that the fund managers apply analytical skills and judgment for asset selection in order to identify undervalued assets and to try to generate superior performance.
5. Performance assessments: In order to assess the success of the fund manager, the performance of the fund is periodically measured against a pre-agreed benchmark – perhaps a suitable stock exchange index or against a group of similar portfolios (peer group comparison). The portfolio construction process is continuously iterative, reflecting changes internally and externally. For example, expected movements in exchange rates may make overseas investment more attractive, leading to changes in asset allocation. Or, if many large-scale investors simultaneously decide to switch from passive to more active strategies, pressure will be put on the fund managers to offer more active funds. Poor performance of a fund may lead to modifications in individual asset holdings or, as an extreme measure; the manager of the fund may be changed altogether.
11
Steps to Stock Selection Process
Types of assets The structure of a portfolio will depend ultimately on the investor’s objectives and on the asset selection decision reached. The portfolio structure takes into account a range of factors, including the investor’s time horizon, attitude to risk, liquidity requirements, tax position and availability of investments. The main asset classes are cash, bonds and other fixed income securities, equities, derivatives, property and overseas assets.
12
Cash and cash instruments
Cash can be invested over any desired period, to generate interest income, in a range of highly liquid or easily redeemable instruments, from simple bank deposits, negotiable certificates of deposits, commercial paper (short term corporate debt) and Treasury bills (short term government debt) to money market funds, which actively manage cash resources across a range of domestic and foreign markets. Cash is normally held over the short term pending use elsewhere (perhaps for paying claims by a non-life insurance company or for paying pensions), but may be held over the longer term as well. Returns on cash are driven by the general demand for funds in an economy, interest rates, and the expected rate of inflation. A portfolio will normally maintain at least a small proportion of its funds in cash in order to take advantage of buying opportunities.
Bonds
Bonds are debt instruments on which the issuer (the borrower) agrees to make interest payments at periodic intervals over the life of the bond – this can be for two to thirty years or, sometimes, in perpetuity. Interest payments can be fixed or variable, the latter being linked to prevailing levels of interest rates. Bond markets are international and have grown rapidly over recent years. The bond markets are highly liquid, with many issuers of similar standing, including governments (sovereigns) and state-guaranteed organizations. Corporate bonds are bonds that are issued by companies. To assist investors and to help in the efficient pricing of bond issues, many bond issues are given ratings by specialist agencies such as Standard & Poor’s and 13
Moody’s. The highest investment grade is AAA, going all the way down to D, which is graded as in default. Depending on expected movements in future interest rates, the capital values of bonds fluctuate daily, providing investors with the potential for capital gains or losses. Future interest rates are driven by the likely demand/ supply of money in an economy, future inflation rates, political events and interest rates elsewhere in world markets. Investors with short-term horizons and liquidity requirements may choose to invest in bonds because of their relatively higher return than cash and their prospects for possible capital appreciation. Long Term investors, such as pension funds, may acquire bonds for the higher income and may hold them until redemption – for perhaps seven or fifteen years. Because of the greater risk, long bonds (over ten years to maturity) tend to be more volatile in price than medium- and short-term bonds, and have a higher yield.
Equities
Equity consists of shares in a company representing the capital originally provided by shareholders. An ordinary shareholder owns a proportional share of the company and an ordinary share carries the residual risk and rewards after all liabilities and costs have been paid. Ordinary shares carry the right to receive income in the form of dividends (once declared out of distributable profits) and any residual claim on the company’s assets once its liabilities have been paid in full. Preference shares are another type of share capital. They differ from ordinary shares in that the dividend on a preference share is usually fixed at some amount and does not change. Also, preference shares usually do not carry voting rights and, in the 14
event of firm failure, preference shareholders are paid before ordinary shareholders. Returns from investing in equities are generated in the form of dividend income and capital gain arising from the ultimate sale of the shares. The level of dividends may vary from year to year, reflecting the changing profitability of a company. Similarly, the market price of a share will change from day to day to reflect all relevant available information. Although not guaranteed, equity prices generally rise over time, reflecting general economic growth, and have been found over the long term to generate growing levels of income in excess of the rate of inflation. Granted, there may be periods of time, even years, when equity prices trend downwards – usually during recessionary times. The overall long-term prospect, however, for capital appreciation makes equities an attractive investment proposition for major institutional investors.
