25907502 portfolio evaluation

164 11.621.3© Copy Right: Rai University

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LESSON 31:PORTFOLIO EVALUATION

Construction Revision and EvaluationThe portfolio theory is the basis of portfolio management andrelates to the efficient portfolio investmei1t in financial andphysical assets, including shares and debentures of companies.A portfolio of an individual or a corporate unit is the holdingof securities and investment in financial assets. These holdingsarc the result of individual preferences and decisions of theholders regarding risk and return and a host of other consider-ations.

Fact Sheet - Clients’ Data BaseThe following preferences of the investor are to be noted firstin investment decisions. These will constitute the data base ofthe investor or client.1. Income and savings decisions - how much income can be

saved for contingencies and the present position of wealth,income and savings of the Investor.

2. Asset preferences profile - preference for riskless assets likebank deposits or for risky stock market investment:a. The degree of risk the investor is capable of taking andwilling to take;b. the risk aversion and preference for safety and certainty;c. requirements of regular income;d. objective of capital appreciation;e. objective of speculative gains; etc.

3. Investor’s objectives, constraints and financialcommitments.

4. Tax brackets into which the investor falls and his preferencefor planning the tax liability.

5. Time horizon in which investment should fructify orresults expected. These and other factors constitute the“Fact Sheet” of the investor on the basis of which theindividual portfolio is to be structured, constructed andmanaged. The motives for saving are varied depending onthe individuals. For example, provision for insurance,contingencies, contribution of PF, pension funds, etc.,which arc mostly contractual obligations, provision forfuture income, etc., are some of the motives. Some of thesavers arc influenced by interest return or stable incomewhile others are by speculative gains or get-rich-quickmotive.

Objectives of InvestorsThe investors’ objectives are to be specified in the first place.The objective may be income, capital appreciation or a futureprovision for contingencies such as marriage, death, birth, etc.Provision for retirement and accident could be covered bycontractual obligations like insurance and contributions to PFand pension funds. A certain amow1t of savings has to be keptas cash with themselves or in deposit with banks or post offices

to facilitate daily transactions for purchase and sale. While cashearns no interest, savings deposit with banks, co-operatives andPOs would earn 3% to 5% on savings accounts. But wheninflation is prevalent in the economy at an average rate of 6-8%,this return of 3-5.% will provide only a net negative return tothe savers. So the an10unts kept in the form of cash anddeposit with banks, etc., should normally be the bare mini-mum. The rest of the amount has to be spread in variousinvestment avenues, earning higher returns than the normalinflation rate of 8-10%. These investment avenues are discussedin a separate chapter.

Motives for InvestmentThe investor has to set out his priorities of investment keepingthe following motives in mind. All investors would like tohave:1. Capital appreciation.2. Income.3. Liquidity or marketability.4. Safety or security.5. Hedge against inflation.6. A method of tax plaIU1ing.The investor gets his income from the dividend or yield orinterest. There will be capital appreciation also in the case ofequities. The liquidity and safety of an investment will dependupon the marketability and the credit rating of the borrower,namely, the company or the issuer of securities. These character-istics vary between assets and securities. An investor is alsoconcerned in having a tax plan to reduce his tax commitmentsso as to maximise the take home income. For this purpose,investor should specify his income bracket, his liabilities and hispreference for tax planning etc. The -investment avenues havecertain characteristics of risk and return and also of some taxconcessions attached to them. These tax provisions as such caninfluence the investors in a very big way as these provisions willalter the risk return scenario of investment alternatives. It is,therefore, necessary that all these avenues should be assessed intems of yields, capital appreciation, liquidity, safety and taximplications. The investment strategy should be based on theabove objectives after a thorough srudy of the goals of theinvestor, in the background of characteristics of the investmentavenues.

Tax ProvisionsIt is apt to start with the tax-exempt incomes of the securitiesin which investment can be made. The incomes by way ofinterest on PSU bonds, N.S. certificates, securities of the CentralGovernment and those deposits specified by the CentralGovernment like RBI Relief Bonds arc exempted from incometax subject to certain limits or conditions. The P.O: deposits,certificates and other claims operated by the POs are exemptedalong with others from income-tax up to a limit of Rs. 15,000.

