portfolio revision and evaluation

7/30/2019 Portfolio Revision and Evaluation

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Portfolio revision, reconstruction and

Evaluation

Himanshu Puri

Faculty

DIAS


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PORTFOLIO REVISIONAND

RECONSTRUCTION


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Why Portfolio Revision?

To align the portfolio in accordance with the investment policy

statement and investment strategy

The needs of the beneficiary will change

The relative merits of the portfolio components will change


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Rebalancing

Rebalancing can cause the portfolio manager to

sell shares even if they are not doing poorly

Profit taking with winners is a logical

consequence of portfolio rebalancing

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Upgrading

Investors should sell shares when their

investment potential has deteriorated to the

extent that they no longer merit a place in the

portfolio

It is difficult to take a loss, but it is worse to let

the losses grow

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Change in Client Objectives

The clients investment objectives may change

occasionally:

E.g., a church needs to generate funds for a

renovation and changes the objective for the fund

from growth of income to income

Reduce the equity component of the portfolio

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Change in Market Conditions

Many fund managers seek to actively time the

market

When a portfolio managers outlook becomes

bearish, he may reduce his equity holdings

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Portfolio managers:

Should be careful about making unnecessarytrades

Must pay attention to their experience, intuition,and professional judgment

An experienced portfolio manager worriedabout a particular holding should probablymake a change

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Risk-Adjusted Measures of Portfolio Performance

Sharpes Ratio

p

FPp

RRS

Defined as the ratio of excess returns earned over the risk

free rate to the risk of the portfolio.


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Example

Portfolio Return Risk

Risk-free

rate

A 10% 3% 5%

B 12% 7% 5%

67.13

510

AS

17

512

BS

Thus based on Sharpe ratio portfolio A has performed better than

portfolio B


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So what it does it mean to an investor?

For the investor it means that subject to the returns, variance,

co-variances of the securities of the portfolios remaining

constant, portfolio A is better then portfolio B


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Treynors Ratio

Defined as the ratio of excess returns of the portfolio over the

risk free rate to the beta of the portfolio.

P

FPP

RRT


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Fund return SD beta

A 14 6 1.5

B 12 4 0.5

C 16 3 1

D 10 6 0.5

E 20 10 2

Given the risk free rate is 3%. Rank the performance using Sharpe and Treynors

ratio. Assume C to be a market portfolio


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Fund return SD beta Sharpe Rank Treynor Rank

A 14 6 1.5 1.83 3 7.3 5

B 12 4 0.5 2.25 2 18.0 1

C 16 3 1 4.33 1 13.0 3

D 10 6 0.5 1.17 5 14.0 2

E 20 10 2 1.70 4 8.5 4


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Jensens Alpha

)(( FMFp RRRR

Average return of the portfolio over and above that predicted by CAPM


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Fund return SD beta

A 14 6 1.5

B 12 4 0.5

C 16 3 1

D 10 6 0.5

E 20 10 2

Given the risk free rate is 5% and RM= 10%. Rank the performance Jensens alpha.

Assume C to be a market portfolio

A = .14 {.05+1.5(.10-.05)} = 1.5%


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The above measures help in measuring and comparing the performance on risk adjusted

basis between portfolio managers.

Fama went a step further to break the performance into smaller components.

Assume a fund manager has given a return of 14% with a total risk of 15(%)2. The beta of

fund managers portfolio is 0.5. Given the risk free-rate is 5% and the market risk

premium is 6%.

So obviously this portfolio would lie above the SML.

However a security with a beta of 0.5 should be giving a return of 8%. So the portfolio

manager has given an excess return of 6%.

Famas Decomposition


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Now if the fund manager is getting higher return than the expected return, then it can

only be earned by taking higher risk.

Now since the beta is same so the risk that the manager takes is the unsystematic risk.

Thus the excess return is due to higher unsystematic risk assumed by the fund manager.

Now this only gives us the information that that he has taken a higher risk to get higher

return and tells us nothing about his skill.


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Now we compare this portfolio with a portfolio which has similar total risk as this

portfolio and lies on the SML.

Since on SML the only risk that would be present would be the systematic risk so its

total risk would be equal to systematic risk.

If total risk of the market portfolio is 10(%)2 , then the beta for a portfolio which has

similar total risk as the fund managers portfolio is

1510*2 22.1

The return for this portfolio is =5+1.22*6=12.34%


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Thus the return being earned by the fund manager bearing the same total risk is 14%

as compared to a return of 12.34% on the SML

The difference i.e. 14%-12.34%=1.66% is due to fund managers skill.

So out of 6% excess return over the similar beta portfolio, 1.66% is due to fund managers

skill and the rest (4.34%) is the return since he is bearing a taking a higher unsystematic

risk.

1.66% return earned here is the return due to selection skills of the portfolio manager

and is called return due to net selectivity while the total 6% earned is called the return

from total selectivity. The difference between the two is called the return from

diversification.

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