MIT First Grade College

Manandavadi Road, Mysore-08

Affiliated to University of Mysore

VISION OF THE INSTITUTE

Empower the individuals and society at large through educational excellence; sensitize them for a life
dedicated to the service of fellow human beings and mother land.
MISSION OF THE INSTITUTE
To impact holistic education that enables the students to become socially responsive and useful, with
roots firm on traditional and cultural values; and to hone their skills to accept challenges and
respond to opportunities in a global scenario.
Lecture Notes on: PORTFOLIO MANAGEMENT
Prepared By : ARUNKUMAR. K
Department : P G DEPARTMENT OF COMMERCE
Subject : PORTFOLIO MANAGEMENT
Syllabus

Module 1: Efficient Market Hypothesis - Random walk, Levels of efficiency – Weak, semi
strong and strong, Techniques for measuring efficiency, Empirical tests. Portfolio analysis,
Markowitz risks return optimization. CAPM, Index models and Arbitrage pricing theory and
multifactor models of risk and return.

Module 2: Fundamental and Technical Analysis - Economic and industry analysis – company
analysis, Economic forecasting company earnings, Valuation of companies. Market indicators:
forecasting individual stock performance, techniques, types of charts, Dow Theory, Relative
strength, contrary opinion, Moving averages, conference index, trading volume, concept of
depth, breadth and resilience of the market.

Module 3: Portfolio Analysis – Theory and Practices – Risk Analysis – Types of Risks – Risk
1
 Management –Diversification of risk – Analysis of risk – Building a Balanced portfolio.
Characteristics of portfolio – Principles and Practices – Characteristics of Portfolio Analysis –
Liquidity Vs. Safety – Income Vs. growth – Short Term and Long Term – Risk Vs. Return Need
for insuring risk to attract stable investors.

Module 4: Portfolio Performance Evaluation - Mutual funds - Geometric mean return -

Sharpe, Treynor and Jensen‘s performance measures - Optimal portfolio selection – importance
of computer data analysis of security analysis and portfolio analysis.

References:
1. portfolio analysis and management: Ballad
2. Security analysis and portfolio management: V.A. Avadhani.
3. Security analysis and portfolio management: Punithavathy pandian
4. Security analysis and portfolio management: S.Kevin.

COURSE OUTCOMES
Expected Course Outcomes Cognitive
Level
CO1 Apply the Concept of portfolio management for the better investment. Ap-L3

CO2 Explain and evaluate major portfolio Management and Risk concept including E-L5
mean variance.
CO3 Identify and apply appropriate theories, principles and concepts relevant to A-L3
security analysis and Portfolio management.
CO4 Demonstrate an in depth understanding of the basics of Risk and Return, Return U-L2
measurement, Risk portioning into systematic and unsystematic component.
CO5 Compute and interpret various portfolio performance measures like Sharpe, An-L4
Treynor’s and jensen’s performance measures.

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Table of Contents
Sl. No. Topic Page No.

Module : 01 EFFICIENT MARKET HYPOTHESIS

01 Investment : Meaning and characteristics 04 to 04

02 Portfolio : Characteristics, diversification and Management 05 to 09

03 Forms of Efficient market Hypothesis 09 to 12

04 Markowitz and CAPM Model 13 to 14

05 Arbitrage pricing theory Model 14 to 16

Module 02 : Fundamental and Technical Analysis

06 Fundamental Analysis 17 to 19

07 Economic Analysis 20 to 22

08 Industry Analysis 22 to 25

09 Company Analysis 26 to 26

10 Technical Analysis 27 to 28

11 Dow Theory 28 to 30

Module 03: portfolio Analysis

12 Systematic and Unsystematic Risk 31 to 33

13 Risk Management & Risk Diversification 34 to 36

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 Module 04: Portfolio Performance Evaluation

Portfolio Evaluation 37 to 37
15
16 Mutual Fund 38 to 43

MODULE : 01
EFFICIENT MARKET HYPOTHESIS

INVESTMENT:
Investment is an activity that is engaged in by people who have savings, i.e. investments are
made from savings, or in other words, people invest their savings with an intension of getting
returns. Thus, investment may be defined as a ―commitment of funds made in the expectation
of some position rate of return‖. Expectation of return is an essential element of investment.

Characteristics of Investment:
All investments are characterized by certain features.

1. Return: All investments are characterized by the expectation of a return. Investment is

made with the primary objective of deriving a return. The return may be received in the
form of yield plus capital appreciation.

2. Risk: Risk is inherent in any investment. The risk may relate to loss of capital, delay in
repayment of capital, non-payment of interest, or variability of returns.

3. Safety: The safety of an investment implies the certainty of return of capital without loss
of money or time.

4. Liquidity: An investment which is easily saleable or marketable without loss of money

and without loss of time is said to possess liquidity.

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Investment Avenues:
• Corporate Securities – issued by Joint Stock Companies (Equity Share, Preference Share,
Debentures)
• Mutual fund Schemes
• Post office Deposits and Certificates
• Life Insurance Policies
• Provident Fund Schemes
• Govt. and Semi-Govt. Securities

SECURITIES:
Marketable Investment instruments are called as securities. That means the investment
instruments that can be traded in the market.

Classification of Securities:
I. Ownership Securities:
1. Preference Shares
2. Equity Shares
II. Creditorship Securities
1. Debentures
2. Bonds
III. New Securities
1. Convertible Debentures
2. Zero Coupon Bonds
3. Flexi Bonds
4. Floating Rate Bonds
5. ADR, GDR etc.

PORTFOLIO:
Instead of investing the entire savings in a single security, investing in a group of securities is
called as portfolio. Creation of portfolio helps to reduce risk without sacrificing the returns.

5
CHARACTERISTICS OF PORTFOLIO:

1. Risk-averse. A portfolio should not expose you to any more risk than is necessary to
meet the needs of the investors. For every investment portfolio, there is a minimum
level of risk and return that are necessary to safely achieve its objectives. Investors must
identify this level before they can evaluate the quality of your portfolio.

2. Cost efficient. A good portfolio achieves its objectives at the lowest possible cost. If
your portfolio costs more than about 0.20 percent to own, it could probably be better

3. Risk efficient. Risk is something to be avoided, when- and wherever possible. To know
the quality of the portfolio, investors must know how much return to expect from it and
how likely it is to deliver something else. Risk efficiency is achieved by properly
diversifying your portfolio.

4. Tax efficient. Like other costs, taxes must be minimized in order to maximize the quality
of investment strategy and the portfolio it produces.

5. Simple. A good portfolio minimizes complexity and avoids using unnecessary

components. Investors should be able to quickly review and assess your portfolio‘s
performance from a few account statements that each contain no more than a handful of
securities and transactions each year.

6. Transparent. Investors should clearly understand what each element of portfolio is, and
what it is supposed to do. Trust is not something that should be given to anyone in the
investment business. It should be earned, and then given only sparingly and where
absolutely necessary.

7. Easy to manage. Professional investment managers are good at making what they do
seem too complex and mysterious for you to do yourself. The truth is that most of what
goes on in retail investment management is activity that is more valuable for justifying
high fees than anything else.

6
PORTFOLIO DIVERSIFICATION:
Portfolio Diversification is a foundational concept in investing. It can be a rather basic and easy
to understand concept. However, in its implementation, many investors make catastrophic
mistakes with too much concentration and others settle for average performance because of over
diversification.

