Chapter 5

INTRODUCTION TO PORTFOLIO MANAGEMENT

INTRODUCTION:

Investment management has two general definitions. One relating to advisory services and the other
relating to corporate finance. In the first instance, a Financial Advisor or financial services company
provides investment management by coordinating and overseeing a client’s financial portfolio, for
example, investments, budgets, accounts, insurance and taxes. In Corporate Finance, investment
management is the process of ensuring that a company’s tangible and intangible assets are
maintained, accounted for, and put to their highest and best use.

OBJECTIVES:

After going through this lesson, you will be able to explain:

Portfolio Management.
Objectives of portfolio management.
Types of portfolio management.

MEANING OF PORTFOLIO MANAGEMENT:

Portfolio - is a group of financial assets such as shares, stocks, bonds, debt instruments,
mutual funds, cash equivalents, etc. A portfolio is planned to stabilize the risk of non-
performance of various pools of investment.

Management - is the organization and coordination of the activities of an enterprise in

accordance with well-defined policies and in achievement of its pre-defined objectives.

Portfolio Management - guides the investor in a method of selecting the best available
securities that will provide the expected rate of return for any given degree of risk and also to
mitigate (reduce) the risks. It is a strategic decision which is addressed by the top-level
managers.

For Example, Consider that the investor Mr. Mohan has ₹ 1,00,000 and wants to invest his
money in the financial market other than real estate investments. Here, the rational objective
of the investor is to earn a considerable rate of return with less possible risk.
So, the ideal recommended portfolio for Mr. Mohan can be as follows

OBJECTIVES OF PORTFOLIO MANAGEMENT:

The objectives of portfolio management are applicable to all financial portfolios. These
objectives, if considered, results in a proper analytical approach towards the growth of the
portfolio. Furthermore, overall risk needs to be maintained at the acceptable level by
developing a balanced and efficient portfolio. Finally, a good portfolio of growth stocks often
satisfies all objectives of portfolio management. The main objectives of portfolio
management in finance are as follows:

(i) Security of Principal Investment: Investment safety or minimization of risks is one of the
most important objectives of portfolio management. Portfolio management not only involves
keeping the investment intact but also contributes towards the growth of its purchasing
power over the period. The motive of a financial portfolio management is to ensure that the
investment is absolutely safe. Other factors such as income, growth, etc., are considered only
after the safety of investment is ensured.

(ii) Consistency of Returns: Portfolio management also ensures to provide the stability of
returns by reinvesting the same earned returns in profitable and good portfolios. The
portfolio helps to yield steady returns. The earned returns should compensate the
opportunity cost of the funds invested.

(iii) Capital Growth: Portfolio management guarantees the growth of capital by reinvesting in
growth securities or by the purchase of the growth securities. A portfolio shall appreciate in
value, in order to safeguard the investor from any erosion in purchasing power due to
inflation and other economic factors. A portfolio must consist of those investments, which
tend to appreciate in real value after adjusting for inflation.

(iv) Marketability: Portfolio management ensures the flexibility to the investment portfolio. A
portfolio consists of such investment, which can be marketed and traded. Suppose, if your
portfolio contains too many unlisted or inactive shares, then there would be problems to do
trading like switching from one investment to another. It is always recommended to invest
only in those shares and securities which are listed on major stock exchanges, and also, which
are actively traded.

(v) Liquidity: Portfolio management is planned in such a way that it facilitates to take
maximum advantage of various good opportunities upcoming in the market. The portfolio
should always ensure that there are enough funds available at short notice to take care of the
investor’s liquidity requirements.

(vi) Diversification of Portfolio: Portfolio management is purposely designed to reduce the

risk of loss of capital and/or income by investing in different types of securities available in a
wide range of industries. The investors shall be aware of the fact that there is no such thing as
a zero risk investment. More over relatively low risk investment give correspondingly a lower
return to their financial portfolio.

(vii) Favorable Tax Status: Portfolio management is planned in such a way to increase the
effective yield an investor gets from his surplus invested funds. By minimizing the tax burden,
yield can be effectively improved. A good portfolio should give a favorable tax shelter to the
investors. The portfolio should be evaluated after considering income tax, capital gains tax,
and other taxes.
NEED FOR PORTFOLIO MANAGEMENT:

Portfolio management presents the best investment plan to the individuals as per their
income, budget, age and ability to undertake risks.
Portfolio management minimizes the risks involved in investing and also increases the
chance of making profits.
Portfolio managers understand the client’s financial needs and suggest the best and
unique investment policy for them with minimum risks involved.
Portfolio management enables the portfolio managers to provide customized investment
solutions to clients as per their needs and requirements.

