Portfolio Revision and Evaluation
Portfolio Revision and Evaluation
Portfolio Revision and Evaluation
PORTFOLIO REVISION
AND
RECONSTRUCTION
To align the portfolio in accordance with the investment policy statement and investment strategy
Rebalancing
Rebalancing can cause the portfolio manager to sell shares even if they are not doing poorly
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
Portfolio managers:
Should be careful about making unnecessary trades Must pay attention to their experience, intuition, and professional judgment
An experienced portfolio manager worried about a particular holding should probably make a change
8
Sp
RP RF
Example
Risk-free rate 3% 7% 5% 5%
Risk
10 5 SA 1.67 3
12 5 SB 1 7
Thus based on Sharpe ratio portfolio A has performed better than portfolio B
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
Treynors Ratio
Defined as the ratio of excess returns of the portfolio over the risk free rate to the beta of the portfolio.
TP
RP RF
Given the risk free rate is 3%. Rank the performance using Sharpe and Treynors ratio. Assume C to be a market portfolio
Fund
return
SD
beta
A
B C D
14
12 16 10
6
4 3 6
1.5
0.5 1 0.5
20
10
Fund A B
return 14 12
SD 6 4
Rank 3 2
Rank 5 1
C
D E
16
10 20
3
6 10
1
0.5 2
4.33
1.17 1.70
1
5 4
13.0
14.0 8.5
3
2 4
Jensens Alpha
Rp ( RF ( RM RF )
Average return of the portfolio over and above that predicted by CAPM
Given the risk free rate is 5% and RM= 10%. Rank the performance Jensens alpha. Assume C to be a market portfolio
Fund A B C D E
return 14 12 16 10 20
SD 6 4 3 6 10
Famas Decomposition
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%.
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%. So obviously this portfolio would lie above the SML.
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.
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
2 *10 15
1.22
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
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.