© Copy Right: Rai University11.621.3 165

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This limit is inclusive of a sub-limit of Rs. 3,000, for UTIincome distribution. Thus exemption is, however, notapplicable to Indira Vikas Patra, Kissan Vikas Patra and NSCVITI Issue. Deposits in PPF and NSS are exempted from taxesin the year of deposit and subject to some limits in the year ofwithdrawal except in the case of NSS, which is, however, taxablein the year of withdrawal. PPF is the best method of tax savingupto a limit. Under the category of insurance, in addition toLIC policies, the ULIP (of UTI) enjoys popularity due to thetax shelters:

Capital GainsCapital gains refer to profits earned on the transfer of capitalassets, sale or exchange, etc. These gains are long-term gains, ifthey are held for more than 36 months for all assets exceptshares of a company for which this period is 12 months. Long-term capital gains are taxable at a lower rate of20%. UnderSections 54£ and 54F of the Income-tax Act, the long-termcapital gains are exempt, if these funds are invested in CentralGovernment securities, UTI and CGI Schemes and other speci-fied bonds of semi-government bodies. In the year 2000-01,this exemption is extended only to investments in bonds ofNABARD and NHAI and Infrastructure Bonds.Income from interest on debentures and on company depositsis tax deductible at source, if it exceeds Rs. 2,500 p.a. Theexemption available from income tax for NSS deposits up toRs. 40,000 was since withdrawn in 1992-93. Tax exemption isalso available in respect of income from government securities,semi government bonds, bank deposits, income from mutualfunds, etc., upto a limit. In the budget for 1990-91, a newscheme called Equity linked Saving Scheme was announced bythe government under Section 88A of Income Tax Act toprovide a tax rebate of 20% of the investment made in theeligible assets and new issues, or eligible M.P. Scheme. This wasextended upto a limit of total investment of Rs. 70,000 p.a. in1996-97, in respect of investments in selected avenues such asInsurance, P.F., PPF, NSS and Infrastructure bonds, etc.

Portfolio ConstructionPortfolio construction refers to the allocation of funds among avariety of financial assets open for investment. Portfolio theoryconcerns itself with the principals governing such allocation.The objective of the theory is to elaborate the principles inwhich the risk can be minimised, subject to a desired level ofreturn on the portfolio or maximise the return, subject to theconstraint of a tolerable level of risk.Thus, the basic objective of portfolio management is’ tomaxin1ise yield and minimise risk. The other antiquelyobjectives are as per the needs of investors, namely:1. Regular income or stable return;2. Appreciation of capital;3. Market ability and liquidity;4. Safety of investment; and5. Minimising of tax liability.In pursuit of these objectives, the portfolio manager has to setout all the various alternative investments along with theirprojected return and risk and choose invest- investments whichsatisfy the requirements of the individual investor and cater to

his preferences. The manager has to keep a list of such invest-ment avenues along with the return-risk profile, taximplications, yields and other return such as convertibleoptions, bonus, rights, etc. A ready reckoned giving out theanalysis of the risks involved in each investment and thecorresponding returns should be kept.

Risk-Return AnalysisAll investments have some risks. Investment in shares ofcompanies has larger risks or, uncertainty. These risks arise outof variability of returns or yields and uncertainty of preciationor depreciation of share prices, loss of liquidity etc. The riskover time can be repre-sented (SMl) Security sented by thevariance of the Market UNe returns, while the return over timeis capital appreciation plus payout, divided by the pur-chaseprice of the share.

Normally, the higher the risk that the investor takes, the higheris the return. There is, however, a riskless return on capital ofabout 6.5%, which is the bank rate charged by the RBI or long-term yield on Government securities at around 7% to 9%. Thisriskless return refers to lack of variability of return and nouncertainly in the repayment of capital. Bur other risks such asloss of liquidity due to parting with money etc., may, however,remain bur are rewarded by the total return on the capital. Therisk free return and variable return are shown in the adjacent fig.The risk-return relationship can be represented in a diagram-matic form as in Fig. below2

Risk-return is subject to variation and the objective of theportfolio manager is to reduce that variability and thus reducethe risk by choosing an appropriate portfolio. There arc twotypes of risks, namely,a. Market risk or systematic risk, andb. Company risk or unsystematic risk.The unsystematic risk can be reduced by diversifying theportfolio of scrip’s up to an optimum level of about 15 shares.These scrips should be so chosen that the risks on each of themare diverse and their variability of return is also different. Byinvesting in such a diverse set of scrips, the total risk can bereduced as some of them may have positive and oth-ersnegative covariance and they may vary in the degree of risk aswell. The risk that can be reduced is called unsystematic risk andthese risks are represented diagrammatically in Fig. here.


