Portfolio Management

Doc. Nguyen Dinh Dat

What is Portfolio Management?

Portfolio management is the art of selecting the best investment mix in

the right proportion and continuously shifting them in the portfolio to
increase the return on the investment and maximize the wealth of the
investors. Here, portfolio refers to a range of financial products such as
stocks, bonds, mutual funds and so forth that are held by the investors.
The content

• A portfolio perspective on investing

• Investment clients

• Steps in the portfolio management process

• Pooled investments
1. Portfolio perspective or Portfolio approach.

• It refers to evaluating individual investment by contribution to the risk

and return of an investor’s portfolio.
Portfolio Approach
• Example:

X
Why do we need a portfolio diversification?
Why do we need a portfolio diversification?
- Portfolio diversification helps investors avoid disastrous investment
outcomes.

X
-Portfolio diversification can also help investors reduce risk.

X Y Z

Note: The overall risk of this portfolio is going to be less than the risk of
holding a single stock. This is called a diversification benefit.
Diversification ratio
𝑅𝑖𝑠𝑘 𝑜𝑓 𝑒𝑞𝑢𝑎𝑙𝑙𝑦 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑜𝑓 𝑛 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠
𝑅𝑖𝑠𝑘 𝑜𝑓 𝑠𝑖𝑛𝑔𝑙𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑠𝑒𝑙𝑒𝑐𝑡𝑒𝑑 𝑎𝑡 𝑟𝑎𝑛𝑑𝑜𝑚
Example:
Three stocks and each of them has the standard deviation of return is 15% (the
standard deviation of returns as a measure of risk). The standard deviation of
return for the overall portfolio is 10%.
The result of diversification ratio is 67%.
The reason why the standard deviation of return for the overall portfolio is lower
than the standard deviation of return for one single stock is because the movement
of these stocks is not all necessarily in the same direction. So, because of
diversification, the overall risk is a little less.
Diversification ratio
• Notice:
A lower the ratio is the better because the lower ratio is showing a
lower risk of portfolio as a result of higher degree of diversification.
Does portfolio diversification always protect
your investor wealth?
No, Portfolio diversification does not offer proper protection of risk
especially during the financial crisis where all the assets might lose
their values.
 2. Types of investors
Time
Investors Risk Tolerance Income Needs Liquidity Needs
Horizon
Individuals Vary Vary Vary Vary
DB pensions Long High Depends on age Low
Banks Short Low Pay interest High
Endowments Long High Spending level Low
Long-life
Insurance Low Low High
Short-P&C
Mutual funds Vary Vary Vary High
3.Steps in the portfolio management process
• To interpret the clients 'needs
• To come up with IPS (investment policy statement)
Planning

• To allocate the clients’ money into different asset classes

• To identify the specific securities that need to be purchased
Execution • To buy those securities to construct the portfolio

• To monitor and rebalance the portfolio to match with benchmark portfolio identified
Feedback
A top-down analysis and bottom-up security analysis

• As a top-down analysis, a portfolio manager will examine current

economic conditions and forecasts of such macroeconomic variables
as GDP growth, inflation,… to identify the most attractive asset
classes and to invest in.
• Bottom-up securities analysis, security analysts use model valuations
for securities to identify those that appear undervalued and invest in
them.
4. The pooled investment

The definition of the pooled investment as the way of putting sums of

money from many investors into a large fund spread across many
investment and managed by professional.
Main forms of pooled investment
Investment project Minimum investment
Mutual funds Small amount of money
Exchange traded funds Small amount of money
Separately Managed Accounts Medium amount of money
Hedge funds Large amount of money
Private Equity Funds Large amount of money
Venture capital funds Large amount of money
Mutual fund
Mutual fund is single portfolio that contain investment funds from
multiple investors. Each investor owns shares representing ownership
of a portion of the overall portfolio.

Example:
Investor Amount invested % of total Number of shares
($)

Peter 5.000 10% 1,000

Ken 15.000 30% 3,000

Brighter Co 30.000 60% 6,000

Total 50.000 10,000

Mutual fund
• Net Asset Value (NAV)
• NAV= Assets – Liabilities.
• Net Asset Value per share (NAVPS) is equal to net asset value divide
the number of shares.
Assets – Liabilities
NAVPS =
𝑛
Mutual fund
• Open-end funds accept new investment money and then issue additional
shares which allow investors to buy newly issue shares at the NAVPS or
redeem their shares (sell them back to the fund) at the NAVPS as well.