Derivatives
Derivative instruments are financial assets that are derived from existing primary assets as opposed to being issued by a company or government entity. The two most popular derivatives are futures and options. The extent to which a fund may incorporate derivatives products in the fund will be specified in the fund rules and, depending on the type of fund established for the client and depending on the client, may not be allowable at all. A futures contract is an agreement in the form of a standardized contract between two counterparties to exchange an asset at a fixed price and date in the future. The underlying asset of the futures contract can be a commodity or a financial security. Each contract specifies the type and amount of the 15
asset to be exchanged, and where it is to be delivered (usually one of a few approved locations for that particular asset). Futures contracts can be set up for the delivery of cocoa, steel, oil or coffee. Likewise, financial futures contracts can specify the delivery of foreign currency or a range of government bonds. The buyer of a futures contract takes a ‘long position’, and will make a profit if the value of the contract rises after the purchase. The seller of the futures contract takes a ‘short position’ and will, in turn, make a profit if the price of the futures contract falls. When the futures contract expires, the seller of the contract is required to deliver the underlying asset to the buyer of the contract. Regarding financial futures contracts, however, in the vast majority of cases no physical delivery of the underlying asset takes place as many contracts are cash settled or closed out with the offsetting position before the expiry date. An option contract is an agreement that gives the owner the right, but not obligation, to buy or sell (depending on the type of option) a certain asset for a specified period of time. A call option gives the holder the right to buy the asset. A put option gives the holder the right to sell the asset. European options can be exercised only on the options’ expiry date. US options can be exercised at any time before the contract’s maturity date. Option contracts on stocks or stock indices are particularly popular. Buying an option involves paying a premium; selling an option involves receiving the premium. Options have the potential for large gains or losses, and are considered to be high-risk instruments. Sometimes, however, option contracts are used to reduce risk. For example, fund managers can use a call option to reduce risk when they own an asset. Only very specific funds are allowed to hold options.
16
Property
Property investment can be made either directly by buying properties, or indirectly by buying shares in listed property companies. Only major institutional investors with long-term time horizons and no liquidity pressures tend to make direct property investments. These institutions purchase freehold and leasehold properties as part of a property portfolio held for the long term, perhaps twenty or more years. Property sectors of interest would include prime, quality, well-located commercial office and shop properties, modern industrial warehouses and estates, hotels, farmland and woodland. Returns are generated from annual rents and any capital gains on realization. These investments are often highly illiquid.
17
PHASES OF PORTFOLIO MANAGEMENT Portfolio Management is a process encompassing many activities aimed at optimizing the investment of one’s funds. Five phases can be identified in this process: 1. Security Analysis 2. Portfolio Analysis 3. Portfolio Selection 4. Portfolio Revision 5. Portfolio Evaluation
18
SECURITY ANALYSIS Security analysis is the initial phase of the portfolio management process. This step consists of examining the risk-return characteristics of individual securities. A basic strategy in securities investment is to buy underpriced securities and sell overpriced securities. There are two approaches to security analysis, namely fundamental analysis and technical analysis. Fundamental analysis is really a logical and systematic approach to estimating the future dividends and share price. It is based on the basic premise that the share price is determined by a number of fundamental factors relating to the economy, industry, and company. Each share is assumed to have an economic worth based on its present and future earning capacity. This is called its intrinsic value or fundamental value. The investor can then compare the intrinsic value of the share with the prevailing market price to arrive at an investment decision. If the market price of the share is lower than its intrinsic value, the investor would decide to buy the share as it is underpriced. The price of such a share is expected to move up in the future to match with its intrinsic value. On the contrary, when the market price of a share is higher than its intrinsic value, it is perceived to be overpriced. The market price of such a share is expected to come down in future and hence, the investor would decide to sell such a share. The fundamental approach calls upon the investor to make his buy or sell decision on the basis of a detailed analysis of the information about the
19
company, the industry to which the company belongs, and the economy in which it is established. Thus, a fundamental makes use of EIC (Economy, Industry, and Company) framework of analysis. Fundamental analysis thus involves three steps: 1. Economy Analysis 2. Industry Analysis 3. Company Analysis
Economy analysis is the first stage of fundamental analysis and starts with an analysis of historical performance of the economy. But as an investment is a future oriented activity, the investor is more interested in the expected future performance of the overall economy. Economic forecasting thus becomes a key activity in economic analysis.