Definition of Diversification:
The definition of diversification is the act of, or the result of, achieving variety. In finance and
investment planning, portfolio diversification is the risk management strategy of combining a
variety of assets to reduce the overall risk of an investment portfolio.

Purpose of Portfolio Diversification:

The purpose of portfolio diversification is portfolio risk management. A risk management
plan should include diversification rules that are strictly followed. Portfolio diversification will
lower the volatility of a portfolio because not all asset categories, industries, or stocks move
together. Holding a variety of non-correlated assets can nearly eliminate unsystematic
risk (specific risk).
In other words, by owning a large number of investments in different industries and companies,
industry and company specific risk is minimized. This decreases the volatility of the portfolio
because different assets should be rising and falling at different times; smoothing out the returns
of the portfolio as a whole. ―There is a close logical connection between the concept of a safety
margin and the principle of diversification.‖

In addition, diversification of non-correlated assets can reduce losses in bear markets; preserving
capital for investment in bull markets. Portfolio optimization can be achieved through proper
diversification because the portfolio manager can invest in a greater number of risk assets
(i.e. stocks) without accepting more risk than planned in the whole portfolio. In other words,
portfolio managers with a target amount of total risk are able to invest a greater percentage of
their assets in risk assets with a diversified portfolio versus a non-diversified portfolio. This is
because holding a variety of non-correlated assets lowers the total risk of the portfolio. This is
why some say diversification is the only free ride.
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PORTFOLIO MANAGEMENT:
Portfolio management is a process encompassing many activities.
1. Security Analysis
2. Portfolio Analysis
3. Portfolio Selection
4. Portfolio Revision
5. Portfolio Evaluation

1.Security Analysis: The securities available to an investor for investment are numerous and of
various types. From this vase group of securities, the investor has to choose those securities
which he considers worthwhile to be included in his investment portfolio. This calls for a
detailed analysis of the available securities.

2..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 called as Portfolio Analysis.

3..Portfolio Selection: Portfolio analysis provides the input for the next phase in portfolio
management which is portfolio selection. The goal of portfolio construction is to generate a
portfolio that provides the highest returns at a given level of risk. A portfolio having this
characteristic is known as efficient portfolio.

4..Portfolio Revision: Having constructed the optimal portfolio, the investor has to constantly
monitor the portfolio to ensure that it continues to be optimal. The investor has to revise his

8
portfolio in the light of the developments in the market. This revision leads to purchase of some
new securities and sale of some of the existing securities from the portfolio.

5..Portfolio Evaluation: The objective of constructing a portfolio and revising it periodically is

to earn maximum returns with minimum risk. Portfolio evaluation is the process which is
concerned with assessing the performance of the portfolio over a selected period of time in terms
of return and risk.

EFFICIENT MARKET HYPOTHESIS:

The basic assumption in technical analysis is that stock price movement is quite orderly and not
random. The new theory questions this assumption. From the results of several empirical
studies on stock price movements, the advocates of the new theory assert that share price
movements are random. The new theory came to be known as Random Theory because of its
basic assumption that share price movements represent a random walk rather than an orderly
movement.
The random walk theory assumes that the stock markets are so efficient and competitive that
there is immediate price adjustment. This is the result of good communication system through
which information can be spread almost anywhere in the country instantaneously. Thus, the
random walk theory is based on the hypothesis (assumption) that the stock markets are efficient.
Hence, this theory later came to be known as the Efficient Market Hypothesis (EMH) or the
Efficient Market Model.

Forms of Efficient Market Hypothesis:

The Capital Market is considered to be efficient in three different forms. Thus, the efficient
market hypothesis has been sub-divided into three forms, each dealing with a different type of
information. They are:
1. Weak form of Hypothesis
2. Semi-strong form of Hypothesis
3. Strong form of Hypothesis.

1. Weak form of Hypothesis: It deals with the information regarding the past sequence of
security price movements.
2. Semi-strong form of Hypothesis: It deals with the publicly available information. For
9
 example, corporate annual reports, company announcements, press release, forthcoming
dividends, information on stock splits etc.
3. Strong form of Hypothesis: It deals with all information, both public and private
(inside information about the company).

Testing of Efficient Market Hypothesis:

The different forms of efficient market hypothesis have been tested through several empirical
studies.
1. Empirical Tests of Weak Form Efficiency:
The weak form of the EMH says that the current prices of stock already fully reflect all the
information that is contained in the historical sequence of prices. The new price movements are
completely random. They are produced by new pieces of information and are not related or
dependent on pas price movements. Therefore, there is no benefit in studying the historical
sequence of prices to gain abnormal returns from trading in securities. This implies that
technical analysis, which relies on charts of price movements in the past, is not a meaningful
analysis for making abnormal trading profits. The following are the tests which are used to test
weak form efficiency.

a) Serial Correlation Test: Since the weak form EMH postulates independence between
successive price changes, such independence or randomness in stock price movements can be
tested by calculating the correlation between price changes in one period and changes for the
same stock in another period. The correlation coefficient can take on a value ranging from -1 to
1; a positive number indicates a direct relation, a negative value implies an inverse relationship
and a value close to zero implies no relationship. Thus, if correlation coefficient is close to zero,
the price changes can be considered to be serially independent.

b) Run Test: The run test is another test used to test the randomness in stock price
movement. In this test, the absolute values of price changes are ignored, only the direction of
change is considered. An increase in price is represented by + signs. The decrease is
represented by – sign. When there is no change in prices, it is represented by ‗0‘. A
consecutive sequence of the same sign is considered as a run. For example, the sequence +++ - -
- has two runs. In other words, a change of sign indicates a new run. The sequence -------- +++0-

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- - - -+++++ has five runs. In a run test, the actual number of runs observed in a series of stock
price movements is compared with the number of runs n a randomly generated number series. If
no significant differences are found, the security price changes are considered to be random in
nature.

c) Filter Test: If stock price changes are random in nature, it would be extremely difficult
to develop successful mechanical trading systems. Filter tests have been developed as direct
tests of specific mechanical trading strategies to examine their validity and usefulness. It is often
believed that, as long as no new information enters the market, the price fluctuates randomly
within two barriers – one lower, and the other higher - around the fair price. When new
information comes into the market, a new equilibrium price will be determined. If the news is
favorable, then the price should move up to a new equilibrium above the old price. Investors
will know that this is occurring when the price breaks through the old barrier. If investors
purchase at this point, they will benefit from the price increase to the new equilibrium level.

2. Empirical Tests of Semi-strong form Efficiency:

The semi-strong form of the efficient market hypothesis says that current prices of stocks not
only reflect all informational content of historical prices, but also reflect all publicly available
information about the company being studied. Examples of publicly available information are-
corporate annual reports, company announcements, press releases, announcements of
forthcoming dividends, stock splits etc.

The semi strong from tests deal with whether or not security prices fully reflect all publicly
available information. These tests attempt to establish whether share prices react precisely and
quickly to new items of information. If prices do not react quickly and adequately, then an
opportunity exists for investors or analysis to earn excess returns by using this information.
Therefore, these tests also attempt to find if analysis are able to earn superior returns by using
publicly available information.