TYPES OF PORTFOLIO MANAGEMENT:

Portfolio Management is classified as follows,

(i) Active Portfolio Management: As the name suggests, in an active portfolio management
service, the portfolio managers are actively involved in buying and selling of securities to
ensure maximum profits to individuals.

(ii) Passive Portfolio Management: In a passive portfolio management, the portfolio manager
deals with a fixed portfolio designed to match the current market scenario.

(iii) Discretionary Portfolio Management Services: In discretionary portfolio management

services, an individual authorizes a portfolio manager to take care of his financial needs on his
behalf. The individual issues money to the portfolio manager who in turn takes care of all his
investment needs, paper work, documentation, filing and so on. In discretionary portfolio
management, the portfolio manager has full rights to take decisions on his client’s behalf.

(iv) Non- Discretionary Portfolio Management Services: In non­ discretionary portfolio

management services, the portfolio manager can merely advise the client what is good and
bad for him but the client reserves full right to take his own decisions.

MODEL OF PORTFOLIO MANAGEMENT:

As has already been discussed that, Portfolio Management refers to the art of managing
various financial products and assets to help an individual earn maximum revenues with
minimum risks involved in the long run. Portfolio management helps an individual to decide
where and how to invest his hard-earned money for guaranteed returns in the future.

Let us now discuss the different Models of Portfolio Management.

(i) Capital Asset Pricing Model: Capital Asset Pricing Model also abbreviated as CAPM was
proposed by Jack Treynor, William Sharpe, John Lintner and Jan Mossing. When an asset
needs to be added to an already well diversified portfolio, Capital Asset Pricing Model is used
to calculate the asset’s rate of profit or rate of return (ROI).

In Capital Asset Pricing Model, the asset responds only to:

 Market risks or non-diversifiable risks often represented by beta;
Expected return of the market; and
Expected rate of return of an asset with no risks involved.

Where Non-Diversifiable Risks are those risks which are similar to the entire range of assets
and liabilities.

Capital Asset Pricing Model is used to determine the price of an individual security through
security market line (SML) and how it is related to systematic risks.

where Security Market Line is nothing but the graphical representation of capital asset
pricing model to determine the rate of return of an asset sensitive to non-diversifiable risk
(Beta).

(ii) Arbitrage Pricing Theory: Stephen Ross proposed the Arbitrage Pricing Theory in 1976.
Arbitrage Pricing Theory highlights the relationship between an asset and several similar
market risk factors.

According to Arbitrage Pricing Theory, the value of an asset is dependent on macro and
company specific factors.

(iii) Modern Portfolio Theory: Modern Portfolio Theory was introduced by Harry Markowitz.
According to Modern Portfolio Theory, while designing a portfolio, the ratio of each asset
must be chosen and combined carefully in a portfolio for maximum returns and minimum
risks.

In Modern Portfolio Theory emphasis is not laid on a single asset in a portfolio, but how each
asset changes in relation to the other asset in the portfolio with reference to fluctuations in
the price. Modern Portfolio theory proposes that a portfolio manager must carefully choose
various assets while designing a portfolio for maximum guaranteed returns in the future.

(iv) Value at Risk Model: Value at Risk Model was proposed to calculate the risk involved in
financial market. Financial markets are characterized by risks and uncertainty over the
returns earned in future on various investment products. Market conditions can fluctuate
anytime giving rise to major crisis.

The potential risk involved and the potential loss in value of a portfolio over a certain period
of time is defined as value at risk model. Value at Risk model is used by financial experts to
estimate the risk involved in any financial portfolio over a given period of time.

(v) Jensen’s Performance Index : Jensen’s Performance Index was proposed by Michael
Jensen in 1968. Jensen’s Performance Index is used to calculate the abnormal return of any
financial asset (bonds, shares, securities) as compared to its expected return in any portfolio.
Also called Jensen’s alpha, investors prefer portfolio with abnormal returns or positive alpha.
Jensen’s alpha = Portfolio Return – [Risk Free Rate + Portfolio Beta * (Market Return – Risk
Free Rate)
(vi) Treynor Index: Treynor Index model named after Jack L Treynor is used to calculate the
excess return earned which could otherwise have been earned in a portfolio with minimum or
no risk factors involved.

SUMMARY:

Portfolio is a collection of different financial investments held by a person at a point of time.

These financial investments might include equity shares, debentures, preference shares, fixed
deposit schemes of companies, etc. A portfolio is always considered to be best compared to
the investment in an individual share because securities held in a portfolio certainly offer a
better combination of risk and return. Portfolio management presents the best investment
plan to the individuals as per their income, budget, age and ability to undertake risks.
Portfolio management is classified as active, passive, discretionary and non-discretionary.