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The details are discussed in an earlier Chapter.The unsystematic risk can be lowered by diversifying into abasket of scrips. Thus, at the level of 15 scrips in the diagram,the lowest level of risk is obtained at the point M .on the ABcurve representing the unsystematic risk of the investor. Thus, adegree of diversification of investment is a necessary prerequi-site of portfolio management and for reducing the risk. Butbeyond the point M, the portfolio becomes unmanageable anddiseconomies operate as to increase risk rather than reduce it.In the management of a portfolio, the problem of riskmanageIl,1ent is vital. Given the individual preference ofportfolio holders, the portfolio is to be constructed in such amanner that it is exposed to the minimum risks which theowner can carry, subject to which the returns are to bemaximised. Although the market-related risks cannot bereduced, the company-related risks can be eliminated through aproper diversification. As shown in the above diagram, a properportfolio diversification into around 15 scrips of differentgroups of industries and companies would be able to reducethe company-related risks involved almost to a negligibleproportion. But these companies and industries should not beunduly related or interdependent or under the same umbrellaof industry groups or family of industrialists. An optimumdegree of diversification can be secured which would minimiserisk- and optimise return, if the covariance of scrips included inthe portfolio is less than 1 or negative.

Time Horizon of StrategyEvery investment strategy should have a time horizon from ashort period of one year to a few years. Capital gains is consid-ered long-term if equity investment at least one year and othertypes of investment for at least three years. If investment is tobe a\assessed every year, the past experience shows that theequity prices, reflected by the BSE Sensitive Index, may showvarying degrees of rise or fall per annum, but over a period of 3to 5 years, the market index invariably showed a rise of anythingabove the normal inflation rate per annum. So investmentstrategy should be for a medium time period of 3 to 5 years.Portfolio management encompasses three major categories ofactivities:.1. Asset allocation - type of assets to be chosen among fixed

income securities of the governed or private corporate units,preferred stock debentures or equities, etc., of variousgroups of industries.

2. Review and shifts as between classes of asset~ to takeadvantage of risk- return characteristics, or changes in them.

3. Security selection within each asset class such as choosing ahigher growth type of companies (blue chips).

Types of RiskThe risk is measured statistically by the degree of variance orstandard deviation of returns. There is also a risk involved intime period of holding (the longer the period, the greater therisk) called liquidity premium. The holding of security is subjectto the default risk in repayme!1t of principal called defaultpremium. The risks also arise due to interest rate variability,purchasing power changes, business default or financial failures.They can be named as interest rate risk, purchasing power risk,business risk, and financial risk, which are all part of systematicrisks which lead to a risk premium. These are to be rewarded bya higher return in the market than can be secured on risk-freeassets.The above is the market-related risk. Besides, there is alsogroup-related risk pertaining to a group of industries or firms.There is also a specific risk related to a company.As per the Markowitz model,3 the investors are generally risk-averse. To suit such investors, the portfolio has to be sodesigned as to maximise returns for a given level of risk. It istheoretically possible to identify an efficient portfolio, whichsatisfies the requirements of risk-return for an individualinvestor. This is possible through a detailed analysis ofinformation on each security in each of the asset classes in termsof expected risk (variance of return) and expected return, andcovarianceof each of the security with every other security. In simplelanguage, this efficient portfolio is a well-diversified portfoliocomprising many securities with a low covariance so that thedegree of risk is the lowest possible. Companies under differentindustry groups and different family managements and withdifferent characteristics are to be chosen in that portfolio.

Efficient PortfolioTo construct an efficient portfolio, we have to conceptualisevarious combina-tions of investments in a basket and designatethem as portfolios 1 to n. Then the expected returns from theseportfolios are to be worked out. The risk on these portfolios isto be estimated by measuring the standard deviation ofdifferent portfolio returns. To reduce the risk, investors have todiversify into a number of securities whose risk-return profilesvary.Thus, portfolios carry returns to compensate for interest risk(risk-free return) + a premium for purchasing power risk,market risk, business risk and financial risk. Some risks consti-tute unsystematic risks, which can be reduced or eliminated - bydiversification. Thus, for each individual security. and for acombination of securities represented by the basket in the BSESensitive Index or National Index, the expected returns andstandard deviations can be worked out. The expected return hasto be weighted by the probable chance of getting the returnthrough proper weights and the weighted average return shouldbe worked out.If we compare portfolio Nos. 4 and 5, we see that for the samestandard deviation of 5, portfolio No.5 gives an expected return