FORECASTING TECHNIQUES Economic forecasting may be carried out for short term periods (up to three years), intermediate term periods (three to five years) and long-term periods (more than five years). Some of the techniques of short term economic forecasting are discussed below: Anticipatory Surveys Much of the activities in government, business, trade and industry are planned in advance and stated in the form of budgets. To the extent that institutions and people plan and budget for expenditures in advance, surveys
20
of their intentions can provide valuable input to short term economic forecasting. Barometric or Indicator Approach To find out how the economy is likely to perform in the future various kinds of indicators such as time series data of certain economic variables are studied to economic forecasting. Econometric Model Building This technique makes use of Econometrics, which is a discipline that applies mathematical and statistical techniques to economic theory. The precise relationship between the dependent and independent variables are specified in a formal mathematical manner in the form of equations. The system of the equation is then solved to yield a forecast that is quite precise. Opportunistic Model Building It is also known as GNP model building or sectoral analysis. Initially, an analyst estimates the total demand in the economy, and based on this he estimates the total income or GNP for the forecast period. This initial estimate takes into consideration the prevailing economic environment such as existing tax rates, interest rates, and rate of inflation and economic and fiscal policies of the government.
Industry analysis is to determine the stage of growth through which the industry is passing. Industry analysis refers to an evaluation of the relative strengths and weaknesses of particular industries.
21
A number of key characteristics that should be considered by the analyst. These features broadly relate to the operational and structural aspects of the industry. They have a bearing on the prospects of the industry. Some of these are discussed below: Demand Supply Gap An industry is likely to experience under supply and over-supply of capacity at different times, usually the demand for the product tends to change at a steady rate. Excess supply reduces the profitability of the industry through a decline in the unit price realization. Therefore, the gap between demand and supply in an industry is fairly good indicator of its short-term or mediumterm prospects. Competitive Conditions in the Industry The level of competition among various companies in an industry is determined by certain competitive forces. These competitive forces are: barriers to entry, the threat of substitution, bargaining power of the buyers/suppliers, and the rivalry among competitors. Labour conditions If the labour in a particular industry is rebellious and is inclined to resort to strikes frequently, the prospects of that industry cannot become bright. Attitude of Government The government may encourage the growth of certain industries and can assist such industries through favourable legislation or vice-versa. In India, this has been the experience of alcoholic drinks and cigarette industries.
22
Company analysis is the final stage of fundamental analysis. In company analysis, the analyst tries to forecast the future earnings of the company because there is strong evidence that earnings have a direct and powerful effect upon share prices. The level, trend and stability of earnings of a company, however, depend upon a number of factors concerning the operations of the company. Financial Statements The prosperity of a company would depend upon its profitability and financial health. The financial statements published by a company periodically help us to assess the profitability and financial health of the company. The Balance Sheet and the Profit and Loss Account are two basic financial statements provided by accompany. Financial ratios are most extensively used to evaluate the financial performance of the company. Four groups of ratios may be used for analyzing the performance of a company. Liquidity Ratios These measure the company’s ability to fulfil its short term obligations and reflect its short term financial strength or liquidity. 1. Current ratio = Current Assets Current Liabilities 2. Quick Ratio = Current Assets – Prepaid expenses Current Liabilities
23
3. Leverage Ratios (i)
Debt-Equity Ratio = Long-term debt Shareholder’s equity
(ii)
Total debt ratio = Total Debt Total Assets
(iii)
Proprietary Ratio = Shareholders’ equity Total Assets
(iv)
Interest Coverage Ratio = Earnings before interest and Taxes Interest
4. Profitability Ratios
(i)
Gross Profit Ratio = Gross Profit Net Sales
(ii)
Operating Profit Ratio = EBIT Net Sales
(iii)
Net Profit Ratio = Earnings after tax Net Sales
(iv)
Return on Capital Employed = EBIT Total Capital Employed
(v)
EPS = Net profit available to equity shareholders Number of equity shares
(vi)
Dividend Payout Ratio = DPS EPS
(vii) Price- Earnings Ratio = Market Price per share EPS (viii) Return on Investment = Earnings after taxes Total Assets
24
Technical analysis believes that share price are determined by the demand and supply forces operating in the market. A technical analyst therefore concentrates on the movement of share prices. He claims that by examining past share price movement future share prices can be accurately predicted. Thus, technical analysis is really a study of past or historical price and volume movements so as to predict the future stock price behavior. Bar Chart It is perhaps the most popular chart used by technical analysts. In this chart, the highest price, the lowest price and the closing price of each day are plotted on a day-to-day basis.
