Portfolio Management Lecture Notes for MBA

Portfolio Management

1. Unit – V Portfolio Management

2. INTRODUCTION

3. What is mean by Portfolio? A grouping of financial assets such as stocks, bonds and cash equivalents , as well as their mutual, exchange-traded and closed-fund counterparts. Or Portfolio is a combination of securities such as stocks, bonds and cash. Portfolios are held  directly by investors and/or managed by financial professionals .

4. Define 'Portfolio Management‘. A Portfolio Management refers to the science of analyzing the strengths, weaknesses, opportunities and threats for performing wide range of activities related to the one’s portfolio for maximizing the return at a given risk . It helps in making selection of Debt Vs Equity, Growth Vs Safety, and various other tradeoffs.

5. elements of Portfolio Management Portfolio management is an on-going involving the following basic tasks. Identifications of the investor objectives Strategies to be developed and implemented Review and monitoring of the performance of the portfolio Finally, the evaluation of the portfolio

6. PORTFOLIO ANALYSIS

7. What is meant by Portfolio Analysis?   Portfolio analysis is a systematic way to analyze the products and services that make up an association's business portfolio. The analysis seeks to understand the risks associated with the current composition of the portfolio and identify ways to mitigate the identified risks.

8. Steps involved in Portfolio Analysis Determining the objectives Formulation of Investment Strategy Execution of Strategy Monitoring Revision Evaluation

9. PORTFOLIO CONSTRUCTION

10. introduction Commonly, there are two approaches in the construction of the portfolio of securities viz. Traditional approach and Modern approach

11. Traditional approach In the traditional approach, investor's needs in terms of income and capital appreciation are evaluated and appropriate securities are selected. It deals with two major decisions. They are: Determining the objectives of the portfolio. Selection of securities to be included in the portfolio .

12. 1. Analysis of Constraints The constraints normally discussed are:   Regular Income Capital Appreciation Liquidity Safety of the investment Minimize the tax liability

13. 2. Determination of Objectives The return that the investor requires and the degree of risk he is willing to take depend upon the constraints. The objectives of portfolio range from income to capital appreciation . The common objectives are stated below,   Current Income Growth in Income Capital Appreciation Preservation of capital

14. PORTFOLIO SELECTION

15. 3. Selection of Portfolio   The selection of portfolio depends on the various objectives of the investors. The selections of portfolio under different objectives are dealt subsequently. Objectives and asset Mix Growth of income and asset mix Capital appreciation and asset mix Safety appreciation and asset mix Safety of principal and asset mix

16. 4. Assessment of Risk and return The traditional approach to portfolio building has some basic assumptions. First, the individual prefers larger to smaller returns from securities. To achieve this goal, the investor has to take more risk. The risks are namely interest rate risk, purchasing power risk, financial risk and market risk.

17. 5. Diversification   Once the asset mix is determined and the risk and return are analyzed, the final step is diversification of portfolio. Financial risk can be minimized by commitments to top-quality bonds, but these securities offer poor resistance to inflation. According to the investor's need for income and risk tolerance level portfolio is diversified .

18. Forms of the Diversification Diversification into different types of the assets Diversification into different Instruments Diversification into different Industry Lines Diversification into different companies at different growth levels

19. CAPITAL ASSET PRICING MODEL (CAPM)

20. introduction It is one of the most important contributions in finance and arguably the most widely used. According to the model, expected stock returns are determined by their corresponding level of systematic risk BETA.   Markowitz, William Sharp, John Lintner and Jan Mossin provided the basic structure for the CAPM model.

21. Meaning A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

22. Assumptions of CAPM Market efficiency Risk aversion and mean-variance optimization Homogeneous Risk – Free rate There is no transaction cost i.e. no cost involved in buying and selling of stocks.

23. ConT…. Assets are infinitely divisible. i.e. the investor can even buy ten rupees worth of Reliance Industry shares. There is no personal income tax. Unlimited quantum of short sales is allowed . Any amount of shares an individual can sell short .

24. Capital Market Line (CML) The CML represents linear relationship between the required rates of return for efficient portfolios and their standard deviations .