Semi-strong from tests has been performed with respect to many different types of information.
Much of the methodology used in semi-strong form test has been introduced by Fama, Fisher,
Jensen and Roll. Their was the first of the studies that were directly concerned with the testing
11
 of the semi-strong form of EMH. Subsequent to their study, a number of refinements have been
developed in the test procedure. The general methodology followed in these studies has been to
take an economic event and measure its impact on the share price. The impact is measured by
taking the difference between the actual return and expected return on a security. The expected
return on a security is generally estimated by using the single index model suggested by William
Sharpe.

1. Tests Strong form of Efficiency:

The strong form hypothesis represents the extreme case of market efficiency. The stron form of
the efficient market hypothesis maintains that the current security prices reflect all information
both publicly available information as well as private or inside information. This implies that no
information, whether pubic or inside, can be used to earn superior returns consistently.
The strong form efficiency tests involve two types of tests. The firs type of tests attempt to find
whether those who have access to inside information have been able to utilize profitably such
inside information to earn excess returns. The second type of tests examine the performance of
mutual funds and the recommendations of investment analysis to see if these have succeeded in
achieving superior returns with the use of private information generated by them.

PORTFOLIO ANALYSIS:

Most investors would like to invest in a group of securities rather than a single security. Such a
group of securities held together as an investment is what is known as a portfolio. 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”.

MARKOWITZ MODEL:

12
 The conceptual framework and analytical tools for determining the optimal portfolio in
disciplined and objective manner have been provided by Harry Markowitz in his pioneering
work on portfolio analysis described in his 1952 Journal of Finance article and subsequent book
in 1959. His method of portfolio selection has come to be known as the Markowitz Model.
In fact, Markowitz‘s work marks the beginning of what is known today as
Modern Portfolio Theory.

Limitations of Markowitz Model:

1. In Markowitz model, the large number of input data required for calculations.
An investor must obtain estimates of return and variance of returns for all securities as
also co-variances of returns for each pair of securities included in the portfolio.
2. It is the complexity of computations required. The computations required are numerous
and complex in nature.
3. It has little use in practical applications of portfolio analysis. Much simplification is
needed before the theory can be used for practical applications.
CAPITAL ASSET PRICING MODEL (CAPM):

The Capital Asset Pricing Model was developed by mid-1060s by three researchers. Namely,
William Sharpe, John Linter and Jan Mossin independently. Consequently, the model is often
referred to as Sharpe-Lintner-Mossin Capital Asset Pricing Model.

The CAPM is really an extension of the portfolio theory of Markowitz. The portfolio theory is a
description of how rational investors should build efficient portfolios and select the optimal
portfolio. The capital asset pricing model derives the relationship between the expected return
and risk of individual securities and portfolios in the capital markets if everyone behaved in the
way the portfolio theory suggested.

Assumptions of CAPM:

1. Investors make their investment decisions on the basis of risk-return assessments

measured in terms of expected returns and standard deviation of returns.
2. The purchase or sale of a security can be undertaken in infinitely divisible units.
13
 3. Purchases and sales by a single investor cannot affect prices.
4. There are no transaction costs.
5. There are no personal income taxes.
6. The investor can lend or borrow any amount of funds desired at a rate of interest equal to
the rate for riskless securities.
7. The investor can sell short any amount of any shares.
8. Investors share homogeneity of expectations.

Comparison of Security Market Line (SML) and Capital Market Line (CML):

Capital Market Line (CML) Security Market Line (SML)

In CML, the risk is defined as total risk and is In SML, the risk is defined as systematic risk
measured by standard deviation. and is measured by Beta.
SML is valid for all portfolios and all
CML is valid only for efficient portfolios
individual securities as well.
SML is the basis of the capital asset pricing
CML is the basis of the capital market theory
model.

ARBITRAGE PRICING THEORY OR MODEL

It is developed by Stephen Ross in the year 1976 (American economist). Arbitrage pricing theory is one
of the tools used by investors and Portfolio managers. As per this theory asset pricing that holds an asset
returns can be forecasted with the linear relationship of an asset's expected return on the macroeconomic
factors that affect the assets risk. APT offers to analysts and investors a multiple factors pricing model
for securities based on the relationship between financial assets expected return and its risk.

Capital Asset pricing theory explains the returns of the securities on the basis of their respective
betas. Alternative model in asset pricing developed by Stephen Ross it is known Arbitrage pricing
theory.
14
ARBITRAGE

Arbitrage refers to the process of earning a profit by taking advantage of Differential pricing for the
same asset. the process generates risk-free profit. in the securities market, it involves selling a securities
at a high price and the simultaneous purchase of the same security relative lower price. since the profit
earned through arbitrage is free investors are the incentives to undertake this whenever an opportunity
arises

ASSUMPTIONS OF APT MODEL

1. investors have homogeneous expectation

2. they are risk averse and utility maximizes
3. perfect competition prevails in the market and there is no transaction cost
4. investors always prefer More to less wealth
5. In APT the assumptions of investors utilizing a mean variance Framework is replaced by
assumptions of the process of generating security returns
6. in a pretty model multiple factors have an impact of the returns of an asset in contract with CPA
model that studies that suggest that returns is related to only factors for example systematic risk.

MULTIFACTOR MODEL OF RISK & RETURN.

A multi-factor model is a financial model that employs multiple factors in its calculations to
explain market phenomena and/or equilibrium asset prices. A multi-factor model can be used to
explain either an individual security or a portfolio of securities. It does so by comparing two or
more factors to analyze relationships between variables and the resulting performance.
Multi-factor models are used to construct portfolios with certain characteristics, such as

risk, or to track indexes. When constructing a multi-factor model, it is difficult to decide

how many and which factors to include. Also, models are judged on historical numbers,

which might not accurately predict future values. Multi-factor models also help explain the

15
 weight of the different factors used in the models, indicating which factor has more of an impact
on the price of an asset.

Multi-Factor Model Formula

Factors are compared using the following formula:
Ri = ai + _i(m) * Rm + _i(1) * F1 + _i(2) * F2 +...+_i(N) * FN + ei
Where:
Ri is the return of security
Rm is the market return
F(1, 2, 3 ... N) is each of the factors used
_ is the beta with respect to each factor including the market (m)
e is the error term
a is the intercept

Types of Multi-Factor Models

Multi-factor models can be divided into three categories: macroeconomic models, fundamental
models, and statistical models.
Macroeconomic models: Macroeconomic models compare a security's return to such factors as
employment, inflation, and interest.
Fundamental models: Fundamental models analyze the relationship between a security's return
and its underlying financials, such as earnings, market capitalization, and debt levels.
Statistical models: Statistical models are used to compare the returns of different securities
based on the statistical performance of each security in and of itself. Many times, historical data
is used in this type of modelling.

MODULE: II

FUNDAMENTAL AND TECHNICAL ANALYSIS

SECURITY ANALYSIS:
Security analysis is the initial step in the Portfolio Management process. This step consists of

16
examining the risk-return characteristics of individual securities. A basic strategy in securities
investment is to buy underpriced securities and sell overpriced securities. But the problem is how
to identify underpriced and overpriced securities. This is what security analysis a method to
which helps to calculate the value of assets and also find out effect of various market fluctuations
on the value of tradable financial instrument. portfolio management it deals with managing
various securities and creating an investment objective for individual is called management.

