Portfolio Evaluation and Revision

Portfolio Revision

• The process of addition of more assets in an existing portfolio or changing

the ratio of funds invested is called as portfolio revision.
• The sale and purchase of assets in an existing portfolio over a certain period
of time to maximize returns and minimize risk is called as Portfolio revision.
 Need for Portfolio Revision

 An individual at certain point of time might feel the need to invest more.
 The need for portfolio revision arises when an individual has some additional
money to invest.
 Change in investment goal also gives rise to revision in portfolio.
 Depending on the cash flow, an individual can modify his financial goal, eventually
giving rise to changes in the portfolio i.e. portfolio revision.
 Financial market is subject to risks and uncertainty. An individual might sell off some
of his assets owing to fluctuations in the financial market.
 Portfolio Revision Strategies
Active Revision Strategy
 Active Revision Strategy involves frequent changes in an existing portfolio over a
certain period of time for maximum returns and minimum risks.
 Active Revision Strategy helps a portfolio manager to sell and purchase securities
on a regular basis for portfolio revision.
 
Passive Revision Strategy
 Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules.
 These predefined rules are known as formula plans.
 According to passive revision strategy a portfolio manager can bring changes in the
portfolio as per the formula plans only
 Portfolio Performance Evaluation
• Evaluation of the performance measurement is necessary for investors and portfolio managers
both. However, the need for evaluating may be different for these two sets of people.

• Performance evaluation also shows the areas of effectiveness as well as improvements in the
investment scheme.

• Some of the benefits for evaluating the portfolio performance:

 The return performance of the investment over time (performance measurement)

 How the observed performance is attained (performance attribution)

 If the performance is due to investment decisions (performance appraisal)

 Portfolio Performance Evaluation
 The portfolio performance evaluation involves the determination of how a managed
portfolio has performed relative to some comparison benchmark.
 Performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods.
 The most widely used conventional methods include benchmark comparison and style
comparison.
 The risk-adjusted methods adjust returns in order to take account of differences in risk
levels between the managed portfolio and the benchmark portfolio.
 The major methods are the Sharpe ratio, Treynor ratio, Jensen’s Alpha, Modigliani and
Modigliani, and Treynor Squared.
 The risk-adjusted methods are preferred to the conventional methods.
 The portfolio performance evaluation primarily refers to the determination of how a
particular investment portfolio has performed relative to some comparison benchmark.
 The evaluation can indicate the extent to which the portfolio has outperformed or under-
performed, or whether it has performed at par with the benchmark.
 Portfolio Performance Evaluation - Objectives
 The investor, whose funds have been invested in the portfolio, needs to know the
relative performance of the portfolio.
 The performance review must generate and provide information that will help the
investor to assess any need for rebalancing of his investments.
 The management of the portfolio needs this information to evaluate the
performance of the manager of the portfolio and to determine the manager’s
compensation, if that is tied to the portfolio performance.
 The performance evaluation methods generally fall into two categories, namely
conventional and risk-adjusted methods.
 Risk Adjusted Methods of Performance Evaluation
• A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into
account the degree of risk that must be accepted in order to achieve it.
• The risk is measured in comparison to that of a virtually risk-free investment; usually Government
Securities.
• Depending on the method used, the risk calculation is expressed as a number or a rating. Risk-
adjusted returns are applied to individual stocks, investment funds, and entire portfolio
 A risk-adjusted return measures an investment's return after taking into account the degree of risk that
was taken to achieve it.

 In any case, the purpose of risk-adjusted return is to help investors determine whether the risk taken
was worth the expected reward.

• The risk-adjusted return measures the profit your investment has made relative to the amount of risk
the investment has represented throughout a given period of time.

• If two or more investments delivered the same return over a given time period, the one that has the
lowest risk will have a better risk-adjusted return.
 Sharpe Ratio
 The Sharpe Ratio measures the profit of an investment that exceeds the risk-free rate, per unit of
standard deviation.
 It is calculated by taking the return of the investment, subtracting the risk-free rate, and dividing this
result by the investment's standard deviation.
 All else equal, a higher Sharpe ratio is better.
 The standard deviation shows the volatility of an investment's returns relative to its average return,
with greater standard deviations reflecting wider returns, and narrower standard deviations implying
more concentrated returns.
 The risk-free rate used is the yield on a no-risk investment, such as a Treasury bond (T-bond), for the
relevant period of time.
 Sharpe Ratio Example
For example, say Mutual Fund A returned 12% over the past year and had a standard deviation of 10%,
Mutual Fund B returns 10% and had a standard deviation of 7%, and the risk-free rate over the time
period was 3%. The Sharpe ratios would be calculated as follows:

 Mutual Fund A: (12% - 3%) / 10% = 0.9

 Mutual Fund B: (10% - 3%) / 7% = 1

Even though Mutual Fund A had a higher return, Mutual Fund B had a higher risk-adjusted return,
meaning that it gained more per unit of total risk than Mutual Fund A.
 Treynor Ratio
The Treynor Ratio is calculated the same way as the Sharpe ratio, but uses the investment's beta in the
denominator. As is the case with the Sharpe, a higher Treynor ratio is better.