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of 11 % higher than that on No.4, thereby making it an efficientportfolio. If we compare portfolio NOs. 6 and 7, we see thatwith the same return of 12% in both the portfolios, standarddeviation is lower in portfolio No.6. Thus, portfolio No.6 is anefficient portfolio.These points can be depicted as in Fig. below. The expectedreturn is shown on the Y-axis and standard deviation measur-ing risk on the X-axis. The points connecting the expectedreturn with its standard deviation can be shown as AB graph,constituting the feasible opportunity set. The outermost pointon this graph is the most efficient portfolio, say, M on the ABgraph while the AB graph is called the efficient frontier. M is themost efficient combination for the individual under consider-ation (Ref. lnvestmmt Managenu:nt by Simha, Hemlata andBalakrishnan).The individual investor is generally risk-averse according to thewell-known author Markotwitz. His objectives are influenced bythe stage of life, his financial circumstances and psychologicalmakeup. A young investor may have, for example, a higher levelof tolerance of risk than a retired person or a middle-agedperson. The latter prefers a larger income with less risk. There isa trade-off between risk and return.According to the capital pricing model, efficient frontier isdefined as a risk -return trade-off curve. It is efficient because itprovides the maximum return at a given level of risk of theinvestor. The investor’s capacity to take risk sets the point ofoptimum efficiency on this curve, which is the best for him.Diversification of securities and assets in the portfolio reducesthe risk, provided their covariance is low and they are dissimilarin nature. The total risk is measured by the standard deviationof the return, and market risk by the concept of Beta. Betareflects that part of a portfolio’s return and variation in returnswhich is at-tributable to the overall movement of the marketrather than to any unique character tic of the company.

The efficient frontier of Markowitz and the use of Beta can begraphically represented as in Figs. AB is the capital market line,representing the market possibilities of risk and return (givenby the BSE Index). On the same graph, the efficient frontiercurve is drawn as EF. At point M, for the given risk of OR, thereturn is maximised for the investor at OC.In actual practice, Beta can be derived by the formula: Price ofScrip A (% age)/ Prices of scrips included in BSE Index (% age)- the relation of the individual scrip to that of the basket ofscrips as represented by the BSE Index. If Beta is 1 (slope is

45°), then, on an average, one percentage return on the marketbasket will be associated with a one percentage return on theindividual scrip. If Beta is greater than one it will give a largerreturn than the average market return. These high Beta scrips arevery volatile and risk is also high. On the other hand, if Beta isless than 1 (called defensive scrips), the risk is low and the returnis also lower than the market return. Depending on theinvestor’s choice, the Beta is to be selected and scrips with suchBeta should be held in the portfolio Fig. 44.5 depicts Beta as theangle made by the line of regression between market return andthe individual scrip return.

Market Efficiency TheoremSince the behaviour of the market is outside the control of theinvestor, he can only reduce the specific component of risk bychoosing the individual scrips with proper Betas to achieve theresult of diversification and lower the risk. The comparativerisks of alternative well-diversified portfolios can be measuredby their Betas. If the markets are efficient, the performance ofany portfolio would average out to that of the performance ofthe market and nobody can out perform the market.In the real world, there are three different levels of efficiency ofthe stock market, namely, the weak form, the semi-strong formand the strong form. These concepts -are useful in portfoliomanagement for investors, and are discussed in details in anearlier chapter.In the weak form, the successive changes in stock prices areindependent of each other and the historical market data arealready embodied in the existing price.In the semi-strong form, stock prices adjust rapidly to all newpublic informa-tion, both market and non-market data, andaction taken after the event will produce no more than randomresults.


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In the strong form, stock prices fully reflect not only publicinformation but privately-held information which may laterbecome public.If, in the real world, the market efficiency is of a strong fom1,then the performance of any basket of scrips in any portfolio isas good as any other and no individual investor can outperform the market. If however, the market efficiency is of aweak form, there is scope for selection of a portfolio which isoptimal for the investor in terms of risk and return and yet outperform the market by a proper choice of aggressive scrips withBetas suitable for the purpose.

DiversificationRisk in a portfolio can be reduced by a proper diversificationinto a number of scrips. The companies chosen should not betoo many or too few but of an optimum size as to be effi-ciently manageable. The economies of scale in managementapply to this analysis. It will be seen from Fig. 44.6 that thehigher the risk, higher is the return in till normal process. Therisk-return relationship is shown in the graph.

Depending upon the investor’s preferences and his in-comerequirements, the strategy of investment should be at A, B or Crespectively. Assuming that he takes some risk at B or C, thisrisk can be reduced so far as it concerns the specific companyrisk, but the market risk is out- X side the control of theportfolio manager. The risk can be reduced by a properdiversification of scrips invested. It is also possible to have acombination of A, B and C positions in a portfolio so as tohave a diversified risk- return pattern.In order In order that this diversification secures the results inan optimal manner, the number of scrips chosen should belimited to 12-15. As, Fig. shows, 91e risk is first reduced as thenumber of companies is increased but after a point, the riskagain increases due to the operation of diseconomies of scale.The risk can be lowered from OM to O~ by increasing thenumber of companies from 5 to 15, after which risk cannot belowered as the curve AB representing the unsystematic riskstarts going up again.