Portfolio management it is a art of selecting the best investments plans for an individual
concerned which guarantees maximum return with minimum risks involved. it is generally done
with the help of portfolio managers who after understanding the clients requirement and its
ability to undertake risk design a portfolio with a mix of financial instrument with maximum
return for secure future. Security Analysis and Portfolio Management integrates the many topics
of modern investment analysis. It provides a balanced presentation of theories, institutions,
markets, academic research, and practical applications, and presents both basic concepts and
advanced principles. Topic coverage is especially broad: in analyzing securities, we look at
stocks and bonds, options and futures, foreign exchange, and international securities. The
discussion of options and futures includes a detailed analysis of hedging strategies. A unique
chapter on market indexes teaches students the basics of index information, calculation, and
usage and illustrates the important roles that these indexes play in model formation, performance
evaluation, investment strategy, and hedging techniques. In addition, complete sections on
program trading, portfolio insurance, duration and bond immunization, performance
measurements, and the timing of stock selection provide real-world applications of investment
theory.

17
Various Approaches to Security Analysis

I FUNDAMENTAL ANALYSIS:

The primary motive of buying a share is to sell it subsequently at a higher price. In many cases,
dividends are also expected. Thus, dividends and price changes constitute the return from investing in
shares. Consequently, an investor would be interested to know the dividend to be paid on the share in
the future as also the future price of the share.

An investor who would like to be rational and scientific in his investment activity has to evaluate a lot
of information about the past performance and the expected future performance of companies, industries
and the economy as a whole before taking the investment decision. Such evaluation or analysis is called
Fundamental Analysis.

Econom
y

Industry
Compan
y

Analysi
s

The fundamental analysis involves 3 steps. They are

1. Economic Analysis
2. Industry Analysis
3. Company Analysis

18
 Economic Factors Industrial Factors Company Factors

• Growth rate of • Demand –supply gap in • Age of the plant

the economy the industry • Quality of
• Inflation • Substitute products manageme
• Interest rates • Labour conditions nt
• Govt. Revenue, Exp & • Permanence • Brand image
Deficits • Changes in govt. policy • Labour management
• Industrial Life Cycle relations etc..
• Foreign Exchange
Rate
• Infrastructure
• Monsoon
• Economic &
Political Stability

19
1. Economic Analysis:
The performance of a company depends on the performance of the economy. If the economy
is booming, income rise, demand for goods increases, and hence the industries and companies
in general tend to be prosperous. On the other hand, if the economy is in recession, the
performance of companies will be generally bad.

Economic variables (factors) that an investor must monitor as part of fundamental

analysis.

a. Growth Rates of National Income:

The rate of growth of the national economy is an important variable to be considered by an
investor. GNP, NNP and GDP are the different measures of the total income or total
economic output of the country as a whole. The growth rates of these measures indicate
the growth rate of the economy. While analyzing the growth rate of the economy, an
investor would do well to determine the stage of the economic cycle through which the
economy is passing and evaluate its impact on his investment decision.

b. Inflation:
Inflation prevailing in the economy has considerable impact on the performance of
companies. Higher rates of inflation upset business plans, leads to cost escalation and
result in a squeeze on profit margins. On the other hand, inflation leads to erosion of
purchasing power in the hands of consumers. This will result in lower demand for
products. An investor should evaluate the inflation rate prevailing in the economy
currently as also the trend of inflation likely to prevail in the future.

c. Interest Rates:
Interest rates determine the cost and availability of credit for companies operating in the
economy. A low interest rate stimulates investment by making credit available easily and
cheaply. Moreover, it implies lower cost of finance for companies and thereby assures higher
profitability. On the contrary, higher interest rates result in higher cost of production which may
lead to lower profitability and lower demand.

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d. Government Revenue, Expenditure and Deficits:
As the Government is the largest investor and spender of money, the trends in government
revenues, expenditure and deficits have a significant impact on the performance of
industries and companies. Expenditure by the government stimulates the economy by
creating jobs and generating demand. The nature of government spending is of great
importance in determining the fortunes of many an industry.

e. Exchange Rates:
The performance and profitability of industries and companies that are major importers or
exporters are considerably affected by the exchange rates of the rupee against major
currencies of the world. A depreciation of the rupee improves the competitive position of
Indian products in foreign markets, thereby stimulating exports. An analysis of the
balance of trade deficit, balance of payments deficit and the foreign exchange reserves will
help to project the future trends in exchange rates.

f. Infrastructure:
The development of an economy depends very much on the infrastructure available.
Industry needs electricity of its manufacturing activities, roads and railways to transport
raw materials and finished goods, communication channels to keep in touch with suppliers
and customers. The availability of infrastructure affects the performance of the companies.
An investor should assess the status of the infrastructural facilities available in the economy
before finalizing his investment plans.

g. Monsoon:
The Indian economy is essentially an agrarian economy and agriculture forms a very
important sector of the Indian economy. Because of the strong forward and backward
linkages between agriculture and industry, performance of several industries and
companies are dependents on the performance of agriculture. Moreover, as agricultural
incomes rise, the demand for industrial products and services will be good and industry will
prosper. Hence, the progress and adequacy of the monsoon becomes a matter of great
concern for an investor in the Indian context.

h. Economic and political stability:

21
 A stable political environment is necessary for steady and balanced growth. No industry or
company can grow and prosper in the midst of political turmoil. Stable long-term
economic policies are what are needed for industrial growth. A stable government with
clear cut long-term economic policies will be conducive to good performance of the
economy.

ECONOMIC FORECASTING:
Economic analysis is the first stage of fundamental analysis and starts with an analysis of
historical performance of the economy. But as investment is a future-oriented activity, the
investor is more interested in the expected future performance of the overall economy and its
various segments. For this, forecasting the future direction of the economy becomes necessary.
Economic forecasting thus becomes a key activity in economy analysis.

Economic Forecasting Techniques:

Economic forecasting may be carried out for short-term periods, intermediate term periods and
long-term periods. An investor is more concerned about short-term economic forecasts for
periods ranging from a quarter to three years. Some of the techniques of short-term economic
forecasting are discussed below:

1. Anticipatory Surveys:
Much of the activities in government, business, trade and industry are planned in advance
and stated in the form of budgets. Consumers also plan their major spending in advance.
To the extent that institutions and people plan and budget for expenditures in advance,
surveys of their intentions can provide valuable input to short-term economic forecasting.

2. Barometric or Indicator Approach:

In this approach to economic forecasting, various types of indicators are studied to find
out how the economy is likely to perform in the future. These indicators are time series
data of certain economic variables. The indicators are classified into leading,
coincidental and lagging indicators.

3. Econometric Model Building:

22
 This is the most precise and scientific of the different forecasting techniques. This
technique makes use of Econometrics, which is a discipline that applies mathematical and
statistical techniques to economic theory.

4. Opportunistic Model Building:

This is one of the most widely used forecasting techniques. It is also known as GNP
model building or sectoral analysis. 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 the existing tax rates, interest rates, rate of inflation and other economic and fiscal
policies of the government.

2. INDUSTRY ANALYSIS:
An investor ultimately invests his money in the securities of one or more specific
companies. Each company can be characterized as belonging to an industry. The
performance of companies would, therefore, be influenced by the fortunes of the industry
to which it belongs. For this reason an analyst has to undertake an industry analysis so as
to study the fundamental factors affecting the performance of different industries.