25. CONT… The line RS represents all possible combination of riskless and risky asset . The 'S' portfolio does not represent any riskless asset but the line RS f gives the combination of both . The portfolio along the path R f S called lending portfolio that is some money is invested in the riskless asset or may be deposited in the bank for a fixed rate of interest.

26. CONT… If it crosses the point S, it becomes borrowing portfolio . Money is borrowed and invested in the risky asset. The straight line is called capital market line (CML). It gives the desirable set of investment opportunities between risk free and risky investments.

27. Security Market Line (SML) The risk-return relationship of an efficient portfolio is measured by the capital market line. But, it does not show the risk-return trade off for other portfolios and individual securities. Inefficient portfolios lie below the capital market line and the risk-return relationship cannot be established with the help of the capital market line.

28. CONT… Unsystematic risk can be diversified and it is not related to the market. If the unsystematic risk is eliminated, then the matter of concern is systematic risk alone. This systematic risk could be measured by beta . The beta analysis is useful for individual securities and portfolios whether efficient or inefficient.

29. Limitations of CAPM Model CAPM has the following limitations. They are, It is based on unrealistic limitations It is difficult to test the validity of CAPM Betas do not remain stable over time.

30. MARKOWITZ MODEL Harry M. Markowitz is credited with introducing new concepts of risk measurement and their application to the selection of portfolios. He started with the idea of risk aversion’ of average investors and their desire to maximize the expected return with the least risk .

31. Cont… Markowitz model is thus a theoretical framework for analysis of risk and return and their inter-relationships. He used the statistical analysis for measurement of risk and mathematical programming for selection of assets in a portfolio in an efficient manner . His framework led to the concept of efficient portfolios.

32. Cont… An efficient portfolio is expected to yield the highest return for a given level of risk or lowest risk for a given level of return. Markowitz generated a number of portfolios within a given amount of money or wealth and given preferences of investors for risk and return. Markowitz emphasized that quality of a portfolio will be different from the quality of individual assets within it.

33. ASSUMPTIONS OF MARKOWITZ THEORY  The Modern Portfolio Theory of Markowitz is based on the following assumptions: Investors are rational and behave in a manner as to maximize their utility with a given level of income or money. Investors have free access to fair and correct information on the returns and risk.

34. Cont…. The markets are efficient and absorb the information quickly and perfectly. Investors are risk averse and try to minimize the risk and maximize return. Investors base decisions on expected returns and variance or standard deviation of these returns from the mean. Investors prefer higher returns to lower returns for a given level of risk.

35. Markowitz Diversification Markowitz postulated that diversification should not only aim at reducing the risk of a security by reducing its variability or standard deviation. Markowitz theory of portfolio diversification attaches importance to standard deviation, to reduce it to zero, so that the overall risk of the portfolio as a whole is nil or negligible.

36. Parameters of Markowitz Diversification Markowitz has set out guidelines for diversification on the basis of the attitude of investors towards risk and return and on a proper quantification of risk. The investments have different types of risk characteristics, some caused systematic and unsystematic or company related risks. It involves a proper number of securities, not too few or not too many which have no correlation or negative correlation.

37. CONT… For building up the efficient set of portfolio, as laid down by Markowitz.., we need to look into these important parameters. Expected return. Variability of returns as measured by standard deviation from the mean. Covariance or variance of one asset return to other asset returns. In general the higher the expected return, the lower is the standard deviation or variance and lower is the correlation the better will be the security for investor choice.

38. 'Efficient Frontier' A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not provide enough return for the level of risk.

39. WHAT IS MEANT BY UTILITY ANALYSIS? Utility is the satisfaction the investor enjoys from the portfolio return. An ordinary investor is assumed to receive greater utility from higher return and vice-versa. The investor gets more satisfaction or more utility in X + 1 rupees than from X rupee. Thus, utility increases with increase in return.

40. PORTFOLIO REVISION

41. What is meant by Portfolio Revision? The portfolio management process needs frequent changes in the composition of stocks and bonds. In securities, the type of securities to be held should be revised according to the portfolio theory. If the policy of investor shifts from earnings to capital appreciation, the stocks should be revised accordingly.