• Closed-end funds do not accept the new investment money. If an investor

wanted to take his money back, he could only sell his shares to another
investor in the traded market. In other words, the shares of the closed-end
funds can be traded like regular shares.
A mutual fund can be also categorized based
on types of investment.
• If a given mutual fund invests in money market instruments such as T-
Bills and other liquid short term, then is will be called a money market
fund.

• if it invests mostly in bonds then it will be called a bond mutual fund.

• A stock mutual fund will invest stocks.

• Index mutual fund will invest in shares that are in a particular index
such as the S&P 500.
Exchange Traded Funds

• What Is an ETF?

An exchange-traded fund (ETF) is a collection of securities—such as stocks—

that tracks an underlying index. The best-known example is the S&P 500 ETF
(SPY), which tracks the S&P 500 Index.
ETFs and index mutual funds
• ETFs investors can buy or sell shares from other investors (on the exchanges or
over-the-counter) while with open-end mutual fund investors buy or sell shares
directly from the funds.
• With closed end funds, the market price of shares can differ significantly from
their NAV whereas ETFs are designed to keep their market prices very close to
their NAVs.
• Fees for ETF shares tend to be low relative to mutual funds but a brokerage fee
needs to be paid unlike mutual funds.
A separately managed account

• A separately managed account is a portfolio that is owned by a single

investor and the portfolio manager managed account on behalf of
that investor’s needs and preference. No shares are issued, as the
single investors owns the entire account.
Hedge funds

Hedge funds are limited in the number of investors who are wealthy
and qualified.

- One typical characteristic of hedge fund is high use of leverage.

Therefore, they can be highly risky.

- Also most hedge funds are exempt from reporting requirements of

typical public investment company.
Buyout funds

Buyout funds involve taking a company private by buying all available

shares, usually funded by issuing debt. The company is then
restructured to increase cash flows, and then sold it. Investors typically
exit the investment within three to five years.
Venture capital funds

Venture capital funds are similar to Buyout funds but the company
purchased are in the start-ups phase. These funds provide expertise for
the start-ups. The failure rate of start-ups is extremely high, however
the success one can bring back a huge amount of profits.
Chapter 2: Portfolio risk and return
The content

• Investment characteristics of assets

• Risk aversion and portfolio selection

• Portfolio risk

• Investor’s Optimal Portfolio

Investment Characteristics of Assets
Where the return come from?

Return can come in two forms either capital gains when your
purchased asset increase in value with time or the income you receive
from interest payments of dividends.
Holding period return (HPR)
• It is simply the percentage increase in the value of an investment over
a given time period:

𝑒𝑛𝑑−𝑜𝑓−𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒
• Holding period return = –1
𝑏𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔−𝑜𝑓−𝑝𝑒𝑟𝑖𝑜𝑑 𝑣𝑎𝑙𝑢𝑒
Example:

Investor A bought a stock with price of $10. After one year, the price of
this stock went up to $15 and during this time, A received $1 in
dividend from this stock. Calculate the Holding period return?

15+1
HPR = - 1 = 0.6 = 60%.
10
Average returns
It is simply the average of a series of periodic returns.

𝑅1 +𝑅2 +𝑅3 +⋯+ 𝑅𝑛

Arithmetic mean returns =
𝑛
Example:

Investor A owns a portfolio of three stock X,Y,Z with the returns of 10%,
15%, 20% respectively. Calculate the average return:

10%+15%+20%
The result will be: = 15%.
3
 Geometric mean return
• It is a compound annual rate. Generally, for time series data or to evaluate
the performance or the annualized return over time.

