Portfolio management and

evaluation
 Contents

• Active versus passive portfolio

management
• Strategic versus tactical asset allocation
• Monitoring and revision of the
portfolio
• Portfolio performance measures.
 Active versus passive portfolio management

• Types of investment portfolio management:

1. Active portfolio management

2. Passive portfolio management

 passive portfolio management

• Passive portfolio management :

 Holding securities in the portfolio for relatively
long periods with small and infrequent changes;
 Investors act as if the security markets are
relatively efficient.
 The portfolios they hold may be proxy
(substitute) for the market portfolio (index
funds).
 passive investors do not try outperforming their
designated benchmark.
 passive portfolio management

• The reasons when the investors with passive

portfolio management make changes in their
portfolios:
 the investor’s preferences change;
 the risk free rate changes;
 the consensus forecast about the risk and return
of the benchmark portfolio changes.
 Active portfolio management

• Active portfolio management

 Active investors believe that from time to time
there are mispriced securities or groups of
securities in the market;
 The active investors do not act as if they
believe that security markets are efficient;
 The active investors use divergent predictions
i.e. their forecast of risk and return differ from
consensus opinions.
 Strategic versus tactical asset allocation

• Asset allocation:
Focuses on determining the mixture of asset
classes that is most likely to provide a
combination of risk and expected return that is
optimal for the investor.
 Strategic versus tactical asset allocation

• Asset allocation is a bit different from

diversification:
• It focus on investment in various asset classes.

• Diversification, in contrast, focus more on

security selection – selecting the specific
securities to be held within an asset class.
 Strategic versus tactical asset allocation

• Asset classes :
Are groups of securities with similar
characteristics and properties .
for example, common stocks; bonds; or derivatives
 Strategic versus tactical asset allocation

• Two categories in asset allocation are defined:

1. Strategic asset allocation;

2. Tactical asset allocation.

 Strategic asset allocation

• Strategic asset allocation:

Identifies asset classes and the proportions for
those asset classes that would comprise the
normal asset allocation.

• Strategic asset allocation is used to derive

long-term asset allocation weights.
 Strategic asset allocation
 The fixed-weightings approach:
• Investor using this approach allocates a fixed
percentage of the portfolio to each of the asset
classes.
• Generally, these weights are not changed over time.
• When market values change, the investor may
have to adjust the portfolio annually or after major
market move to maintain the desired fixed-
percentage allocation.
 Strategic asset allocation
Asset class Allocation

Common stock 40%

Bonds 50%

Short-term securities 10%

Total portfolio 100%

 Tactical asset allocation
• Produces temporary asset allocation weights in
response to temporary changes in capital
market conditions.

• The investor’s goals and risk- return preferences

are assumed to remain unchanged .

• The asset weights are occasionally revised to

help attain the investor’s constant goals.
 Asset allocation
• Alternative asset allocations are often related
with the different approaches to risk and
return.
• Conservative, Moderate and Aggressive asset
allocation.
 The conservative allocation: providing low
return with low risk;
 The moderate : average return with average
risk
 The aggressive : high return and high risk.
Comparison between the alternative asset allocations

Asset class Alternative asset allocation

Conservative Moderate Aggressive

Common 20% 35% 65%

Stocks
Bonds 45% 40% 20%

Short term 35% 15% 5%

securities
Total Portfolio 100% 100% 100%
 Monitoring and revision of the portfolio

• Portfolio revision
Is the process of selling certain issues in portfolio
and purchasing new ones to replace them.
 Monitoring and revision of the portfolio

• Reasons for the revision of investment portfolios :

1. As the economy evolves, certain industries and
companies become either less or more attractive as
investments;
2. The investor over time may change his/her
investment objectives and in this way his/ her
portfolio isn’t longer optimal;
3. The constant need for diversification of the portfolio.
Individual securities in the portfolio often change in
risk-return characteristics and their diversification
effect may be lessened.
 Monitoring and revision of the portfolio

• Investor’s portfolio monitoring:

1. Changes in market conditions;
(such as GDP growth, inflation rate, interest rates,
, as well as the new information about industries
and companies)
2. Changes in investor’s circumstances;
(wealth, time horizon, liquidity requirements, etc..)
3. Asset mix in the portfolio.
 Monitoring and revision of the portfolio

• Rebalancing a portfolio :
Is the process of periodically adjusting portfolio
to maintain certain original conditions.
- Constant proportion portfolio;
- Constant Beta portfolio;
- Indexing.(matching a market index)
 Monitoring and revision of the portfolio

• Over time the values of the portfolio

components and their Betas will change and
this can cause the portfolio Beta to shift.