25
Date
High Price (Rs.)
Low Price (Rs.)
Close Price (Rs.)
1
346.5
335
340.5
2
355
340
354.1
3
359.4
354
356.2
4
357.8
348
350.6
5
353.75
345.15
349.9
6
355.6
346
350.75
7
353.35
349.15
352.05
365 360 355 P R I C E S
350 345
High Price (Rs.)
340
Low Price (Rs.)
335
Close Price (Rs.)
330 325 320 1
2
3
4
5 DAYS
26
6
7
8
PORTFOLIO ANALYSIS From a given set of securities, any number of portfolios can be constructed. A rational investor attempts to find the most efficient of these portfolios. The efficiency of each portfolio can be evaluated only in terms of the expected return and risk of the portfolio as such. Thus, determining the expected return and risk of different portfolios is a primary step in portfolio management. This step is designated as portfolio analysis. EXPECTED RETURN OF A PORTFOLIO As a first step in portfolio analysis, an investor needs to specify the list of securities eligible for selection in the portfolio. Next he has to generate the risk-return expectations for these securities. These are typically expressed as the expected rate of return (mean) and the variance or standard deviation of the return. Let’s consider a portfolio of two equity shares P and Q with expected return of 15% and 20% resp. if 40% of the available total funds is invested in share P and the rest in Q, then the expected portfolio return will be: (.4 x 15) + (.6 x 20) = 18 per cent RISK OF A PORTFOLIO The variance of return and standard deviation of return are alternative statistical measures that are used for measuring risk in investment. The variance or standard deviation of an individual security measures the riskiness of a security in absolute sense. This depends on their interactive risk, i.e. how the returns of a security move with the returns of other
27
securities in the portfolio and contribute to the overall risk of the portfolio. Covariance is the statistical measure that indicates the interactive risk of a security. Year Rx
Deviation Ry
Deviation Product of
Rx – Rx
Ry – Ry
Deviations (Rx – Rx ) (Ry – Ry )
1
10
-4
17
5
-20
2
12
-2
13
1
-2
3
16
2
10
-2
-4
4
18
4
8
-4
-16
Rx =
Ry =
56/4 =
48/4 =12
-42
14
Covariance = Product of deviation / 4 = -42/4 = -10.5 The covariance is a measure of how returns of two securities move together. If the returns of the two securities move in the opposite direction consistently the covariance would be negative.
28
PORTFOLIO SELECTION The objective of every rational investor is to maximize his returns and minimize the risk. Diversification is the method adopted for reducing risk. It essentially results in the construction of portfolios. The proper goal of portfolio construction would be to generate a portfolio that provides the highest return and the lowest risk. Such a portfolio would be known as the optimal portfolio. The process of finding the optimal portfolio is described as portfolio selection. The feasible set of portfolios in which the investor can possibly invest, is known as the portfolio opportunity set. In the opportunity set some portfolios will obviously be dominated by others. A portfolio will dominate another if it has either a lower standard deviation and the same expected return as other, or a higher expected return and the same standard deviation as the other.
29
Efficient Set of Portfolios Portfolio No. Expected Return
Standard deviation
(%)
(Risks)
1
5.6
4.5
2
7.8
5.8
3
9.2
7.6
4
10.5
8.1
5
11.7
8.1
6
12.4
9.3
7
13.5
9.5
8
13.5
11.3
9
15.7
12.7
10
16.8
12.9
If we compare portfolio no. 4 and 5, for the same standard deviation of 8.1 portfolio no. 5 gives a higher expected return of 11.7, making it more efficient than portfolio no. 4.
30
PORTFOLIO REVISION The financial markets are continually changing. In this dynamic environment, a portfolio that was optimal when constructed may not continue to be optimal with the passage of time. It may have to be revised periodically so as to ensure that it continues to be optimal. NEED FOR REVISION The need for portfolio revision may arise because of some investor related factors also. These factors may be listed as: 1. Availability of additional funds for investment 2. Changes in risk tolerance 3. Changes in the investment goals 4. Need to liquidate a part of the portfolio to provide funds for some alternative use Constraints in Portfolio Revision The practice of portfolio adjustment involving purchase and sale of securities gives rise to certain problems which act as constraints in portfolio revision. 1. Transaction Cost Buying and selling of securities involve transaction costs such as commission and brokerage. Frequent buying and selling may push up transaction costs thereby reducing the gains from portfolio revision.