Industry Characteristics that should be considered by the investor

In an industry analysis, there are 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 given below:
a. Demand-supply Gap: The demand for a product usually tends to change at a steady
rate, where the capacity to produce the product tends to change at irregular intervals, depending
upon the installation of additional production capacity. As a result, an industry is likely to
experience under-supply and over-supply of capacity at different times. Excess supply reduces
the profitability of the industry through a decline in the unit price realization and vice versa. As
a part of industry analysis, an investor should estimate the demand supply gap in the industry.

23
b. Competitive Conditions in the Industry: The level of competition among various
companies in the industry is determined by certain competitive forces. These competitive
forces are: barriers to entry, the threat of substitution, bargaining power of the buyers,
bargaining power of the suppliers and the rivalry among competitors.

c.Labour Conditions: The state of labour conditions in the industry under analysis is an
important consideration in an economy such as ours where the labour unions are very
powerful. 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.

d. Attitude of Government: The attitude of the government towards an industry has a

significant impact on its prospects. The government may encourage the growth of certain
industries and can assist such industries through 24avourable legislation.

e. Supply of Raw Materials: Some industries may have no difficulty in obtaining the
major raw materials as they may be indigenously available in plenty. Other industries may
have to depend on a few manufactures with in the country or on imports from outside the
country for their raw material supply. Industry analysis must take into consideration the
availability of raw materials and its impact on industry prospects.

f. Cost Structure: Another factor to be considered in industry analysis is the cost structure
of the industry. viz., the proportion of fixed cost to variable costs. The higher the fixed
cost component, higher is the sales volume necessary to achieve break-even point.
Conversely, the lower the proportion of fixed cost relative to variable cost, lower would be
the break-even point.

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INDUSTRY LIFE CYCLE:
Marketing experts believe that each product has a life cycle. They have identified four stages in
the four stages in the life of a product, namely introduction stage, growth stage, maturity stage
and the decline stage.
1. Pioneering Stage:
This is the first stage in the industrial life cycle of a new industry where the technology as
well as the product are relatively new and have not reached a state of perfection. The
pioneering stage is characterized by rapid growth in demand for the output of industry. As a
result, there is a great opportunity for profit. Many companies compete with each other. As
large number of companies attempt to capture their share of the market, there arises high
business mortality rates. Weak firms are eliminated and a lesser number of firms survive the
pioneering stage. The industries which are in pioneering stage are called as Sunrise
Industries.

2. Expansion Stage:
Once an industry has established itself it enters the second stage of expansion or growth. The
industry now includes only those companies that have survived the pioneering stage. These
companies continue to become stronger. Each company finds a market for itself and
develops its own strategies to sell and maintain its position in the market. The competition
among surviving companies brings about improved products at lower prices.
Companies in the expansion stage of an industry are quite attractive for investment purposes.
Investors can get high returns at low risk because demand exceeds supply in this stage.

3. Stagnation Stage:
In this stage, the growth of the industry stabilizes. The ability of the industry to grow
appears to have been lost. Sales may be increasing but at a slower rate than that experienced
by competitive industries or by the overall economy. The industry begins to stagnate. The
transition of the industry from the expansion stage to the stagnation stage is often very
slow. An investor should dispose of his holdings in an industry which begins to pass from
the expansion stage to the stagnation stage because what is to follow is the decay of the
industry

25
 4. Decay stage:
From the stagnation stage, the industry passes to the decay stage. This occurs when the
products of the industry are no longer in demand. New products and new technologies have
come to the market. Customers have changed their habits, style and liking. As a result, the
industry becomes obsolete and gradually ceases to exist. Thus, changes in social habits,
changes in technology and declining demand are the causes of decay of an industry. An
investor should get out of the industry before the onset of the decay stage.

3. COMPANY ANALYSIS:
Company analysis is the final stage of fundamental analysis. The economy analysis provides
the investor a broad outline of the prospects of growth in the economy. The industry analysis
helps the investor to select the industry in which he should invest his money. Company
analysis provides the answer to this question.
Company analysis deals with the estimation of return and risk of individual shares. This calls
for information. Many pieces of information influence investment decisions. Information
regarding companies can be broadly classified into two broad groups:
(a) Internal
(b) External
Internal information consists of data and events made public by companies concerning
their operations. The internal information sources include annual reports to shareholders,
public and private statements of officers of the company, the company‘s financial
statements etc
External sources of information are those generated independently outside the company.
These are prepared by investment services and the financial press.

In company analysis, the analyst tries to forecast the future earnings of the company
because there is strong evidence those 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.

26
 II TECHNICAL ANALYSIS:
Prices of securities in the stock market fluctuate daily on account of continuous buying and
selling. Stock prices move in trends and cycles and are never stable. An investor in the stock
market is interested in buying securities at a low price and selling them at a high price so as to
get a good return on his investment. Therefore, the investor tries to analyze the movement of
share prices in the market. Two approaches are commonly used for this purpose. One of these is
the fundamental analysis wherein the analyst tries to determine the true worth of a share based on
the current and future earning capacity of the company. He would buy the share when its market
price is below its intrinsic value. The second approach to security analysis is called
technical analysis. It is an alternative approach to the study the stock behaviour.

Basic Principles of Technical Analysis:

1. The market value of a security is related to demand and supply factors operating in the
market.
2. There are both rational and irrational factors which surround the supply and demand
factors of a security.
3. Security prices behave in a manner that their movement is continuous in a particular
direction for some length of time.
4. Trends in stock prices have been seen to change when there is shift in the demand and
supply factors.
5. The shifts in demand and supply can be detected through charts prepared specially to
show market action.
6. Patterns which are projected by charts record price movements and these recorded
patterns are used by analysis to make forecasts about the movement of prices in future.

Price Charts used in Technical Analysis:

Charting represents a key activity in technical analysis, because graphical representation is the
very basis of technical analysis. It is the security prices that are charted. A share may be traded
in the market at different prices on the same day. Of these different prices prevailing in the
market on each trading day, four prices are important. These are highest price of the day, lowest
price of the day, the opening price and the closing price. Of these four prices, the closing price is
by far the most important price of the day. The price chart is the basic tool used by the technical
27
analyst to study the share price movement.
Three types of price charts are currently used by technical analysis. These are the Line Chart,
The Bar Chart and the Japanese Candlestick Chart.

a. Line Chart:
It is the simplest price chart. In this chart, the closing prices of a share are plotted on the
XY graph on a day to day basis. The closing price of each would be represented by a
point on the XY graph. All these points would be connected by a straight line which
would indicate the trend of the market.

b. Bar Chart:
It is perhaps the most popular chart used by technical analysis. in this chart, the highest
price, the lowest price and the closing price of each day are plotted on a day-to-day basis.
A bar is formed by joining the highest price and the lowest price of a particular day by a
vertical line. The top of the bar represents the highest price of the day, the bottom of the
bar represents the lowest price of the day and a small horizontal hash on the right of the
bar is used to represent the closing price of the day.
c. Japanese Candlestick Charts:
The Japanese candlestick chart shows the highest price, the lowest price, the opening
price and the closing price of the shares on a day-to-day basis. The highest price and the
lowest price of a day are joined by a vertical bar. The opening price and closing price of
the day which would fall between the highest and the lowest prices would be represented
by a rectangle so that the price bar chart looks like a candlestick. Thus, each day‘s
activity is represented by a candlestick.