The optimum number of companies should be such that theyare of divergent qualities in tCffi1S of performance, product,lines, management, marketing, etc. Such a diversification onlycan secure reduction of risk :iiJ.d maximisation of rerums. Inthis process, a proper selection of scrips with, Betas ofaggressive nature (B > 1) and some with defensive nature (B <1) should be chosen, depending upon the individual preferencesof the investor. In the selection of these companies, all theprocesses e},:plained.The optimum number of companies should be such that theyare of divergent qualities in tCffi1S of performance, product,lines, management, marketing, etc. Such a diversification onlycan secure reduction of risk and maximisation of returns. Inthis process, a proper selection of scrips with, Betas of aggres-sive nature (B > 1) and some with defensive nature (B < 1)should be chosen, depending upon the individual pref-erencesof the investor. In the selection of these companies all theprocess explained above under portfolio management shouldbe followed and after analysis and assessment, investmentshould be made.

Portfolio ManagementPortfolio management is a process en-compassing manyactivities of investment in assets and securities. It is a dynamicand flexible concept and involves continuous and systematicanalysis, judgment and operations. The objective of this serviceis to help the novices and uninitiated investors with theexpertise of professionals in portfolio management. Firstly itinvolves construction of a portfolio based upon the fact sheetof the investor giving but his objectives, constraints, preferencesfor risk and return and his tax liability. Secondly, the portfolio isreviewed and adjusted from time-to-time in tune with themarket conditions. The adjustment is done through changes inthe weighting pattern of the securities and asset classes in theportfolio. The shifting of assets and securities will take advan-tage of changes in market’ conditions and in prices in thesecurities and assets in the portfolio. Thirdly, the evaluation ofportfolio performance is to be done by the manager in terms oftargets set for risk and return and changes in the portfolio are tobe affected to meet the changing conditions.


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Elements of Portfolio Management

1. Identification of the investors’ objectives, constraints andpreferences, which will help formulate the investment policy.

2. Strategies are to be developed and implemented in tunewith the invest-ment policy formulated. This will help theselection of asset classes and securities in each classdepending upon their risk-return attributes.

3. Review and monitoring of the performance of theportfolio by continuous overview of the market conditions,companies’ performance and investors’ circumstances.

4. Finally the evaluation of the portfolio for the results tocompare with the targets and needed adjustments have tobe made in the portfolio to the emerging conditions and tomake up for any shortfalls in achievement vis-a-vis targets.

The collection of data on the ,investors’ preferences, objectives,etc., is the foundation of portfolio management. This gives anidea of channels of investment in terms of asset classes to beselected and securities to be chosen based upon the liquidityrequirements, time horizon, taxes, asset preferences of inves-tors, etc. These are the building blocks for construction of aportfolio. According to these objectives and constraints, the investmentpolicy can be formulated. This policy will by down the weightsto be given to different asset classes of investment such asequity shares, preference shares, debentures, company depos-its,etc., and the proportion of funds to be invested in each classand selection of assets and securities in each class are made onthis basis. The next stage is to formulate the investmentstrategy for a time horizon for income and capital appre-ciationand for a level of risk tolerance. The investment strategiesdeveloped by the portfolio managers have to be correlated withtheir expectation of the capital market and the individual sectorsof industry. Then a particular combination of assets is chosenon the basis of investment strategy and manager’s expectationsof the market.

Execution of StrategyThe next stage, namely, implementation and execution of thisinvestment process, is the most critical process in the portfoliomanagement. Here the research, analysis and the judgments ofthe manager are very essential inputs in the process. Hisinitiative, innovation and judgments would be the basis of hissuccess in management. The performance of the portfolio isevaluated and adjustments are made in me portfolio composi-tion from time-to-time. This is called monitoring andrestructuring of portfolios for improving the performance tomake it optimal and efficient. The changes in investor’sconditions and in the market conditions and in industryperformance are taken into account in the portfolio adjust-ments.The portfolio thus constructed may relate to the needs of agiven level of income, a provision for contingencies and apreference for fixed income, etc.,. of the investor.Some investors would prefer assets like real estate, gold,debentures or bonds giving a fixed income while a few wouldprefer riskless investments in PSU bonds - short- term or long-term government securities, etc. Certain risk-takers may prefer

invest-ment in high-yielding growth stocks and ventureequities.

MonitoringMonitoring of the portfolios is a continuous upgrading andchanges in asset composition to take advantage of the marketconditions and economic and industry performance. Portfoliomonitoring is a continuous on-going assessment of the currentportfolio to the goals, changes in investors’ preferences, capitalmarket conditions and expectations. The monitoring requires aperiodic meeting with investors to know the changes in theconditions, continuous review of the investment policy relativeto investors’ preferences.