42. methods used for Portfolio Revision Passive Management Active management The formula plans Rupee cost averaging Constant Rupee Plan Constant Ratio Plan Variable Ratio Plan

43. Constraints in Portfolio Revision There are so many constraints disturbing the process of portfolio revision. Some of such constraints are described below. Transaction Cost Income Tax Time Consuming

44. Strategies for Portfolio Revision Generally, different strategies are adopted for portfolio revision. They are   Active Revision Strategy   Passive Revision Strategy

45. SWAPS   Swap is a contract between two parties to exchange a set of cash flows over a pre- determined period of time . The two parties are known as counter parties. The agreement means that A has sold stocks and bought bonds while B has sold bonds and bought stocks.

46. Cont… Here, they have restricted their portfolios without the transaction costs, even though they have to pay the swap fee to the swap bank that set up the contract between two parties.

47. MUTUAL FUNDS

48. What is meant by Mutual funds?   Mutual fund is a vehicle that pools together funds from investors to purchase stocks, bonds or other securities. An investor can participate in the mutual fund by buying the units of the fund.

49. Cont… Mutual funds are investment companies that use the funds from investors to invest in other companies or investment alternatives. They have the advantage of professional management, diversification.

50. Classification of mutual fund schemes Open ended Funds Close – Ended Funds Interval Funds

51. PORTFOLIO EVALUATION

52. introduction Portfolio manager evaluates his portfolio performance and identifies the sources of strength and weakness. The evaluation of portfolio provides a feedback about the performance to evolve better management strategy. Even though evaluation of portfolio performance is considered to be the last stage of investment process, it is a continuous process. The managed portfolios are commonly known as Mutual funds.

53. Meaning Investment analysts and portfolio managers continuously monitor and evaluate the results of their performance. The revision of portfolio investments is made on the basis of such monitoring and evaluation .

54. Cont…. Portfolio Managers should have the ability to Perceive the market trends correctly and make correct expectations and estimates regarding risk, returns, Ability to make proper diversification to reduce the company related risk and Use proper Beta estimates for selection of securities to reduce the systematic risk.

55. Cont… While evaluating the performance, he has to consider two major factors such as return achieved and the level of risk that the portfolio is exposed to . The Manager has to make proper diversification into different industries, asset classes and instruments in order to reduce the unsystematic risk.

56. models used for Portfolio Evaluation Sharpe and Jack Treynor haiove proposed the methods of measuring the reward per unit of risk in their pioneering work on evaluation of portfolio performance. There are three ratios will use for evaluation of the Portfolio Performance. They are, Sharpe Ratio Treynor Ratio Jensen Measure

57. SHARPE’S PERFORMANCE INDEX The performance measure developed by William Sharpe is known as the Sharpe ratio. It is also known as the reward to variability ratio. Sharpe’s performance index gives a single value to be used for the performance ranking of various funds or portfolios. Sharpe index measures the excess return earned on a portfolio per unit of its total risk.

58. Cont….. The Sharpe measure is similar to the Treynor measure except that it employs standard deviation, not beta, as the measure of risk. The formula for calculating Sharpe ratio is as follows: Portfolio average return – Risk free rate of interest Sharpe Index = ----------------------------------------- ---------------------------- Standard deviation of the portfolio return R p - R f S t = -------------- σ p

59. TREYNOR’S PERFORMANCE INDEX The performance measure developed by Jack Treynor is called as Treynor ratio. According to this Systematic Risk or Beta is the appropriate measure of Risk. This relates the excess return on a portfolio to the portfolio beta.

60. Cont…. Beta co-efficient is treated as a measure of undiversifiable systematic risk. The formula is, Portfolio average return – Risk free rate of interest Sharpe Index = ----------------------------------------- Beta co-efficient of portfolio R p - R f S t = -------------- β p

61. JENSEN’S PERFORMANCE INDEX Another type of risk adjusted performance measure has been developed by Michael Jensen , Which is known as the Jensen measure or ratio. This ratio attempts to measure the difference between the actual return earned on a portfolio and the return expected from the portfolio given its level of risk.

62. Cont…. The basic model of Jensen is given below R p = ά + β (R m - R f )

63. Unit- V Completed

64. The End