• If the target portfolio Beta is 1,10 and it had

risen over the monitored period of time to
1,25.
 Monitoring and revision of the portfolio

• The portfolio Beta could be reduced to the target

in the following ways:
1. Put additional money into the stock portfolio
and hold cash.
• Diluting the stocks in portfolio with the cash will
reduce portfolio Beta, because cash has Beta of
0.
• But in this case cash should be only a temporary
component in the portfolio.
 Monitoring and revision of the portfolio

• The portfolio Beta could be reduced to the

target in the following ways:
2. Put additional money into the portfolio and
buy stocks with a Beta lower than the target
Beta figure.
-But the investor may be is not able to invest
additional money and this way for rebalancing
the portfolio can be complicated.
 Monitoring and revision of the portfolio

• The portfolio Beta could be reduced to the

target in the following ways:

3. Sell high Beta stocks in portfolio and hold

cash.

4. Sell high Beta stocks and buy low Beta stocks.

 Monitoring and revision of the portfolio

• Revising a portfolio is not without costs for an

individual investor.
• These costs can be:
- Direct costs – trading fees and commissions
for brokers.
- Selling the securities may have income tax
implications which differ from country to
country.
 Portfolio performance measures

• Portfolio performance evaluation involves

determining periodically how the portfolio
performed in terms of
- the return earned, and
- the risk experienced by the investor.
 Portfolio performance measures
• The market value of a portfolio at a point of
time is determined by:

- Adding the markets value of all the securities

held at that particular time.
 Portfolio performance measures

• The return on the portfolio (rp):

rp = (Ve - Vb) / Vb
• here:
• Vb = beginning value of the portfolio;
• Ve = ending value of the portfolio.
 Portfolio performance measures
• The essential idea behind performance
evaluation is to:
• compare the returns which were obtained
on the portfolio with the results of
benchmark portfolios.

• The benchmark should reflect the objectives

of the investor.
 Portfolio performance measures
• Portfolio Beta can be used as an indication of
the amount of market risk that the portfolio
had during the time interval.

• It can be compared directly with the betas of

other portfolios.
 Portfolio performance measures
• You cannot compare the return of two
portfolios without adjusting for risk.

• Risk adjusted measures of performance can

be used:
• Sharpe’s ratio;
• Treynor’s ratio;
• Jensen’s Alpha.
 Portfolio performance measures
Sharpe’s ratio:
• Shows excess return over risk free rate, (risk premium,)
by unit of total risk, measured by standard deviation.
Sharpe’s ratio = (řp– řf) / σp

Where:
řp = the average return for portfolio p during some period
of time;
řf = the average risk-free rate of return during the period;
σp = standard deviation of returns for portfolio p during the
period.
 Portfolio performance measures
• Treynor’s ratio:
• Shows an excess actual return over risk free
rate, (risk premium,) by unit of systematic
risk, measured by Beta:
Treynor’s ratio = (řp –řf) / βp
Where:
βp = Beta, measure of systematic risk for the
portfolio p.
 Portfolio performance measures
• Jensen‘s Alpha :
Shows excess actual return over required return
and excess of actual risk premium over
required risk premium.
• This measure is based on the CAPM.
Jensen’s Alpha = (řp– řf) – βp (řm –řf)
• Where:
řm = the average return on the market in period
t;
(řm –řf) = the market risk premium during period
t.
 Portfolio performance measures
• If a portfolio is completely diversified, all of these
measures (Sharpe, Treynor’s ratios and Jensen’s alfa)
will agree on the ranking of the portfolios.
 The reason is that: with the complete diversification
total variance is equal to systematic variance.
• When portfolios are not completely diversified,
Treynor’s and Jensen’s measures can rank relatively
undiversified portfolios much higher than the
Sharpe measure does.
• Since the Sharpe ratio uses total risk, both systematic
and unsystematic components are included.
 Example
• Assume we have three stocks which were actively traded in
the local stock exchange last calendar year,
• The following table present their prices at the beginning and
at the end of the year, amount of dividends paid on each
stock for this year and stock Beta at the end of the year.
• Also , a risk-free rate of return is 3% and the market return
for the given year is 7.5%.