Using the previous fund example, and assuming that each of the funds has a beta of 0.75, the
calculations are as follows:

 Mutual Fund A: (12% - 3%) / 0.75 = 0.12

 Mutual Fund B: (10% - 3%) / 0.75 = 0.09

Here, Mutual Fund A has a higher Treynor ratio, meaning that the fund is earning more return per unit
of systematic risk than Fund B.
 Modigliani-Modigliani measure, Treynor Squared

• Modigliani-Modigliani measure, also known as the M2 measure, is used to derive

the risk-adjusted return of an investment.
• It shows the return on an investment adjusted for risk in comparison to a
benchmark. It is shown as units of percentage return.
• Treynor Square ratio is the difference between expected return of market portfolio,
and the expected return of portfolio with the same beta (1) as the market portfolio.
 Jenson Alpha
• This measure calculates the difference between the actual return of the market return.

• Market return can be computed by CAPM:

 Information Ratio
• Let’s say we want to compare our portfolio against a benchmark such as Russell 1000, FTSE 100, SNP
500 and so on, then we can compute the information ratio.

• Information ratio is also known as the appraisal ratio because it helps us understand the amount of risk
taken to achieve the excess return over the benchmark portfolio:

• Volatility is calculated by computing the standard deviation

 Portfolio Expected Return
Example :
• A portfolio holds the assets together and a weight is assigned to each asset. As an instance, the
portfolio might hold 40% of asset ABC and 60% of asset DEF.
• From the asset expected return, we can compute the expected return of the portfolio. It is calculated by
computing the weighted average:

• Let’s consider that there are 6 assets in total and we invested 1/6 of the total amount to be invested in
each asset.

• In the example, we have allocated an equal proportion to each stock, therefore, the portfolio expected
return is going to be computed by calculating a product of the expected return of each asset and the
weight of the asset:
Portfolio Expected Return
 Portfolio Returns
• Let us assume that the period of evaluation is t, market value at the start of the time period was
MV0 and at the end of this time period is MV t.
• Further, the cash inflows at the start and end of the time period t are CF 0 and CFt.
• The return from the portfolio for this period can be computed as:
 Portfolio Returns
Example
• On Jan 1, 2017, the value of the portfolio was Rs 100,000 and another Rs. 50,000 was inducted in
the portfolio. There were no intermediate cash flows and on Dec 31, 2017, another Rs. 25,000 were
introduced.

• The portfolio value as on close of business on Dec 31, 2017, is Rs. 200,000. The time period here is
1 year.

• As we can see from the above equation, we add any external cash inflow at the beginning of the
period to the initial market value of the portfolio and subtract any external cash inflow at the end
from the market value at time period t.

• The only assumption made here is that no liquid cash is maintained with the portfolio manager and
all the cash is invested in the portfolio.

• Now let’s assume that there are multiple such time periods or multiple cash inflows within the time
period for which we are computing the returns.

• In these cases, we use time-weighted rate of return (TWRR) and money-weighted rate of return
(MWRR) respectively.
 Portfolio Returns
Time-Weighted Rate of Return (TWRR)

• If there are n time periods within our analysis period t and r t,i denotes the return from the sub-period
i, then the time-weighted rate of return can be computed as:

Money-Weighted Rate of Return (MWRR)

• MWRR is essentially the internal rate of return from the portfolio. While computing the IRR, the
initial market value MV 0 is considered as the cash inflow at t = 0. All the current inflows are
considered as positive in the below equation.
• Let R be the internal rate of return or the MWRR from the portfolio, it can be computed using the
equation:

Where, MVt is the ending market value of the portfolio, MV 0 is the initial market value,
m is the number of time units in the considered period (number of days, weeks, months, etc.)
CFi are the clash flows, L(i) is the time units remaining after the cash flow CFi is inducted
 Portfolio Attribution
• Attribution analysis is a sophisticated method for evaluating the performance of a portfolio or fund
manager.
• Also known as “return attribution” or “performance attribution,” it attempts to quantitatively analyze
aspects of an active fund manager’s investment selections and decisions and to identify sources of
excess returns, especially as compared to an index or other benchmark.
• For portfolio managers and investment firms, attribution analysis can be an effective tool to assess
strategies.
• For investors, attribution analysis works as a way to assess the performance of fund or money
managers.
• Attribution analysis focuses on three factors: the manager’s investment picks and asset allocation, their
investment style, and the market timing of their decisions and trades.