𝑛
• Geometric mean return = 1 + 𝑅1 ∗ 1 + 𝑅2 ∗ 1 + 𝑅3 ∗ ⋯ (1 + 𝑅𝑛 ) – 1
Example:
An investor A owned one stock and its returns over last three years
were 10%, 15% and 20% respectively. Calculate the Geometric mean
return:

3
The result will be: 1 + 0.1 ∗ 1 + 0.15 ∗ 1 + 0.2 - 1 = 14.9%.
Money-weighted rate of return (IRR)

It is the internal rate of return on a portpolio based on all of its

cash inflows and outflows. IRR is the interest rate at which the cash
outflow equal to the cash inflow.
Example:

Investor A buys stock X for $40 at the beginning (t =0) and then at the
end of the year 1(t=1), the investor buys another stock Y for $36. At the
end of year 2, the investor decides to sell X for $55 and Y for $45. At
the end of each year in the holding period, each stock paid a $2 per
share dividend. What is the money-weighted rate of return (IRR)?
So we have the cash flow of the investment as following:
𝐶𝐹0 = -40
𝐶𝐹1 = -36 + 2
𝐶𝐹2 = 55+ 45 +4

Use the calculator, you can easily get the result for IRR equal to 24%.
Annualized return

Annualized returns are returns over a period scaled down to a 12-

month period. This scaling process allows investors to objectively
compare the returns of any assets over any period.

The formula for annualize return:

𝟑𝟔𝟓
Annualized return = (𝟏 + 𝒄𝒖𝒎𝒖𝒍𝒂𝒕𝒊𝒗𝒆 𝒓𝒆𝒕𝒖𝒓𝒏) 𝒅𝒂𝒚𝒔 𝒉𝒆𝒍𝒅 -1
Example:
Investor A receive 1% return over 25 days. What is annualized return
rate of the investment?
365
Annualized return = (1 + 0.01) 25 - 1 = 15.64%.
Portfolio return
To calculate the expected return of a portfolio, an investor needs to add up the
weighted averages of each security's expected returns. The equation for the
expected return of a portfolio with three securities is as follows:

Expected Return=WA×RA+WB×RB+WC×RC
where:
WA = Weight of security A
RA = Expected return of security A
WB = Weight of security B
RB = Expected return of security B
WC = Weight of security C
RC = Expected return of security C​
 Other return measures
Gross Gross return refers to the total return on a For example, a portfolio
return security portfolio prior to deducting manager earn for investor
management fees and taxes 20% return at the first place.
The gross return will be:
20%
Net return Net return refers to the return after deducting In this case is 2%, therefore
management fees the net return will be
20%-2% = 18%
Pre-tax nominal Pre-tax nominal return is the return before So Pre-tax nomital return is
return paying taxes 18%
After tax Is return after tax liability is deducted Let say, it is 30%. As the
nominal return result, after tax nominal
return will be
18%(1-0.3)= 12.6%
Real return is the nominal return adjusted for inflation In this case, the inflation is
3%.
Real return will be
12.6%- 3% = 9.6%
Variance (standard deviation) for returns for an individual security
• The variance is a measure of the volatility of the asset returns. The
returns fluctuate significantly over the period of time. That means the
risk related to the asset is high.
Formulas to calculate variance
where:

µ: the mean of expected value of the population’s

distribution

𝑥ҧ : the mean of the observations

x: the return for each period.

N: the total number periods.

Example:

Annual returns data 12%, 5%, -10%, 15%. What is the population and
sample variance?
Covariance and correlation
Covariance is a measure of how two variables move together over time.
- Positive covariance means that the variables tend to move together.
- Negative covariance means that the two variables tends to move in
opposite directions.
- A covariance of zero means there is no linear relationship between
two variables.
Formulas to calculate the covariance
Correlation
• Correlation is a standardized measure of the linear relationship between two
variables with values ranging between -1 and +1. Correlation 1 means that there
is perfect positive correlation between two variables, they move up and down
together.

• A correlation of 0 means that there is no correlation between two variables.

• A correlation of -1 means that there is perfect negative correlation between two

variables.
A formula that connects correlation and
covariance

Cov(𝑅𝑖 ,𝑅𝑗 )
𝜌(𝑅𝑖 , 𝑅𝑗 ) =
𝜎(𝑅𝑖 )𝜎(𝑅𝑗 )
Portfolio expected return and variance

We have a formula for calculating portfolio expected return:

E(𝑅𝑝 ) = 𝑊1 𝑅1 + 𝑊2 𝑅2

We also have a formula for calculating risk of portfolio:

𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝜌𝜎1 𝜎2
Example:

Investor A owns two stock X and Y in his portfolio. X accounted for 40%
of the portfolio and Y the remaining 60%. X has an expected return of
15% and a standard deviation of 12%. Y has expected return of 18%
and a standard deviation of 20%. The correlation is 0.5. What is the
expected return and risk of the portfolio? How does the risk/return
change when the weights of X and Y change?
E(𝑅𝑝 ) = 40% ∗ 0.15 + 60% ∗ 0.18 = 16.8%
𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 =
2 2 2
0.42 0.12 + 0.6 0.2 + 2 ∗ 0.4 0.6 ∗ 0.5 ∗ 0.12 ∗ 0.2
= 0.15
= 15%
 THE PORTFOLIO BENEFIT

Expected return(R)

-----------------------------
18%

15% --------------------

12% 20% Risk (𝜎)

The characteristics of major assets classes
Asset class Annual average return Standard deviation
(Geometric mean)

Small-cap stocks The highest The highest

Large-cap stocks
Long term corporate bonds

Long term treasury bonds

Treasury bills The lowest The lowest

There is a risk-return trade-off, high risk- high return.

Chapter 2: Portfolio risk and return
(Continue…)
The content

• Risk aversion

• Utility theory

• Indifference curves

• The application of utility theory to portfolio selection

1. Risk Aversion
Risk aversion refers to the behaviour of an investor who, when faced with a
range of different investments with the same expected return, tend to
choose the least risky option.

Notice: Risk tolerance which refers to individuals’ ability and willingness to

take risk.

=> High risk aversion is the same as low risk tolerance.

Example:

X Y

Expected return: 15% Expected return: 15%

Risk ( 𝛿) : 10% Risk ( 𝛿) : 15%
Risk Profiles
• A rational investor is usually a risk averse one.
• A risk neutral investor is simply the one who does not care about risk.

X Y

Expected return: 15% Expected return: 15%

Risk ( 𝛿) : 10% Risk ( 𝛿) : 15%

• A risk neutral investor will consider both investment opportunities

X and Y the same despite their different risk level.
Example:
• A risk-seeking investor actually prefers more risk to less, given equal
expected returns, the investor will choose the riskier investment
opportunities.

X Y

Expected return: 15% Expected return: 15%

Risk ( 𝛿) : 10% Risk ( 𝛿) : 15%
-> The investor chooses Y
2. Utility Theory and Indifference Curves
What does Utility theory refer to?
• The world “ Utility” means the ability to satisfy a particular need or
the usefulness of something. Therefore, in finance, Utility theory or
utility function is an important concept that measures an inventors’
preferences over an asset in terms of risk and return.
The utility of formula
1
Utility of an investment = E(r) – *A* 𝛿2
2

where:
E(r) is the expected return of an investment
A is a measure of risk aversion.
𝛿 2 is a measure of risk of the investment.

Notice: when using this formula is that you must do all calculations in
decimals. So if the data given is in percent, you must convert it into decimal
beforehand.
Example:
Investor X has the risk aversion of 2 and owns a risk-free asset
returning 5%. What is the utility of X’s investment?

The standard deviation (σ) is equal to zero because this is a risk-free

rate return.

1
=> Utility of an investment = 0.05 - *2* 0 = 0.05
2
Example:
The investor X is considering another asset with higher standard deviation (=
10%) . At what level of expected return will the investor have the same
utility?
1
0.05= E(r) - *2* 0.01
2

E(r)= 0.06
 The Investor X needs higher return of 0.06 or 6% to be equally satisfied
with the higher risk investment.
Expected return
0.05

In order to have the same utility level (0.05),

when risk equal to zero, the expected return is
5%. When the risk rise to 10%, the expected
0.06
0.05 return of the investor also increases to 6%.

Risk
0 0.1
Indifference curves

Expected return
The line which connects all the points where
0.05
the investor has the same level of satisfaction
or Utility is called indifference curve. This is
the indifference curve for the investor X where
the level of utility is 0.05

0.06 The indifference curve tells us the different risk

0.05 and return numbers at which the investor is
equally happy.

Risk
0 0.1
 Indifference curves

Expected return
0.06 0.05

The investor X has another investment opportunity

0.1
with an expected return of 10% and σ= 20%, what is
the Utility of the investment?

1
In this case, the Utility = 0.1 – * 2* 0.22 = 0.06
2
0.06
0.05 In order to have the same utility level (0.06), when
risk-free rate return, the expected return will be 6%.
Risk
0 0.1. 0.2
 Does the investors seem to be happier with higher utility?

