portfolio revision and evaluation
TRANSCRIPT
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Portfolio revision, reconstruction and
Evaluation
Himanshu Puri
Faculty
DIAS
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PORTFOLIO REVISIONAND
RECONSTRUCTION
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Why Portfolio Revision?
To align the portfolio in accordance with the investment policy
statement and investment strategy
The needs of the beneficiary will change
The relative merits of the portfolio components will change
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Rebalancing
Rebalancing can cause the portfolio manager to
sell shares even if they are not doing poorly
Profit taking with winners is a logical
consequence of portfolio rebalancing
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Upgrading
Investors should sell shares when their
investment potential has deteriorated to the
extent that they no longer merit a place in the
portfolio
It is difficult to take a loss, but it is worse to let
the losses grow
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Change in Client Objectives
The clients investment objectives may change
occasionally:
E.g., a church needs to generate funds for a
renovation and changes the objective for the fund
from growth of income to income
Reduce the equity component of the portfolio
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Change in Market Conditions
Many fund managers seek to actively time the
market
When a portfolio managers outlook becomes
bearish, he may reduce his equity holdings
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Portfolio managers:
Should be careful about making unnecessarytrades
Must pay attention to their experience, intuition,and professional judgment
An experienced portfolio manager worriedabout a particular holding should probablymake a change
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Risk-Adjusted Measures of Portfolio Performance
Sharpes Ratio
p
FPp
RRS
Defined as the ratio of excess returns earned over the risk
free rate to the risk of the portfolio.
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Example
Portfolio Return Risk
Risk-free
rate
A 10% 3% 5%
B 12% 7% 5%
67.13
510
AS
17
512
BS
Thus based on Sharpe ratio portfolio A has performed better than
portfolio B
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So what it does it mean to an investor?
For the investor it means that subject to the returns, variance,
co-variances of the securities of the portfolios remaining
constant, portfolio A is better then portfolio B
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Treynors Ratio
Defined as the ratio of excess returns of the portfolio over the
risk free rate to the beta of the portfolio.
P
FPP
RRT
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Fund return SD beta
A 14 6 1.5
B 12 4 0.5
C 16 3 1
D 10 6 0.5
E 20 10 2
Given the risk free rate is 3%. Rank the performance using Sharpe and Treynors
ratio. Assume C to be a market portfolio
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Fund return SD beta Sharpe Rank Treynor Rank
A 14 6 1.5 1.83 3 7.3 5
B 12 4 0.5 2.25 2 18.0 1
C 16 3 1 4.33 1 13.0 3
D 10 6 0.5 1.17 5 14.0 2
E 20 10 2 1.70 4 8.5 4
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Jensens Alpha
)(( FMFp RRRR
Average return of the portfolio over and above that predicted by CAPM
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Fund return SD beta
A 14 6 1.5
B 12 4 0.5
C 16 3 1
D 10 6 0.5
E 20 10 2
Given the risk free rate is 5% and RM= 10%. Rank the performance Jensens alpha.
Assume C to be a market portfolio
A = .14 {.05+1.5(.10-.05)} = 1.5%
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The above measures help in measuring and comparing the performance on risk adjusted
basis between portfolio managers.
Fama went a step further to break the performance into smaller components.
Assume a fund manager has given a return of 14% with a total risk of 15(%)2. The beta of
fund managers portfolio is 0.5. Given the risk free-rate is 5% and the market risk
premium is 6%.
So obviously this portfolio would lie above the SML.
However a security with a beta of 0.5 should be giving a return of 8%. So the portfolio
manager has given an excess return of 6%.
Famas Decomposition
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Now if the fund manager is getting higher return than the expected return, then it can
only be earned by taking higher risk.
Now since the beta is same so the risk that the manager takes is the unsystematic risk.
Thus the excess return is due to higher unsystematic risk assumed by the fund manager.
Now this only gives us the information that that he has taken a higher risk to get higher
return and tells us nothing about his skill.
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Now we compare this portfolio with a portfolio which has similar total risk as this
portfolio and lies on the SML.
Since on SML the only risk that would be present would be the systematic risk so its
total risk would be equal to systematic risk.
If total risk of the market portfolio is 10(%)2 , then the beta for a portfolio which has
similar total risk as the fund managers portfolio is
1510*2 22.1
The return for this portfolio is =5+1.22*6=12.34%
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Thus the return being earned by the fund manager bearing the same total risk is 14%
as compared to a return of 12.34% on the SML
The difference i.e. 14%-12.34%=1.66% is due to fund managers skill.
So out of 6% excess return over the similar beta portfolio, 1.66% is due to fund managers
skill and the rest (4.34%) is the return since he is bearing a taking a higher unsystematic
risk.
1.66% return earned here is the return due to selection skills of the portfolio manager
and is called return due to net selectivity while the total 6% earned is called the return
from total selectivity. The difference between the two is called the return from
diversification.