Chapter 8

Portfolio Management
 What Is Portfolio Management?

• Portfolio management is the art and science of

selecting and overseeing a group of
investments that meet the long-term financial
objectives and risk tolerance of a client, a
company, or an institution.
• The first step in the portfolio management
process is to specify the investment policy
which summarizes the objectives, constraints
and preferences of the investor.
 Investment Objectives
• The commonly stated investment goals are:
• 1. Income: To provide a steady stream of
income through regular interest/dividend
payment.
• 2. Growth: To increase the value of the
principal amount through capital appreciation.
• 3. Stability: To protect the principal amount
invested from the risk of loss.
 Return Objective
• The following steps are required to determine the return
objective of the investor:
1. Specify Measure of Return: A measure of return needs to be
specified. It can be specified in an absolute term or a relative
term. It can also be specified in nominal or real terms. One
may also distinguish pre-tax returns from post-tax returns.
2. Desired Return: A return desired by the investor needs to be
determined. The desired return indicates how much return is
expected by the investor. E.g. higher or lower than average
returns.
3. Required Return: A return required by the investor also
needs to be determined. A required return indicates the return
which needs to be achieved at the minimum for the investor.
 Investment Constraints
• Investment constraints are the factors that restrict or
limit the investment options available to an investor.
• Liquidity
• Such constraints are associated with cash outflows
expected and required at a specific time in future and
are generally in excess of income available.
• Moreover, prudent investors will want to keep aside
some money for unexpected cash requirements.
• The Investor needs to keep liquidity constraints in mind
while considering an asset’s ability to be converted into
cash without impacting the portfolio value
significantly.
 Investment Constraints
• Time Horizon
• These constraints are related to the time periods over
which returns are expected from portfolio to meet
specific needs in the future.
• Such constraints are important to determine the
proportion of investments in long-term and short-
term asset classes.
 Investment Constraints
• Tax
• These constraints depend on when, how and if returns of
different types are taxed.
• The tax environment needs to be kept in mind while drafting
the policy statement.
• Often, capital gains and investment income are subjected to
differential tax treatments
• Legal and Regulatory
• These constraints usually specify which asset classes are not
permitted for investments or dictate any limitations on asset
allocations to certain investment classes.
 Investment Constraints
• Unique Circumstances
• Such constraints are mostly internally generated and
signify investor’s special concerns. Some individuals
and philanthropic organizations may not invest in
companies selling alcohol, tobacco or even defense
products. Such concerns and any special
circumstance restricting the investor’s investments
should be well considered while formulating
investment policy statement.
 Risk Objective
• Risk objectives are the factors that are
associated with both the willingness and the
ability of the investor to take the risk.
• When the ability to accept all types of risks
and willingness is combined, it is termed as
risk tolerance.
• When the investor is unable and unwilling to
take the risk, it indicates risk aversion.
Risk Tolerance Assessment:
Key Elements of Portfolio Management
• Asset Allocation
• The key to effective portfolio management is the long-term
mix of assets. Generally, that means stocks, bonds, and "cash"
such as certificates of deposit.
• Asset allocation is based on the understanding that different
types of assets do not move in concert, and some are more
volatile than others. A mix of assets provides balance and
protects against risk.
• Investors with a more aggressive profile weight their
portfolios toward more volatile investments such as growth
stocks.
• Investors with a conservative profile weight their portfolios
toward stable investments such as bonds and blue-chip stocks.
 Key Elements of Portfolio Management

• Diversification
• Diversification is spreading risk and reward within an
asset class. Because it is difficult to know which
subset of an asset class or sector is likely to
outperform another, diversification seeks to capture
the returns of all of the sectors over time while
reducing volatility at any given time.
• Real diversification is made across various classes of
securities, sectors of the economy, and geographical
regions.
 Key Elements of Portfolio Management
• Rebalancing
• Rebalancing is used to return a portfolio to its original target
allocation at regular intervals, usually annually.
• This is done to reinstate the original asset mix when the
movements of the markets force it out of kilter.
• Rebalancing generally involves selling high-priced securities
and putting that money to work in lower-priced and out-of-
favor securities.
• The annual exercise of rebalancing allows the investor to
capture gains and expand the opportunity for growth in high
potential sectors while keeping the portfolio aligned with the
original risk/return profile.
 Portfolio management Strategy
• Portfolio management may be either passive or active
in nature.
• Passive management is a set-it-and-forget-it long-term
strategy.
• Active management involves attempting to beat the
performance of an index by actively buying and selling
individual stocks and other assets.
• Active managers may use any of a wide range of
quantitative or qualitative models to aid in their
evaluations of potential investments.
 Measuring Portfolio Return
• What Is Portfolio Return?
• Portfolio return refers to the gain or loss
realized by an investment portfolio containing
several types of investments.
• The only way to accurately calculate your
portfolio return is to understand the
performance of each individual asset.
 Holding Period Return

•Holding period return (HPR) is one of the simplest methods for

calculating investment returns.
• It takes income from interest or dividends into account.
•The HPR formula is as follows:
• HPR = Income + (End of period value – initial value) / Initial
value
•When calculated correctly, HPR can reveal the total return from
holding a given asset.
•This is highly beneficial when looking at overall portfolio returns,
as the formula accounts for assets being held for different periods of
time.
 Annualized Returns