Expected return
0.06 0.05

0.1 With higher utility, the indifference curves move to the

left. The investor seems to be happier as he faces the
same level of risk but receives better return.

0.06
0.05

Risk
0 0.1. 0.2
 Types of indifference curves
Expected return
A risk-averse

Risk Neutral

Risk-seeking
Risk
3. Application of Utility theory to portfolio selection:

Utility function is an effective tool that helps portfolio managers

to make good decisions in portfolio selection.
Capital Allocation Line (CAL)

Example:
We have a portfolio of two assets including:
- A risk-free asset (σ = 0 ) and R1 = 5%
- A risky asset with 𝑅2 = 10% and σ = 20%.

• To calculate the risk and return of the portfolio when adjusting the
proportion of the portfolio invested in Asset 2 from 0 to 100%.
Portfolio expected return and variance

We have a formula for calculating portfolio expected return:

E(𝑅𝑝 ) = 𝑊1 𝑅1 + 𝑊2 𝑅2

We also have a formula for calculating risk of portfolio:

𝜎𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝜌𝜎1 𝜎2

𝑊1 : Percentage of the portfolio invested in Asset 1

𝑊2 : Percentage of the portfolio invested in Asset 2
𝜎1 : Asset 1 standard deviation of returns
𝜎2 : Asset 2 standard deviation of returns
𝜌1,2 : Correlation coefficient between the returns of Asset 1 and Asset 2
• Asset 1 has σ = 0 because it is a risk-free asset.

• 𝛿port𝑓𝑜𝑙𝑖𝑜 = 𝑊22 𝛿22 = 𝑊2 𝛿2

 𝑾𝟐 𝜹𝒑𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐 Expected return
0% 0 5%

25 % 5% 6.25%

50 % 10% 7.5%

100 % 20% 10%

𝑅𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

10% Capital Allocation Line (CAL)

5%

𝛿𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
 Where is the the investor’s Optimal portfolio? Or Where will the investor X be the most satisfied?

1
Utility of an investment = E(r) – 2*A* 𝛿 2
𝑅𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜

10% Capital Allocation Line (CAL)

5%

𝛿𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
Content

• Risk and return for different values of ρ.

• Portfolio of many risky assets.

• Investment opportunities set.

• Minimum-Variance and Efficient Frontiers.

• The equation for the capital market line.

What does the Portfolio risk depends on?
The Portfolio risk depends on 3 parts:
 Risk of an individual asset
 Weight of each asset
 Covariance or Correlation between assets
The relationship between standard deviation and the correlation.

Correlation measures the linear relationship between two variables with values ranging between -1
and +1.

When the correlation equal to 1 means that there is perfect positive correlation between two variables,
they move up and down together. Therefore, there is no diversification benefit.

Diversification benefit which means that the overall risk of the portfolio is going to be less than the risk
of holding a single stock as the stocks in the portfolio tend to have different movements.

If correlation decrease, the standard deviation will decrease or the risk of the portfolio decreases and the
diversification benefit increase.
Risk and Return for Different Values of 𝜌
Example:
Two assets are X and Y. X has an expected return of 12% and a standard
deviation of 16%. Y has an expected return of 20% and a standard
deviation of 30%.
What will happen to a portfolio’s risk when ρ= 1.

𝛿𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑊12 𝛿12 + 𝑊22 𝛿22 + 2𝑊1 𝑊2 𝛿1 𝛿2 (1) = 𝑤1 *𝛿1 + 𝑤2 *𝛿2

Return

Y
20%

12% X

16% 30% Risk

The straight line represents the situation when the correlation of the portfolio is 1. There is no diversification
benefit. The Investor will receive higher rate of return and at the same time, higher risk.
What will happen to a portfolio’s risk when
𝜌=0.5
Return Y

20%

12% X

16% 30% Risk

What will happen to a portfolio’s risk when 𝜌= -1
• To sum up, as you are t
Portfolio of many risky assets
 Which portfolio is the better diversification one?

Portfolio 1 Portfolio 2

A ski resort. A summer hotel.

A winter clothes manufacturer. A winter clothes manufacturer.
Investment opportunities set, Minimum- Variance and Efficient Frontiers
• P: Optimal Risky Portfolio ; CAL is based on the market
To identify the optimal portfolio for the investor
 Investors have
Different optimal Different capital
different views of
risky portfolios Allocation lines
the market
Is there a unique optimal risky portfolio?