• Asset class and weighting of assets within a portfolio figure in analysis of the investment choices.

• Investment style reflects the nature of the holdings: low-risk, growth-oriented, etc.

• The impact of market timing is hard to quantify, and many analysts rate it as less important in
attribution analysis than asset selection and investment style.
 Optimal Portfolio Computation

​
71 What is the optimal portfolio in choosing among the following securities? Assume
risk free rate of 7 % and the variance of market return is 12%.
Security Expected Returns Beta Residual Variance
A 14 1.5 40
B 13 1.3 30
C 11 0.8 34
D 10 0.7 25
E 9 1.0 20
F 12 1.2 30
How much amount will an investor invest in each security of the optimal portfolio
assuming that he has Rs 100000?
 Steps in computing Optimal Portfolio Mix with ER
Steps for Computation
 Step 1: Calculate Treynor Ratio {(ER – Rf)/Beta}
 Step 2: Rank the stocks based on Treynor Ratio and re-arrange the securities as per the rank
 Step 3: Calculate {(ER – Rf) / Residual Variance (6m2)} * Beta
 Step 4: Calculate Beta square / Residual Variance (6m2)
 Step 5: Calculate cumulative of Step 3 for each security
 Step 6: Calculate cumulative of Step 4 for each security
 Step 7: Calculate C = {Market Return * Step 5)} / {1 + (Market Return * Step 6)}
 Spot the highest C.
 Securities below the highest C should be ignored because returns start declining
 Step 8: Calculate Z = Beta / Residual Variance
 Step 9: Calculate { Step 8 * ((ER-Rf)/B) – Highest C)}
 Step 10: Calculate the Zigma of Step 9 and its proportion of each to the Zigma
 Step 11: In the proportion of Step 10, split the investment amount across multiple securities. This will
be the optimal portfolio
 Residual Variance, Alpha, Market Return
Residual Variance
• Weighted Average of the residual variances of the stocks in the portfolio with the weights squared.
• It is that part of the total variance which is explained by the variance in the market’s returns

Alpha and Beta

• Alpha and beta are two different parts of an equation used to explain the performance of stocks and
investment funds.
• Beta is a measure of volatility relative to a benchmark, such as the S&P 500.
• Alpha is the excess return on an investment after adjusting for market-related volatility and random
fluctuations.
• Alpha and beta are both measures used to compare and predict returns.

Market Return
• A stock market return is the profit, dividend, or both that an investor receives on their investment.
 Optimal Portfolio Computation – Example 2

What​ is the optimal portfolio in choosing among the following securities? Assume risk free
rate of 5 % and the variance of market return is 10%.
Security Expected Returns Beta Residual Variance
A 15 1 30
B 12 1.5 20
C 11 2 40
D 8 0.8 10
E 9 1 20
F 14 1.5 10
 Optimal Portfolio Computation – Example 3

​
Mr X is constructing an optimum portfolio. The market return forecast says that it
would be 13.5% for the next two years with market variance of 10%. The risk free
rate of return is 5%. The following securities are under review. Find out the
optimum portfolio.
Security Alpha Beta Residual Variance
Anil 3.72 0.99 9.35
Avil 0.6 1.27 5.92
Bow 0.41 0.96 9.79
Viril -0.22 1.21 5.39
Billy 0.45 0.75 4.52
 Steps in computing Optimal Portfolio Mix – with Alpha & without ER
Steps for Computation
 Step A: Calculate Ei = Square root of Residual Variance (6m2)
 Step B: Calculate ER = Alpha (x) + (Beta * Rm) + Ei
 Step 1: Calculate Treynor Ratio {(ER – Rf)/Beta}
 Step 2: Rank the stocks based on Treynor Ratio and re-arrange the securities as per the rank
 Step 3: Calculate {(ER – Rf) / Residual Variance (6m2)} * Beta
 Step 4: Calculate Beta square / Residual Variance (6m2)
 Step 5: Calculate cumulative of Step 3 for each security
 Step 6: Calculate cumulative of Step 4 for each security
 Step 7: Calculate C = {Market Return * Step 5)} / {1 + (Market Return * Step 6)}
 Spot the highest C.
 Securities below the highest C should be ignored because returns start declining
 Step 8: Calculate Z = Beta / Residual Variance
 Step 9: Calculate { Step 8 * ((ER-Rf)/B) – Highest C)}
 Step 10: Calculate the Zigma of Step 9 and its proportion of each to the Zigma
 Step 11: In the proportion of Step 10, split the investment amount across multiple securities. This will be the optimal
portfolio