DOW THEORY
Dow developed is theory to explain the movement of the indices of Dow Jones averages. he
developed it on the basis of certain type of hypothesis. the first Hypothesis was that no
single individual or buyer can influence the market primary trend. However and individual
investors can affect the daily price movements by buying or selling large quantities of a
scrip. the intermediate price movement can also be affected to a lesser degree of an
investor.
Dow second hypothesis was that market discounts everything even natural calamities
28
 such as an earthquake, plague or fire get quickly discounted in the market. the global
financial crisis of 2008 affected the share market for a while before it return to normalcy.
Dow’s third hypothesis was that theory is not infallible. it is not a tool to beat the market
but provides a way to understand is better.

THE THEORY

The Dow Theory sees a trend of primary, intermediate and short-term. The primary trend may
be broad upwards or downwards movement that may last for a year or two. The intermediate
Trends are corrective movements which May last from three weeks to 3 months. The primary 10
may be interrupted by intermediate trend. The short term trend refers to a day today price
movements. it refers to de oscillations or fluctuations. These Three Types of trends can be
compared to the tide, waves and ripples in the sea.

VOLUME OF TRADE

Dow gave a special emphasis on Volumes. Volume expands in a bull market and narrows in a
bear market. if the value of trade Falls with a rise in a price or vice versa, it is a matter of
concern for the investor's and the trend May not persist for a long time. Technical analyst sees
trading volume as an excellent method of confirming Trends. The market is said to be bullish
when a small volume of trade and large volume of trade follow of fall in the price and rise in the
price respectively. Specifically,
• a big rise or fall in a price leads to big changes in volume.
• a larger volume with a rise in price indicates a bull market and the larger value with
falling prices indicates bear market.
• if volume declines for a 5 consecutive days then it will be continue for another four
days and the same is true in the case of increasing volume.

BREADTH OF THE MARKET

The breadth of the market is a term often used to refer to the advances and declines that
occur in the stock market. Advances refer to the number of shares whose prices have increased
from the previous day’s trading. Declines indicate the number of Shares whose prices are falling
from the previous day trading. This is an indicator that it is easy to plot and watch because data
available in all business dailies. The net difference between the number of stocks advances and
declines during the same period is the breadth of the market. A cumulative index of net
difference measures the market breadth.

MOVING AVERAGE

The market indices do not rise or fall in a straight line. The upward and downward
movements or interrupted by counter moves. The underlying trend can be studied by
smoothening the data. This is done by using the data moving average technique.

29
 The word Moving here means that the body of the data moves ahead to include recent
observations. if it is a 5 day moving average, on the 6th day of the body of data moves to
include the 6th day of reservation, eliminating first day of observation, and so. In the moving
average calculation, the closing price of the stock is used.
Moving averages are used to study the movement of the market as well as the individual
scrip price. They show values he underlying trend in the scrip. The period of the average
determines that Period of the trend that is being identified. To identify a short-term trend, 10 to
30 day moving averages are used. for the medium-term 52 to 125 days are averages are used
and for the long-term 200 a moving averages are used.

DEPTH OF THE MARKET

it indicates how much liquid in the market for a security based on the number of studying
orders to buy and sell exist at various price levels. the greater the depth of the market it more
likely is to trade large volume of a securities without greatly impact on its price is known as
depth of the market.

RESILIENCE OF THE MARKET

Capacity to recover quickly from difficulties and toughness. It is an ability of a substance

or object to spring back into shape.

RELATIVE STRENGTH

Relative strength is a technique used in momentum investing and identifying value stocks it
consists of investing in securities that have performed well related to their market benchmark.
For example relative strength investors might select technology companies that have
outperformed the Nasdaq composite index, or large caps stocks that are Laggards against the
S&P 500 index.

Technical analyst used in indicators known as relative strength index (RSI) to generate
overbought or oversold signals. While the goal of value investing is to buy low and Sell high,
the goal relative strength investing is to buy high and sell even higher. as such relative strength
investors assume that the trends currently displayed by the market will continue for long enough
that they can realise a positive return. any sudden reversal to the trend is likely to lead to
negative results.

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 MODULE-III

PORTFOLIO ANALYSIS

RISK:
Risk can be defined in terms of variability of returns. ―Risk is the potential for variability of
returns‖. An investment whose returns are fairly stable is considered to be a low-risk investment,
whereas an investment whose returns fluctuate significantly is considered to be a high risk
investment. For example: Equity shares whose returns are likely to fluctuate widely are
considered risky investments. Government securities whose returns are fairly stable are
considered to possess low risk.
ELEMENTS OF RISK:
The essence of risk in an investment is the variation in its returns. This variation in returns is
caused by a number of factors. These factors which produce variations in the returns from an
investment constitute the elements of risk.
The elements of risk may be broadly classified into two groups. The first group comprises
factors that are external to a company and affect a large number of securities simultaneously.
These are mostly uncontrollable in nature.
The second group includes those factors which are internal to companies and affect only those
particular companies. These are controllable to a great extent. The risk produced by the first
group of factors is known as Systematic Risk and that produced by the second group is known
as Unsystematic Risk.
The total variability of returns of a security represents the total risk of that security. Systematic
risk and unsystematic risk are the two components of total risk. Thus,
Total Risk = Systematic Risk + Unsystematic Risk

I. SYSTEMATIC RISK:
The impact of economic, political and social changes is system-wide and that portion of total
variability in security returns caused by such system-wide factors is referred to as Systematic

31
 Risk. Systematic risk is further subdivided into interest rate risk, market risk and purchasing
power risk.
1. Interest Rate Risk: Interest Rate Risk is a type of systematic risk that particularly
affects debt securities like bonds and debentures. A bond or debenture normally has a fixed
coupon rate of interest. The issuing company pays interest to the bond holder at this coupon rate.
A bond is normally issued with a coupon rate which is equal to the interest rate prevailing in the
market at the time of issue. Subsequent to the issue, the market interest rate may change but the
coupon rate remains constant till the maturity of the instrument. The change in the market
interest rate relative to the coupon rate of bond causes changes in its market price. As a result,
the market price of debt securities fluctuates in response to variations in the market interest rates.
This variation in bond prices caused due to the variations in interest rates is known interest rate
risk.

2. Market Risk: Market risk is a type of systematic risk that affects shares. Market prices
of shares move up or down consistently for some time periods. A general rise in share prices is
referred to as a bullish trend, whereas a general fall in share prices is referred to as bearish trend.
In other words, the share market alternates between the bullish phase and bearish phase. The
alternating movements can be easily seen in the movement of share price indices such as BSE
Sensitive Index, BSE National Index, NSE Index etc. The stock market is seen to be volatile.
This volatility leads to variations in the returns of investors in shares. The variations in returns
caused by the volatility of the stock market are referred to as the market risk.

3. Purchasing Power Risk: It refers to the variation in investor returns caused by inflation.
Inflation results in lowering of the purchasing power of money. If there is inflation in the
economy, the prices of goods and services would increase and thereby the investor actually
experiences a decline in the purchasing power of his investments and the return from the
investment. Thus, inflation causes a variation in the purchasing power of the returns from an
investment. This is known as Purchasing Power Risk.

II UN-SYSTEMATIC RISK:
The returns from a security may sometimes vary because of certain factors affecting only the
company issuing such security. Examples are raw material scarcity, labour strike, and
32
 management inefficiency. When variability of returns occurs because of such firm-specific
factors, it is known as Unsystematic Risk. The two types of unsystematic risk are referred to as
Business Risk and Financial Risk.