The answer is yes. As long as assume homogeneity of expectations what this means
that all investors have a similar view of the market and have the same expectation
about risk and return related to every single security. In addition, they also have
similar expectation about the correlation between different securities.

A B C

Investors
The equation for the capital market line
The equation for a straight line is given by:
y= c + m.x
where: m is the slope of the line
c is the intercept on the y-axis

𝑅𝑀− 𝑅𝐹
𝑅𝑝 = 𝑅𝐹 +[ ] 𝛿𝑃
𝛿𝑀
Content
• Systematic and unsystematic risk
• Calculate and interpret of Beta
• Capital asset pricing model
• Security market line (SML)
• Comparing the SML and CML
• Calculate and interpret the Sharpe ratio, Treynor ratio, 𝑀2 , Jensen’s alpha
What is risk?

In finance and investing, risk often refers to the chance an outcome or

investment's actual gains will differ from an expected outcome or
return.

30%
10%
Apple

-30%
Systematic and unsystematic risk

What is unsystematic risk?

Unsystematic risk is unique to a specific company or industry.

For example, the death of Steve Job affected the price of Apple’ stock.

However, this risk can be diversified away.

For example, instead of only investing in Apple, you could invest in a

portfolio of stocks.
What is systematic risk?

Systematic risk refers to the risk of a breakdown of an entire system

rather than simply the failure of individual parts.

For example, there is a global economic slowdown. There is a reduction

in consumer demand. It affects all firms. Therefore, systematic risk
cannot be diversified away because of almost stocks’ price decreasing.
Academic studies have shown that once you get to 30 or so securities in a portfolio,
the standard deviation remains constant. The remaining risk is systematic or non-
diversifiable risk.
Calculation and interpretation of beta

Beta (𝛽) is used to determine the volatility of an asset or portfolio in

relation to the overall market. The overall market has a beta of 1.0,
and individual stocks are ranked according to how much they deviate
from the market.

Notice: We use Beta to measure the systematic risk.

Beta can be calculated as follows:
covariance of Asset i′ s return with the market return
βi =
variance of the market return

Covim ρim δi δm δi
= = = ρim ( )
δ2m δ2m δm
Example
The standard deviation of the return on the market index is estimated
as 20%.
- If asset A’ standard deviation is 30% and its correlation of returns with
the market index is 0.8. what is Asset A’s beta?
δi 0.3
βi = ρim ( ) = 0.8 ( ) = 1.2
δm 0.2
- If the covariance of Asset A’s returns with the returns on the market
index is 0.048, what is the beta of Asset A?
Covim 0.048
βi = = = 1.2
δ2m 0.22
The capital asset pricing model (CAPM)

• CAPM is the most important models in finance. It allows us to

compute the expected returns of assets are based on systematic risk.
Example:

ABC’s standard deviation of returns is 25% and its correlation with the
market is 0.6. The standard deviation of returns for the market is 20%.
The expected market return is 10% and the risk free rate is 3%. What is
ABC’s expected return?
β = ρ*σi /σm = 0.6*0.25/0.2 =0.75

ri = rf + β(rm − rf )
= 0.03 + 0.75(0.1-0.03) = 0.0825 = 8.25%.
CAMP is the most important models in finance and they are several
applications:

• The expected return can be estimated using the CAPM formula.

• To estimate the price of an asset, the future cash flows can be

discounted at the CAPM rate.

• The CAPM rate is also used in the capital budgeting process in

corporate finance.
Example:

ABC’s cash flow from operations is $500 million at the end of the first year.
We are going to assume that cash flow will grow at a rate of just 15% for the
next 10 years.

The beta of the stock is 1.2, the risk free rate is 6% and market risk premium
5%.
The number of shares outstanding is 1,068.7 millions.
The price of the stock is $3.2.

Should we invest in the share?

 0 1 2 3 4 5 6 7 8 9 10
500.00 575.00 575.00 661.25 760.44 874.50 1005.68 1156.53 1330.01 1529.51

P = PV(12%,10,B2:K2) =3,249
Price per share: $3.04 < Current Price
Security market line

The security market line is a graphical representation of the capital

asset pricing model (CAPM) and applies to all securities, whether they
are efficient or not.
Security market line

y= b+ a*x
Comparing the CML and the SML
- Notice that with CML/ we considered the
total risk/ whereas with the SML, we are
considering only systematic risk.