• Assume that these three stocks were put to the portfolio in

equal proportions (33.33% in each stock).
• Assume that the standard deviation for this portfolio is 16.
75% and that standard deviation for the market portfolio is
13. 50%.
 Example
Stock Price at Price at Amount Beta at
the the end of the end
beginning of the dividends of the
year, paid year

A 12 14 3 0.95

B 22 20 2 1.3

C 34 31 6 1.5
 Example
I. Find the portfolio return for the given year

II. Calculate Sharpe’s, Treynor’s ratios and

Jensen’s Alpha.

III. Comment on the results of measuring

portfolio performance with the different
measures.
 Example
The portfolio return for the given year
• First: find the expected return for each asset
using CAPM: E(Ri)= Rf+ βi (Rm- Rf)

• E(Ra)= 0.03+ (0.95)*(0.075-0.03) = 0.07275

E(Ra)= 7.3%
 Example
The portfolio return for the given year
• First: find the expected return for each asset
using CAPM: E(Ri)= Rf+ βi (Rm- Rf)

• E(Rb)= 0.03+ (1.3)*(0.075-0.03) = 0.0885

E(Rb)= 8.9%
 Example
The portfolio return for the given year
• First: find the expected return for each asset
using CAPM: E(Ri)= Rf+ βi (Rm- Rf)

• E(Rc)= 0.03+ (1.5)*(0.075-0.03) = 0.0975

E(Rc)=9. 8 %
 Example
The portfolio return for the given year
• Second: find the expected return for the
portfolio using: E(rp) = Σ wi * Ei (r)

E(rp)= wa*E(Ra)+wb* E(Rb)+ wc*E(Rc)

E(rp)= (1/3)* (9. 8 % + 8.9% + 7.3%)
E(Rp)= 8.7%
 Example
Calculate Sharpe’s, Treynor’s ratios and
Jensen’s Alpha.
• Sharpe’s ratio:
Sharpe’s ratio = (řp– řf) / σp
= (0.087- 0.03)/ 0.016 75

Sharpe’s ratio = 0.341

 Example
Calculate Sharpe’s, Treynor’s ratios and Jensen’s Alpha.

• Treynor’s ratio:
Treynor’s ratio = (řp –řf) / βp

We need to calculate βp first:

βp = Σ wi * βi

= (1/3)*( 0.95+1.2+1.5)=

βp = 1.22

•
 Example
Calculate Sharpe’s, Treynor’s ratios and
Jensen’s Alpha.
• Treynor’s ratio:
Treynor’s ratio = (řp –řf) / βp

= (0.0 8 7- 0.03)/1.22

Treynor’s ratio =0 .047

 Example
Calculate Sharpe’s, Treynor’s ratios and
Jensen’s Alpha.
• Jensen’s Alpha.
Jensen’s Alpha = (řp– řf) – βp (řm –řf)
= (0.087- 0.03) - 1.22*(0.075- 0.03)
= 0.057 - 0.055
Jensen’s Alpha = 0.002
 Example
comment on the results of measuring portfolio performance with different
measures.

• Generally, the greater the value of the Sharpe

ratio, the more attractive the risk-adjusted
return.

• The higher the Treynor ratio, the better the

performance of the portfolio under analysis.
 Example
Comment on the results of measuring portfolio performance
with different measures.