1. Business Risk:
Every company operates within a particular operating environment. This operating environment
comprises both internal environment within the firm and external environment outside the firm.
The impact of these operating conditions is reflected in the operating costs of the company. The
operating costs can be segregated into fixed cost and variable cost. A larger proportion of fixed
costs is disadvantageous to a company. Business risk is thus a function of the operating
conditions faced by a company and is the variability in operating income caused by the operating
conditions of the company.

2. Financial Risk:
Financial risk is a function of financial leverage which is the use of debt in the capital structure.
The presence of debt in the capital structure creates fixed payments in the form of interest which
is a compulsory payment to be made whether the company makes profit or loss. This fixed
interest payment creates more variability in the EPS available to equity holders. This variability
of EPS due to the presence of debt in the capital structure of a company is referred to as
financial risk.

MEASUREMENT OF SYSTEMATIC RISK:

Systematic risk is the variability in security returns caused by changes in the economy or the
market. All securities are affected by such changes to some extent, but some securities exhibit
greater variability in response to market changes. Such securities are said to have higher
systematic risk. The average affect of a change in the economy can be represented by the change
in the stock market index. The systematic risk of a security can be measured by relating that
security‘s variability would indicate higher systematic risk and vice verse.

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
33
 security as well as the returns of a representative stock market index. Two statistical methods
may be used for the calculation of Beta, namely the correlation method or the regression method.
As beta measures the volatility of a security‘s returns relative to the market, the larger the beta,
the more volatile the security. A beta of 1.0 indicates a security of average risk. A stock with
beta greater than 1.0 has above average risk. Its returns would be more volatile than the market
returns.

RISK MANAGEMENT:
Risk management mat be defined as the process of planning, organizing, directing and
controlling the financial resources in order to minimize the adverse effects of potential losses at
the least possible cost.
Risk management is basically concerned with the establishment of policies, creation of a risk
management structure and allocation of capital required for risk management function.

FUNCTIONS/PROCESS OF RISK MANAGEMENT:

1. Risk Identification: Risk identification is really key to the whole process. The risk
manager begins by identifying all of the resources for which his organization is responsible.
These resources or assets may be human, financial, material or environmental. Investor then
considers all of the potential exposures to loss.

2. Risk Measurement and Evaluation: The second step in the risk management process is
measurement and evaluation of risk in order to estimate the frequency and severity of future
losses. Evaluation of financial risks arising out of volatility in markets for currencies, interest
rates, commodities and stocks involves risk measurement and modeling.

3. Risk Control: Risk management basically involves deciding on the risk control process.
The risk can be controlled either by way of diffusion or by means of transfer. The quantum of
risk can be diffused by the use of indemnity clause in contractual agreements and by applying

Diversification process. The two principal forms of risk transfer are insurance and hedging using
derivatives.
34
 4. Risk Finance: Developing a suitable financial plan to meet risk management objectives
is the final but crucial step in risk management. It involves deciding how much of pure risk the
company should retain and how much it should transfer to an insurer. The goal of risk finance is
to have enough funds available to sustain potential loss so that the organization can continue to
function and maintain a reasonable level of earnings.

DIVERSIFICATION OF RISK:
The definition of diversification is the act of, or the result of, achieving variety. In finance and
investment planning, portfolio diversification is the risk management strategy of combining a
variety of assets to reduce the overall risk of an investment portfolio.

Diversification is a technique that reduces risk by allocating investments among various financial
instruments, industries and other categories. It aims to maximize return by investing in different
areas that would each react differently to the same event. Most investment professionals agree
that, although it does not guarantee against loss, diversification is the most important component
of reaching long-range financial goals while minimizing risk.

PORTFOLIO ANALYSIS:

Most investors would like to invest in a group of securities rather than a single security. Such a group of
securities held together as an investment is what is known as a portfolio. 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:

35
 An investor needs to specify the list of the securities which are eligible in the portfolio. The
investors have to generate the risk-return expectations for these securities. These are typically
expressed as the expected rate of return (mean) and the variable or standard deviation of the
return. The expected return of a portfolio of assets to simply the weighted average of the return
of the individual securities held in the portfolio. the weigh applied to each return is the fraction
of the portfolio invested in that security.

Risk of a Portfolio:

The variance and standard deviation of return are alternative statistical measures that are used for
measuring risk in investment. These statistics measure the extent to which returns are expected
to vary around an average over time. The calculation of variance of a portfolio is a little more
difficult than determining its expected return. The variation or SD of an individual security
measures the riskiness of a security.

Co-variance is the statistical measure that indicates the interactive risk of a security relative to
others in a portfolio of securities. In other words, the ay security returns vary with each other
affects the overall risk of the portfolio.

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. For this reasons portfolio is constructed.
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.

Feasible set of Portfolios:

With a limited number of securities an investor can create a very large number of portfolios by
combining these securities in different proportions. These constitute the feasible set of portfolios
in which the investor can possibly invest. This is also known as the Portfolio Opportunity Set.

36
 MODULE-IV

PORTFOLIO PERFORMANCE EVALUATION

PORTFOLIO EVALUATION:

Portfolio evaluation is the last step in the process of portfolio management. Portfolio evaluation
is the stage where we examine to what extent the objective has been achieved. Through portfolio
evaluation, the investor tries to find out how well the portfolio has performed. Portfolio
evaluation is really a study of the impact of such decisions.

Portfolio Evaluation refers to the evaluation of the performance of the portfolio. It is essentially
the process of comparing the return earned on a portfolio with the return earned on one or more
other portfolios or on a benchmark portfolio.

Need for Portfolio Evaluation:

The situations where the portfolio evaluation is needed are:

1. Self Evaluation: Where individual investors undertake the investment activity on their
own, the investments decisions are taken by them. They construct and manage their own
portfolio of securities. In such a situation, an investor would like to evaluate the
performance of his portfolio in order to identify the mistakes committed by him.
2. Evaluation of Portfolio Managers: A mutual fund or investment company usually
creates different portfolios with different objectives aimed at different sets of investors.
Each such portfolio may be entrusted to different professional portfolio managers who
are responsible for the investment decisions regarding the portfolio entrusted to each of
them.
3. Evaluation of Mutual Funds: Investors and organisations who are placing their funds
with the mutual funds would like to know the comparative performance of each so as to
select the best mutual fund or investment company.

37
MUTUAL FUND:

A mutual fund is a company that pools money from many investors and invests the money in
stocks, bonds, short-term money-market instruments, other securities or assets, or some
combination of these investments. The combined holdings the mutual fund owns are known as
its portfolio. Each share represents an investor‘s proportionate ownership of the fund‘s holdings
and the income those holdings generate.

Characteristics of mutual funds:

Some of the traditional, distinguishing characteristics of mutual funds include the following:

1. Investors purchase mutual fund shares from the fund itself (or through a broker for the
fund) instead of from other investors on a secondary market, such as the NewYork Stock
Exchange or Nasdaq Stock Market.
2. The price that investors pay for mutual fund shares is the fund‘s per share net asset value
(NAV) plus any shareholder fees that the fund imposes at the time of purchase (such as
sales loads). 6 | MUTUAL FUNDS
3. Mutual fund shares are ―redeemable,‖ meaning investors can sell their shares back to the
fund (or to a broker acting for the fund).
4. Mutual funds generally create and sell new shares to accommodate new investors. In
other words, it sells its shares on a continuous basis, although some funds stop selling
when, for example, they become too large.
5. The investment portfolios of mutual funds typically are managed by separate entities
known as ―investment advisers‖ that are registered with the SEC.