- The CML applies to efficient portfolios.

SML however applies to any securities
whether it is efficiently priced or not.
Performance Evaluation
The Sharpe ratio
It is the excess return of a portfolio over the risk-free rate divided by the risk
of the portfolio.
𝑅𝑝 −𝑅𝑓
Sharpe Ratio = return
𝜎𝑝
Limit:
- It uses total risk /rather 𝑃1 : 0.8
than systematic risk or beta. P: 0.6
- This ratio which is not informative
enough itself
𝜎
Treynor
• Treynor is the excess return of the portfolio over the risk-free rate
divided by the systemic risk.
𝑅𝑝 −𝑅𝑓
Treynor =
𝛽𝑝

This Treynor deals with the limit of Sharpe ratio. It uses the systematic
risk. However, it is not informative enough itself.
M squared
𝛿𝑀
𝑀2 = (𝑅𝑝 - 𝑅𝑓 ) - (𝑅𝑝 - 𝑅𝑓 )
𝛿𝑃
- M squared gives similar rakings to the Sharpe ratio. Both M squared
and Sharpe ratio use total risk.
- The benefit of this measure over the Sharpe ratio is that it get a
number which has meaning.
Jensen’s alpha
Jensen’s alpha is simply the return on a portfolio minus the return
predicted by CAMP.

For example: the return on the portfolio is equal to 15% and the number predicted by CAMP is
12%. Calculate the Jensen’s alpha and explain the result?
Chapter 3: Basic of portfolio planning and construction
Content
• Portfolio planning

• How to define the IPS

• How to construct a basic portfolio

 • Understanding the client’s needs
• Preparation for an investment policy statement
Planning

• Asset allocation
• Security analysis
Execution • Portfolio construction

• Portfolio monitoring and rebalancing

• Performance measurement and reporting
Feedback
Portfolio planning

• Portfolio planning can be defined as a program developed in

advanced of constructing a portfolio that is expected to satisfy the
client’s investment objectives.
Investment policy statement (IPS)

• To be clear about a client’s investment objectives, we create

investment policy statement (IPS).

• Investment policy statement (IPS) defines a plan for investment

success, given the client’s situation and requirements.

• Notice that, the IPS should be reviewed on a regular basis.

The major components of an IPS
• Introduction: This describes the client.
• Statement of purpose: This section states the purpose of the IPS
• Statement of duties and responsibilities: This section details the
duties and responsibilities of the client.
• Procedures: this section describes the steps to update the IPS and to
respond to various contingencies.
• Investment objectives: This section describes the client’s objectives in
investing such as return and risk objectives.
• Investment constraint: This section presents the constrain such as
time horizon, liquidity requirement and …
• Investment guidelines: whether leverage, derivatives, or specific
kinds of assets are allowed.

• Evolution and review: related to feedback on investment results.

• Appendices: this section includes the strategic asset allocation,

rebalancing policy and so on.
Risk objectives
• Risk objectives are specification for portfolio risk that reflect the risk
tolerance of the client.

- Risk objectives can be either absolute (e.g… no losses greater than

10% in any year) or relative (e.g… annual return will be within 2% of
S&P500 return).

- Notice that: Relative risk objectives relate to a specific benchmark.

• The overall risk tolerance depends on the willingness and ability to take
risk.

• Ability to take risk is based on financial factors such as wealth, time

horizon, expected income…

• The willingness to take risk is related to a client’s psychology, such as

personality type and level of financial knowledge.

For example, the client has bad experience (lost a lot of money) from his
previous investment that will impact his psychology to some extent which
will impact his willingness to take risk.

Notice that: Every client will have a somewhat different risk tolerance. It is
extremely important to specify the risk tolerance in the IPS.
Example: Risk tolerance
Client A Client B
Age: 35 Age: 40
Has high salary Has income volatility
Fairly secures jobs Has to pay mortgage monthly
Owns house Is a single mother
Client A’s ability to take risk: Client B’s ability to take risk:

Has knowledge about the financial market Has been working in financial market 15 years
Client A’s willing to take risk: Client B’ willing to take risk:
Client A’s risk tolerance: Client B’s risk tolerance:
Return objectives

• Return objectives are typically based on an investor’s desire to meet a

future financial goals, such as a particular level of income in retirement.
• Return objectives can be absolute (e.g 10% annual return) or relative (e.g
outperform the S&P500 by 3% per year).