•While the HPR formula is a great tool for comparing

investments made over different periods, annualizing
returns can take this process one step further.
•Annualized returns illustrate the average return of an
investment over an entire year.
•This practice helps investors compare investments
more easily by giving the return amounts a common
denominator, in this case, one year.
 Measuring Portfolio Return
•The formula for portfolio returns can be solved with simple
addition — but only after you determine a few things about
each asset type.
•Essentially, investors will need to calculate the weight and
return of each asset in their portfolios.
•Portfolio 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​
 Measuring Portfolio Return
•Example;
•Johnny’s portfolio has three asset types: real estate,
stocks, and bonds. The total investment amount for his
portfolio is $750,000. In Johnny’s portfolio, the annual
returns are: real estate 10%, stocks 8%, and bonds 2%.
Johnny invested $425,000; $275,000 and $50,000 in in
real estate, stocks and bonds respectively.
• what will be the portfolio return?
 Measuring Portfolio Return
• Solution:
• Step 1; Determine weight of individuals assets
– Real estate: 425,000/750,000 = .56.
– Stock: 275,000 / 750,000= .36
– Bond: 50,000/750,000=.06
• Step 2: Determine return of induvial assets
– Real estate: 0.1; Stock: 0.08 ; Bond: 0.02
• Step 3: calculate portfolio return
• Portfolio Return=WA×RA+WB×RB+WC×RC
•PR= (0.56*0.1)+(0.36*0.08)+(0.06*0.02)
•PR= 0.056+0.0288+0.0012
•PR=0.086=8.6%
 Measuring Portfolio Performance

•Many investors mistakenly base the success of their portfolios

on returns alone.
•Few investors consider the risk involved in achieving those
returns.
•Today, there are three sets of performance measurement tools to
assist with portfolio evaluations.
•The Treynor, Sharpe, and Jensen ratios combine risk and return
performance into a single value, but each is slightly different.
•Which one is best? Perhaps, a combination of all three.
 Treynor Measure
• Jack L. Treynor was the first to provide investors with a composite
measure of portfolio performance that also included risk.
•Treynor introduced the concept of the security market line, which
defines the relationship between portfolio returns and market rates of
returns whereby the slope of the line measures the relative volatility
between the portfolio and the market (as represented by beta).
•The beta coefficient is the volatility measure of a stock portfolio to
the market itself.
•The greater the line's slope, the better the risk-return tradeoff.
 Treynor Measure
•The Treynor measure, also known as the reward-to-volatility
ratio, is defined as:
•Treynor Measure= (PR−RFR​)/ β
•where:
•PR=portfolio return
•RFR=risk-free rate
•β=beta​

•The numerator identifies the risk premium, and the denominator

corresponds to the portfolio risk. The resulting value represents
the portfolio's return per unit risk.
 Treynor Measure
•To illustrate, suppose that the 10-year annual return for
market portfolio is 10% while the average annual return
the risk-free rate is 5%. Then, assume the evaluation is
of three distinct portfolio managers with the following
10-year results:
Managers Average Annual Return Beta
Manager A 10% 0.90
Manager B 14% 1.03
Manager C 15% 1.20
 Treynor Measure
•The Treynor value for each is as follows:

  Calculation Treynor Value

T(market) (0.10-0.05)/1  0.05
T(manager A) (0.10-0.05)/0.90  0.056
T(manager B) (0.14-0.05)/1.03  0.087
T(manager C) (0.15-0.05)/1.20 0.083
•If the portfolio is evaluated on performance alone, manager C
seems to have yielded the best results.
•However, when considering the risks that each manager took to
attain their respective returns, Manager B demonstrated a better
outcome.
 Sharpe Ratio
• The Sharpe ratio is almost identical to the Treynor
measure, except that the risk measure is the standard
deviation of the portfolio instead of considering
only the systematic risk as represented by beta.
•The Sharpe ratio is defined as:
•Sharpe ratio=(PR−RFR)/SD
•where: PR=portfolio return
•RFR=risk-free rate
•SD=standard deviation
 Sharpe Ratio
•Using the Treynor example from above, and assuming that the
market had a standard deviation of 18% over a 10-year period,
we can determine the Sharpe ratios for the following portfolio
managers:

Portfolio
Manager Annual Return Standard
Deviation
Manager X 14% 0.11
Manager Y 17% 0.20
Manager Z 19% 0.27
 Sharpe Ratio
  Calculation Sharpe ratios
S(market) (0.10-0.05)/0.18 0.278

S(manager X) (0.14-0.05)/0.11  0.818

S(manager Y) (0.17-0.05)/0.20  0.600

S(manager Z) (0.19-0.05)/0.27 0.519

 Jensen Measure
•Similar to the previous performance measures discussed,
the Jensen measure is calculated using the CAPM.
•The Jensen measure calculates the excess return that a
portfolio generates over its expected return. This measure
of return is also known as alpha.
•The Jensen ratio measures how much of the portfolio's
rate of return is attributable to the manager's ability to
deliver above-average returns, adjusted for market risk.
•The higher the ratio, the better the risk-adjusted returns.
 Jensen Measure
•The formula is broken down as follows:
•Jenson’s alpha=PR−CAPM
•where:
•PR=portfolio return
•CAPM=risk-free rate+β(return of market -risk-
free rate of return)​
 Jensen Measure
•If we assume a risk-free rate of 5% and a
market return of 10%, what is the alpha for the
following funds?
Average Annual
Manager Beta
Return
Manager D 11% 0.90
Manager E 15% 1.10
Manager F 15% 1.20
 Jensen Measure
•Step 1: calculate the portfolio's expected return
(CAMP):
0.0950 or 9.5%
ER(D) 0.05 + 0.90 (0.10-0.05) 
return

0.1050 or 10.5%
ER(E) 0.05 + 1.10 (0.10-0.05) 
return

0.1100 or 11%
ER(F) 0.05 + 1.20 (0.10-0.05) 
return
 Jensen Measure
•Step 2: We calculate the portfolio's alpha by
subtracting the expected return of the portfolio
from the actual return:

Alpha D 11%- 9.5%  1.5%

Alpha E 15%- 10.5%  4.5%

Alpha F 15%- 11%  4.0%