The current investment strategy reflects the capital marketconditions and expectations and any changes in them will bringout the changes in optimal conditions in the portfolio. Theportfolio is thus subjected to the ongoing review and assess-ment to change the composition of the portfolio in tune withthe change conditions in the market and of the investor.To give specific examples, if market conditions and theprospects of the cement industry are likely to be better in thecoming year, as judged by the Government policy changes vis-a-vis the steel industry, then the investor references can be bettersatisfied by shifting from steel shares to cement shares. Besides,within the cement industry, a manager may shift from a poorlyperforming company like Orient Cement to a better performingcompany like India Cement. Similarly, changes can take place asbetween different asset classes such as moving from debenturesto equities and vice versa or from income stocks to growthstocks, etc.Thus, portfolio changes can be brought about by the changes inmarket expectations and from the half yearly results or yearlyresult$ of the companies, industry and economy. Theseadjustments. of the portfolio may also be initiated due tochanges in the managers’ expectations off the company andmarket or asset classes. Certain changes in asset classes may havea time limit as a critical input. Thus, purchases and sales ofequity shares on the stock market arc to be well-timed .basedupon the assessment of the market technical position. Thisrequires technical analysis in addition to fundamental analysis.In fact, any shift of the investment from one type of asset toanother requires a careful analysis of time, risk-return and hostof other factors. .An important characteristic of the portfolio is risk reduction,which can be achieved by a diversification of the portfolio intothe various asset classes and securities within the asset class.


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Changes in security prices or market expectations of themanager may have necessitated changes in the asset composi-tion. The efficient frontier in terms of modern portfolio theorymay itself change the composition of the portfolio due to thechange in the Beta value in the longer time horizon. Thecomposition has to be changed to bring portfolio back to theoptimal conditions and back to the efficient frontier line.The investment alternatives for portfolio management are setout below:1. Asset Classesa. Equity - new issuesb. Equity - old issues’c. Preference sharesd. Debentures - convertible and non-convertible - new and old

issuese. PSU Bondsf. Government Securitiesg. Company deposits, etc.2. Industry Groupsa. Textilesb. Cementc. Aluminumd. Petrochemicalse. Fertilizersf. Paper, etc.3. High Income Yielding Securities; Blue chips and growth

stock. Regular dividend paying companies at a stable rate areincome yielding shares. The blue chips are not onlydividend paying regularly but their performance is above theaverage and the dividend distributions may increase overtime. The growth stocks arc shares with a large scope forcapital appreciation in addition to good dividends.

4. Companies with export orientation and those with onlydomestic demand.

5. Companies based on location as those in the west, south,east and north of India.

6. Type of management, viz., family type, professional type,etc.

Building of the PortfolioThe portfolio construction, as referred to earlier, is made on thebasis of the investment strategy, set out for each investor.Through ‘choice of asset classes, instruments of investmentsand the specific scrips, say of bonds or equities of different risksand return characteristics, the choice of tax characteristics, risklevel and other features of investments, are decided upon. Theconstruction of Portfolio and other elements in the portfoliomanagement are already set out in Fig..

Portfolio RevisionAfter fixing the target Beta and duration of the portfolio, theinvestment activity starts with the selection of Scrips andBonds, etc. Bur the portfolio once constructed undergoeschanges due to changes in market prices and a reassessment ofcompanies and the portfolio Beta and the proportion in each

asset class will change to bring back the portfolio to the targetedlevel of Beta and duration. portfolio revision will take place andcomposition of portfolio will change. A change in interest ratewill also affect the portfolio through change in duration.Constant market changes necessitate readjustment of portfolioleading to purchases and sales of equities, bonds etc., which inturn will result in change in Beta and duration.Thus, any portfolio requires constant monitoring and revision.Operatior1s on a portfolio will thus take place on a daily basis,keeping in mind, the targeted Beta, duration and return. .Changes in investor’s financial status, his preferences and marketconditions, will also require changes in portfolio composition.The next stage is performance evaluation which is referred tolater. Before we discuss evaluation, it is necessary to set outsome Theoretical tools like security analysis, Markotwitz model,risk-return evaluation ‘etc. These are referred to below, briefly,although they were set out in detail, in earlier Chapters.

Security Pricing and Portfolio ManagementPortfolio Management is based upon Security Analysis which isan Analysis of Share prices.(1) Analysis at Macro Level (2) Analysis at Macro Level of Market of Company

Markowitz Model of Portfolio TheoryThis Portfolio Model is based on the exposure to market riskand the degree of diversification of the portfolio. ‘The Beta ofthe portfolio provides a measure of exposure to market riskand the coefficient of determination, namely, R2 provides ameasure of diversification.Cross sectional measures are used for risk estimates forindividual holdings, that comprise the portfolio, The individualScrips in the portfolio have their own Betas, which are weightedby the proportion of the funds invested in each.