• If an asset's return is even higher than the risk

adjusted return, that asset is said to have
"positive alpha" or "abnormal returns".

• Investors are constantly seeking investments

that have higher alpha.
 Example2
• Suppose that the 10-year annual return for
the S&P 500 (market portfolio) is 10%
• While the average annual return on
Treasury bills (a good proxy for the risk-free rate)
is 5%.

• Then, assume the evaluation is of three distinct

portfolio managers with the following 10-year
results:
 Example2
Average Annual
Managers Beta
Return

Manager A 10% 0.90

Manager B 14% 1.03

Manager C 15% 1.20

 Example2
• The Treynor value for each is as follows:
Treynor ratio
Calculation

T(market) (0.10-0.05)/1 0.05

T(manager A) (0.10-0.05)/0.90 0.056

T(manager B) (0.14-0.05)/1.03 0.087

T(manager C) (0.15-0.05)/1.20 0.083

 Example2
• If the portfolio manager (or portfolio) is
evaluated on performance alone, manager C
seems to have yielded the best results.
• However, when considering the risks that each
manager took to attain their respective
returns, Manager B demonstrated a better
outcome.
• In this case, all three managers performed
better than the aggregate market.
• Using the Treynor example from above, and
assuming that the S&P 500 had a standard
deviation of 18% over a 10-year period, we
can determine the Sharpe ratios for the
following portfolio managers:
 Portfolio
Manager Annual Return Standard
Deviation

Manager X 14% 0.11

Manager Y 17% 0.20

Manager Z 19% 0.27

(market) (0.10-0.05)/0.18 0.278

S(manager X) (0.14-0.05)/0.11 0.818

S(manager Y) (0.17-0.05)/0.20 0.600

S(manager Z) (0.19-0.05)/0.27 0.519

• a superior portfolio has the superior
risk-adjusted return or, in this case, the fund
headed by manager X.
 Example
• If we assume a risk-free rate of 5% and a
market return of 10%, what is the alpha for
the following funds?
 Example
Average Annual
Manager Beta
Return

Manager D 11% 0.90

Manager E 15% 1.10

Manager F 15% 1.20

 Example
We calculate the portfolio's expected return:

ER(D) 0.05 + 0.90 (0.10-0.05) 0.0950 or 9.5% return

ER(E) 0.05 + 1.10 (0.10-0.05) 0.1050 or 10.5% return

ER(F) 0.05 + 1.20 (0.10-0.05) 0.1100 or 11% return

 We calculate the portfolio's alpha by subtracting the
expected return of the portfolio from the actual return:

Alpha D 11%- 9.5% 1.5%

Alpha E 15%- 10.5% 4.5%

Alpha F 15%- 11% 4.0%

• Manager E did best because although
manager F had the same annual return, it was
expected that manager E would yield a lower
return because the portfolio's beta was
significantly lower than that of portfolio F.
 Assessing portfolio performance using CML
• We can classify the performance of the portfolio
manager’s when we compare the portfolio return
E(rp) with the rate of return determined by the
CML E(rp)* as follows:
• Acceptable , when:
E(rp) =E(rp)*
• Good, when:
E(rp) >E(rp)*

• Not acceptable, when:

 Example
• Assume the following rates of return and the
beta of 4 portfolios:
portfolio Rate of return % E(rp) Beta

A 5.6 3.3

B 4.4 0.5

C 4.2 3.1

D 11.1 7.1
 Example
• Assume that , the CML equation is as follows:
E(rp)* = 4+ β 0.8.
Classify the performance of those portfolio
managers to :
Acceptable, good , or not acceptable.
 Example

• First we have to calculate the rate of return for

each portfolio using CML equation E(rp)*.
portfolio E(rp)* Compare Classification
E(rp)* with
E(rp)

A 4+(3.3*.8) = 6.6 6.6 > 5.5 Not acceptable

B 4+(0.5*.8) = 4.4 4.4= 4.4 Acceptable

C 4+(3.1*.8) 6.48 > 4.2 Not acceptable

=6.48
D 4+(7.1*.8) =9.6 9.6 < 11.1 Good