Benefits/Advantages of Mutual Funds:

An investor can invest directly in individual securities or indirectly through a financial

intermediary. Globally, mutual funds have established themselves as the means of investment for
the retail investor.

1. Professional management: An average investor lacks the knowledge of capital market

38
operations and does not have large resources to reap the benefits of investment. Hence, he
requires the help of an expert. It, is not only expensive to ‗hire the services‘ of an expert but it is
more difficult to identify a real expert. Mutual funds are managed by professional managers who
have the requisite skills and experience to analyze the performance and prospects of companies.
They make possible an organized investment strategy, which is hardly possible for an individual
investor.

2. Portfolio diversification: An investor undertakes risk if he invests all his funds in a single
scrip. Mutual funds invest in a number of companies across various industries and sectors. This
diversification reduces the riskiness of the investments.

3. Reduction in transaction costs: Compared to direct investing in the capital market, investing
through the funds is relatively less expensive as the benefit of economies of scale is passed on to
the investors.

4. Liquidity: Often, investors cannot sell the securities held easily, while in case of mutual
funds, they can easily encash their investment by selling their units to the fund if it is an open-
ended scheme or selling them on a stock exchange if it is a close-ended scheme.

5. Convenience: Investing in mutual fund reduces paperwork, saves time and makes investment
easy.

6. Flexibility: Mutual funds offer a family of schemes, and investors have the option of
transferring their holdings from one scheme to the other.

7. Tax benefits: Mutual fund investors now enjoy income-tax benefits. Dividends received from
mutual funds‘ debt schemes are tax exempt to the overall limit of Rs 9,000 allowed under section
80L of the Income Tax Act.

8. Transparency: Mutual funds transparently declare their portfolio every month. Thus an
investor knows where his/her money is being deployed and in case they are not happy with the
portfolio they can withdraw at a short notice.

39
 9. Stability to the stock market: Mutual funds have a large amount of funds which provide
them economies of scale by which they can absorb any losses in the stock market and continue
investing in the stock market. In addition, mutual funds increase liquidity in the money and
capital market.

10. Equity research: Mutual funds can afford information and data required for investments as
they have large amount of funds and equity research teams available with them.

Disadvantages of Mutual Funds:

But mutual funds also have features that some investors might view as disadvantages,

1. Costs Despite Negative Returns: Investors must pay sales charges, annual fees, and
other expenses regardless of how the fund performs. And, depending on the timing of their
investment, investors may also have to pay taxes on any capital gains distribution they receive—
even if the fund went on to perform poorly after they bought shares.
2. Lack of Control: Investors typically cannot ascertain the exact make-up of a fund‘s
portfolio at any given time, nor can they directly influence which securities the fund manager
buys and sells or the timing of those trades.
3. Price Uncertainty: With an individual stock, investors can obtain real-time (or close to
real-time) pricing information with relative ease by checking financial websites or by calling
your broker. Investors can also monitor how a stock‘s price changes from hour to hour—or even
second to second. By contrast, with a mutual fund, the price at which you purchase or redeem
shares will typically depend on the fund‘s NAV, which the fund might not calculate until many
hours after investors have placed order.

CLASSIFICATION OF MUTUAL FUNDS:

Mutual funds can be classified on the basis of:

I. Functional Classification
II. Portfolio Classification
III. Geographical Classification

40
I. Functional Classification of Mutual Funds:

1. Open-ended schemes:

In case of open-ended schemes, the mutual fund continuously offers to sell and repurchase its
units at net asset value (NAV) or NAV-related prices. Unlike close-ended schemes, open-ended
ones do not have to be listed on the stock exchange and can also offer repurchase soon after
allotment. Investors can enter and exit the scheme any time during the life of the fund. Open-
ended schemes do not have a fixed corpus. The corpus of fund increases or decreases, depending
on the purchase or redemption of units by investors. There is no fixed redemption period in
open-ended schemes, which can be terminated whenever the need arises. The fund offers a
redemption price at which the holder can sell units to the fund and exit. Besides, an investor can
enter the fund again by buying units from the fund at its offer price. Such funds announce sale
and repurchase prices from time-to-time. UTI‘s US-64 scheme is an example of such a fund. The
key feature of open-ended funds is liquidity. They increase liquidity of the investors as the units
can be continuously bought and sold. The investors can develop their income or saving plan due
to free entry and exit frame of funds. Open-ended schemes usually come as a family of schemes
which enable the investors to switch over from one scheme to another of same family.

2..Close-ended schemes:

Close-ended schemes have a fixed corpus and a stipulated maturity period ranging between 2 to
5 years. Investors can invest in the scheme when it is launched. The scheme remains open for a
period not exceeding 45 days. Investors in close-ended schemes can buy units only from the
market, once initial subscriptions are over and thereafter the units are listed on the stock

exchanges where they dm be bought and sold. The fund has no interaction with investors till
redemption except for paying dividend/bonus. In order to provide an alternate exit route to the
investors, some close-ended funds give an option of selling back the units to the mutual fund
through periodic repurchase at NAV related prices. If an investor sells units directly to the fund,
he cannot enter the fund again, as units bought back by the fund cannot be reissued. The close-
ended scheme can be converted into an open-ended one. The units can be rolled over by the

41
 passing of a resolution by a majority of the unit--holders.

3..Interval scheme:

Interval scheme combines the features of open-ended and close-ended schemes. They are open
for sale or redemption during predetermined intervals at NAV related prices.

II Portfolio Classification of Mutual funds:

Here, classification is on the basis of nature and types of securities and objective of investment.

1. Income funds: The aim of income funds is to provide safety of investments and regular
income to investors. Such schemes invest predominantly in income-bearing instruments like
bonds, debentures, government securities, and commercial paper. The return as well as the risk
are lower in income funds as compared to growth funds.

2. Growth funds: The main objective of growth funds is capital appreciation over the medium-
to-long- term. They invest most of the corpus in equity shares with significant growth potential
and they offer higher return to investors in the long-term. They assume the risks associated with
equity investments. There is no guarantee or assurance of returns. These schemes are usually
close-ended and listed on stock exchanges.

3. Balanced funds: The aim of balanced scheme is to provide both capital appreciation and
regular income. They divide their investment between equity shares and fixed nice bearing
instruments in such a proportion that, the portfolio is balanced. The portfolio of such funds
usually comprises of companies with good profit and dividend track records. Their exposure to
risk is moderate and they offer a reasonable rate of return.

4. Money market mutual funds: They specialize in investing in short-term money market
instruments like treasury bills, and certificate of deposits. The objective of such funds is high
liquidity with low rate of return.

42
III. Geographical Classification of Mutual funds:

1. Domestic funds: Funds which mobilize resources from a particular geographical locality like
a country or region are domestic funds. The market is limited and confined to the boundaries of a
nation in which the fund operates. They can invest only in the securities which are issued and
traded in the domestic financial markets.

2. Offshore funds: Offshore funds attract foreign capital for investment in ‗the country of the
issuing company. They facilitate cross-border fund flow which leads to an increase in foreign
currency and foreign exchange reserves. Such mutual funds can invest in securities of foreign
companies.

43
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 NJSDATE
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