Depending on the risk preference of the investor, weights canbe changed to get the desired portfolio Beta to less than 1.1 ormore than 1.1 (got in the above Table).In the same way, the portfolio R2 or R can be calculated andcompared with the market return and its R2 or R. The standard


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deviation for the portfolio can be compared with that of theMarket Index return and its R to ensure that its R is suitable tothe investors risk preferences.William Sharpe has suggested a new model. Instead ofcomparing the risk of each Scrip to every other Scrip, it can becompared with market risk, which leads to the comparison ofmarket return to Scrip Return. He takes into account only thesystematic Risk on the Portfolio (Beta).

Ri = α + β I + cα is the intercept of the straight line.β is slope of the straight line or β co-efficient.I is expected return on Market Index, and e is the Randomcomponent. The sharpe Index method has given us twocomponents of Risk.Systematic Risk = B2 x Variance of Index.

= β2 O2

Unsystematic Risk = Total Variance of a PortfolioSecurity Return – Systematic Risk = e2

= β2 O2 + e2

Total Risk of Market = Systematic Risk covered by Beta andUnsystematic Risk covered by diversification.

Risk AnalysisWhile the risks of fixed interest securities cm be known as theyarc rated by agencies like lCRA and Crisil, the risk on equitiescannot be assessed and has to be borne by the investor. The riskon equities is more than on bonds, debentures or fixeddeposits and not amenable to scientific measurement as that isthe residual risk of the firm. These risks may be due toinflation, interest rate changes, financial risk, business risk,market risk, liquidity risks, and other risks. Some of them relateto the market and economy and hence not controllable whilethe others are company specific in nature, which can be con-trolled and reduced by diversification. Thus, investment inmore than one company and industry is necessary for reducingrisks. Investment in too many companies, may not be desirablebut investment in two companies in steel industry is not havingthe same risks as invesffi1ent in one Steel Company and onedrug company. Risk concepts and related aspects are dealt withalready in another chapter.

Evaluation of Portfolio PerformanceInvestment analysts and Portfolio Managers continuouslymonitor and evaluate the results of their performance. Therevision of portfolio investments is conducted on the basis ofsuch monitoring and evaluation. The ability of Managers to ourperform the market depends on their expertise and experience.The basic features of good Portfolio Managers are their abilityto perceive the market n-ends correctly and make correctexpectations and estimates regarding risk, returns, ability tomake proper diversification, to reduce the company related riskand use proper Beta estimates for selection of securities toreduce the systematic risk. In such case, it is possible for anexpert Portfolio Manager to show superior performance overthe market. This performance also depends on the timing ofinvestments and superior investment analysis and securityselection. He has to have the acumen to select the under valued

shares under each risk class, for which a high degree of equityresearch is needed.The two major factors which influence his performance are thereturn achieved and the level of risk that the portfolio isexposed to. The Manager has to make proper diversificationinto different industries, asset classes and instruments so as toreduce the unsystematic risk to the minimum for a given levelof return. The market related risk has to be managed by aproper selection of Beta for the securities.

Criteria for Evaluation of PortfolioPortfolio managers and investors who manage their ownportfolios continu-ously monitor and review the performanceof the portfolio. The evaluation of each portfolio, followed byrevision and reconstruction are all steps in the portfolioManagement.Managers and Analysts ‘wish to know how they performed intheir investment strategies in terms of return per unit of risk ,both in absolute terms and relative terms relative to overallmarket performance. They have to assess the extent to whichthe objectives aimed at are being achieved say in terms ofincome, capital appreciation.In this context, evaluation has to take into account whether theportfolio secured above average returns, average or belowaverage, as compared to the market return. The ability todiversify with a view to reduce and even eliminate all unsystem-atic risk and expertise in managing the systematic risk related tothe market by use of appropriate risk measures, namely, Betas.Selection of proper securities is thus the first requirement.Superior timing and superior stock selection may result in aboveaverage return. Diversification in terms of Markowitz model orSharpe’s Single Index Model will reduce the market related riskand maximise the returns for a given level of risk. Marketreturns being related positively to risk, evaluation has to takeinto account:1. Rate of returns, or excess return over risk free rate.2. Level of Risk both Systematic (Beta) and Unsystematic and

residual risks through proper diversification.Under the Traditional theory, the evaluation is only in terms ofthe rate of return, particularly in comparison with other assetsof the same risk class. The theory of Markowitz and ModernPortfolio Theory have opened up the avenue for selecting andevaluating the portfolios on the basis of risk adjusted return.Modern portfolio theory has postulated that the portfolioselection and evaluation should be on the basis of both Riskand Return-and the objective should be to optimise the returnfor a given level of risk or t6 minimise the risk for a given levelof return. Due to uneven fluctuations of return and highdegree of variability of returns, risk adjusted returns becomethe basis for evaluation. This is possible due to later develop-ments involving the quantification of risk by the statisticalmeasures of S.D., variance and covariance pf returns ofsecurities in a portfolio.There was no composite index, which measures both returnand risk under the Traditional Theory. In Modern PortfolioTheory it became necessary to develop some compositemeasures of both return and risk in portfolio performance, asthe objective now is maximisation of return and minimisationof risk. Because of the trade-off between them, simple