31
2. Taxes Frequent sales of securities of periodic portfolio revision will result in short term capital gains which would be taxed at a higher rate compared to long term capital gains. 3. Statutory Stipulations The largest portfolios in every country are managed by investment companies and mutual funds. These institutional investors are governed by certain statutory stipulations regarding their investment activity.
32
PORTFOLIO EVALUATION Portfolio Evaluation is the last step in the process of portfolio management. It is the stage where we examine to what the extent the objectives has been achieved. Through portfolio evaluation the investor tries to find out how well the portfolio has performed. Without portfolio evaluation, portfolio management would be incomplete.
NEED FOR EVALUATION Evaluation is an appraisal of performance. Whether the investment activity is carried out by individual investors themselves or through mutual funds and investment companies, different situations arise where evaluation of performance becomes imperative. Self Evaluation An investor would like to evaluate the performance of his portfolio in order to identify the mistakes committed by him. This self evaluation will enable him to improve his skills and achieve better performance in future. Evaluation of Portfolio Managers Evaluation of Mutual Funds
33
Two methods of measuring the reward per unit of risk have been proposed by William Sharpe and Jack Treynor in their pioneering work on evaluation of portfolio performance. Sharpe Ratio It is the ratio of the reward or risk premium to the variability of return or risk as measured by the standard deviation of return. The formula for calculating Sharpe Ratio may be stated as: Sharpe Ratio (SR) = (rp – rf) /
p
Where rp = Realised return on the portfolio
rf = Rik free rate of Return p
= Standard deviation of portfolio return
Treynor Ratio It is the ratio of the reward or risk premium to the variability of return or risk as measured by beta of portfolio. Treynor Ratio (TR) = (rp – rf) /
p
34
Fund
Return (%)
Standard Deviation (%)
Beta
A
12
18
.7
Z
19
25
1.3
M (Market Index) 15
20
1.0
the risk free rate of return is 7 per cent. SR = A = 12 – 7 /18 = .277 Z = 19 – 7 /25 = .48 M = 15 – 7 /20 = .40 as per Sharpe’s performance measure, fund Z has performed better than the benchmark market index, while fund A has performed worse than the market index. TR = A = 12 – 7 /.7 = 7.14 Z = 19 – 7 / 1.3 = 9.23 M = 15 – 7 / 1.0 = 8.00 according to Treynor’s performance measure also, fund Z has performed better and fund A has performed worse than the benchmark.
35
Conclusion The composition of a share portfolio says a lot about its owner. An outsider should be able to look at the holdings in it and see
whether the owner of the shares is aiming for growth or income whether the owner is risk-averse or willing to take risks whether the owner considers himself a beginner, an intermediate or advanced investor whether the owner is a short term or long term investor
The point is that different types of investors, with different goals, resources and aptitudes require very different types of investments. If you've put together your portfolio rationally, it will reflect your circumstances. The purpose of this workshop is to drive home the lesson that in creating and managing a portfolio, do so rationally. Think about your objectives and how different asset classes meet them, think about risk and how to reduce it, think about diversification and the level you are comfortable with, and think about your weaknesses and strengths and how to work within them. Investing with a high degree of self-awareness will not only bring you the best results but also preserve your peace of mind in what can be a fraught theatre of nerves.
36
Bibliography
1.
Avadhani, V.A., Securities Analysis and Portfolio Management, Himalaya Publishing House, Mumbai, 1997
2.
David Blake, Financial Market Analysis, McGraw-Hill, London, 1992.
3.
Edwin J. Elton and Martin J. Gruber, Modern Portfolio Theory and Investment Analysis, 4th edition, John Wiley & Sons, New York, 1994.
4.
James L. Farrell, Jr., Portfolio Management: Theory and Application, 2nd ed., McGraw-Hill, Inc., New York, 1997.
5.
Preeti Singh, Investment Management, Himalaya Publishing House, Mumbai, 1993.
6.
Samir K. Barua, J.R. Varma and V. Raghunathan, Portfolio Management, 1st revised ed., Tata McGraw-Hill, New Delhi, 1996.
37