• Notice that:
- Return requirement can be stated before and after fees but it should be
very clear how the fees will be calculated.
- The stated risk and return must be compatible. It would not make sense
that the risk tolerance is low but clients are seeking a relatively high return.
The example below to compute the return objective

Your client is 30 and wishes to retire in 30 years. She has $180,000 in

savings of which she wants to put aside 20,000 as an emergency fund
to be held in cash. You estimate that $500,000 in today’ money will be
sufficient to fund your ‘client’s retirement income needs. Expected
inflation is 2.5% over the next 30 years. How much money must your
client have in nominal terms to fund her retirement? What is the
required return objective?
• FV = PV*(1 + 𝑟)𝑛 = 500,000 ∗ (1 + 0.025)30 = $1,048,783
• Rate(nper, pmt,pv,fv) = (30;0;-160,000;1048,783) = 6,47%

• Nominal terms to fund her retirement: $1,048,783.

• The required return: 6,47%
The investment constraints
• Time horizon this constraint deals with the period during which a
portfolio is accumulating before assets need to be withdrawn.

• The example above, this money is being invested for 30 years and
then the money will be taken out at the end of 30 years. For this
particular portfolio, the time horizon is long.
• Liquidity – the liquidity constraints must also be specified in the IPS.
This tell us about any constraints or requirements to withdrawing
funds from the portfolio.

• For example: if you have a client who need to withdraw some funds
to pay for his child’ university ’fee after 3 years that would be
specified under a liquidity requirement.

• Notice: You are not sure about how much will be taken out and when
it will be taken out. In this case, the liquidity requirement is relatively
uncertain. Therefore, the liquidity requirement is relatively high then
the portfolio should be invested in relatively liquid securities (bonds,
stocks)
Legal and regulatory requirements

• Legal and regulatory requirements – Constraints such as government

restrictions on portfolio contents or laws against insider trading.
Tax concerns
• Tax concerns - this deals with the tax status or the tax situation of a
client which must be specified in the IPS.

• For example, in some countries, there are very high taxes on the
dividend income then it makes sense to create a portfolio of stocks
that pay relatively low dividends.
Unique circumstances
• Restriction due to investor preferences (religious, ethical, etc.) or
other factors not already considered.

• For example: if you have a client who does not want to invest in
companies that deal with alcohol, tobacco and firearms that needs to
be specified under unique circumstances.
Gathering client information

• Important for portfolio manager and investment advisors to know

their clients
• You need to understand the clients:
- Family situation: married or not married, spouses income, the
children
- Employment situation: the sources of income, the volatility of
income, what industry the clients is working.
- Financial situation: amount of savings
Basics of portfolio planning and construction

Strategic Asset
Allocation Tactical Asset Security
Allocation Selection
Strategic asset allocation:
• Strategic asset allocation is a set of percentage allocation to various
asset classes that is designed to meet the investor’s objectives.
• The strategic asset allocation is developed by combining the
objectives and constraints in the IPS with the performance
expectations of the various asset classes.
defining expectations
related to markets (stock,
bonds, others)

Combine Strategic asset allocation

Objectives and constraints in

IPS
Construct an optimal portfolio
Tactical asset allocation:

Tactical asset allocation refers to an allocation that deviates from the

baseline (strategic) allocation in order to profit from a forecast of
shorter-term opportunities in specific asset classes.

Long term Short-term

60% Stocks + 40% Stock +

40% Bonds 60% Bonds
Passive versus active investing
• Investing in a fund that is based on the S&P500 that is called passive
investing. Investors are not trying to figure out which stocks are
undervalue or overvalue.

• Active investing means that investors are actively looking for stocks
that are undervalues.
Investment approach

The core satellite approach what means is investors divide their

portfolio into two parts. The core part and a satellite.

The core part: where investors put most of this money in some sort of
index fund so they are taking only systematic risk.

a part of the portfolio or the satellite is invested in stock that they

believe are undervalued that part is called active investing.