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maximisation of returns or single goal of minimisation or riskwill be defeating the objectives of Modern Portfolio Manage-ment.It was in this context that later researches have tried to evolve acomposite index to measure risk based returns taking intoaccount the different components of risk, viz., systematic,unsystematic and residual risk. The credit for evolving thesecriteria goes to Sharpe, Treynor and Jensen.Where ST is Sharpe index when, Rt is average return onportfolio, Rf is risk free return, O is the total risk of theportfolio.It measures total! risk by standard deviation. Reward is in thenumerator as risk premium. Total risk is in the denominator asstandard deviation of its return. We get a measure ofportfolio’s total risk and variability of returns in relation to therisk premium which is the product of the portfolio Manager’sexpertise.The method adopted by Sharpe is to rank all portfolios on thebasis of evaluation measure ST. If one portfolio has more STthan another, the first one is better performer as per theSharpe’s measure. Take the following example:

Portfolio Management Construction Revison andevaluation

Treynor’s MeasureIn treynor’s measure the risk measure of standard devationnamely, total risk of the portfolio is replaced by market risk,measured by beta, which is not diversification the equation canbe set our as

Tn = Treynor’s measure of evaluationRn = Return on the portfolio, Rf =Risk free rate,Bn is beta ofthe portfolio as measure of systematic riskTreynor based his formula on the concept of characteristic line.this line is the least squires regression line relating the return to

the risk and Beta is the slope of the line. the regression linetakes the form ofRp =a+bx+eRp = is the return of portfoiloa is the intercept reflecting the risk free return.B is the slope of the line and is the market return and e is theerror term.Thus concept can be graphically represented as follows.Based on this characteristic line Treynor formula is

Take a Problem as an examplePortfolio Return Bn R f

A 20 0.5 10B 24 1.0 10

Portfolio A performs better than portfolio B as Tn A> TnB.The numerator in Treynor’s formula is the reward measured bybeta coefficient.The difference between Sharpe measure and Treynor measure isthe followingSharpe neither takes the total risk of portfolio in to accountwhile Trey nor considers only systematic risk as relevant toperfomance. Total risk consists of both systematic and unsys-tematic risk, while the later is amenable to reduction bymanagement of proper diversification the former cannot beelimated but borne by the investor The higher this market riskone takes the higher is the return If diversification is perfect andunsystematic risk is nil or negligible then the only elements ofrisk in both the portfolio measurement is the systematicvarience. The ranking of portfolios on the basis of both themeasure therefore should give identical results But it is possiblethat these two measure in practice give varying results due todifference in the investment strategies and diversificationtechniques.

ProblemsExample on Evaluation of portfolio performanceThe Measure of sharpen performance evaluation may becollected from the following data.


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Three Portfolios of the securities

A comparison of the two measure namely, Treynor’s andSharpe performance Evaluation is made in the above example.

ConclusionBy Treynor’s measure the portfolios Ais better as it has a higherrank of 3.00 than that of B(0.1) by Sharpe index measure alsothe same conclusion is arrived namely portfolio A is better thanB as the former got a rank higher than the latter

Jenson/s MeasureJensen measure of the performance of portfolio is differentfrom that of Sharpe and Trey nor in that he latter provides ameasure of ranking the relative performance of variousportfolios on a risk adjusted basis while the former gives ameasure of absolute performance on a risk adjusted basis Thisstranded based on CAPM measure the portfolio Mangerpredictive ability to achieve higher return then expected for thegiven riskiness.

Jensen’s Model

RJt- Rft = αj+βj (R mt -Rft)Rjt =Avarge return on portfoilo Jfor periodRft = Risk free rate of return for periodαj = Intercept of the graph measuring the forecasting ability ofthe ManagerB = Systematic risk measureRmt =Average return on the market portfolio for period t.it is possible that αj =0,. Which is natural performance on thesame as that of market.α>o, it is superior performance over the marketαj < o it is inferior performanceThe Jenson approach can be illustrated by an example.


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25907502 portfolio evaluation

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