Unit-IV: Elements of Portfolio Management - Portfolio Models - Markowitz Model, Efficient

Frontier and Selection of Optimal Portfolio. Sharpe Single Index Model and Capital Asset
Pricing Model, Arbitrage Pricing Theory.

The portfolio is a collection of investment instruments like shares, mutual funds, bonds, fixed
deposits and other cash equivalents etc. Portfolio management is the art of selecting the right
investment tools in the right proportion to generate optimum returns from the investment made.
Best portfolio management practice runs on the principle of minimum risk and maximum return
within a given time frame. A portfolio is built based on investor’s income, investment budget
and risk appetite keeping the expected rate of return in mind.

OBJECTIVES OF PORTFOLIO MANAGEMENT

When a portfolio is built, following objectives are to be kept in mind by the portfolio manager
based on an individual’s expectation. The choice of one or more of these depends on the
investor’s personal preference.

1. Capital Growth
2. Security of Principal Amount Invested
3. Liquidity
4. Marketability of Securities Invested in
5. Diversification of Risk
6. Consistent Returns
7. Tax Planning

Investors hire portfolio managers and avail professional services for the management of
portfolio by as paying a pre-decided fee for these services. Let us understanding who is a
portfolio manager and tasks involved in the management of portfolio.

WHO IS A PORTFOLIO MANAGER?

Portfolio Manager is a person who understands his client’s investment needs and suggests a
suitable investment mix to meet his client’s investment objectives. This tailor-made investment
plan is recommended keeping in mind the risk-return balance.

PROCESS IN PORTFOLIO MANAGEMENT

Portfolio management process is not a one-time activity. The portfolio manager manages the
portfolio on a regular basis and keeps his client updated with the changes. The tasks involved
in it are stated below:
 Understanding the client’s investment objectives and availability of funds
 Matching investment to these objectives
 Recommending an investment policy
 Balancing risk and studying the portfolio performance from time to time
 Taking decision of the investment strategy based on discussion with the client
 Changing asset allocation from time to time-based on portfolio performance
 WHY IS PORTFOLIO MANAGEMENT IMPORTANT?
It is important due to the following reasons:

1. PM is a perfect way to select the “Best Investment Strategy” based on age, income, risk taking
the capacity of the individual and investment budget.
2. It helps to keep a gauge on the risk taken as the process of PM keeps “Risk Minimization” as
the focus.
3. “Customization” is possible because individual’s needs and choices are kept in mind i.e. when
the person needs the return, how much return expectation a person has and how much
investment period an individual selects.

TYPES OF PORTFOLIO MANAGEMENT

Portfolio Management Services are classified into two broad categories:

On the basis of a level of activity viz.

ACTIVE & PASSIVE PORTFOLIO MANAGEMENT

Active PM refers to the service when there is active involvement of portfolio managers in buy-
sell transactions for securities to ensure meeting the investment objectives of the investor
whereas Passive PM refers to managing a fixed portfolio where the portfolio performance is
matched to the market index (i.e. market)

On the basis of discretionary powers allowed to Portfolio Manager i.e.

DISCRETIONARY & NON-DISCRETIONARY PORTFOLIO MANAGEMENT

Discretionary PM refers to the process where portfolio management is authorized to take

financial decisions for the funds invested based on investment needs of the investor. Apart from
that, he also does the entire documentary work and filing too. Non-Discretionary PM refers to
the process where portfolio manager acts just as an advisor for which investments are good and
which are not lucrative and the decision is taken by the investor.
MARKOWITZ MODEL

Modern Portfolio Theory

Modern Portfolio Theory was introduced by Harry Markowitz.

According to Modern Portfolio Theory, while designing a portfolio, the ratio of each asset must
be chosen and combined carefully in a portfolio for maximum returns and minimum risks.

In Modern Portfolio Theory emphasis is not laid on a single asset in a portfolio, but how each
asset changes in relation to the other asset in the portfolio with reference to fluctuations in the
price.

Modern Portfolio theory proposes that a portfolio manager must carefully choose various assets
while designing a portfolio for maximum guaranteed returns in the future.

Assumption of the Markowitz Theory:

Markowitz theory is based on the modern portfolio theory under several assumptions.

The assumptions are:

Assumption under Markowitz Theory:
(1) The market is efficient and all investors have in their knowledge all the facts about the
stock market and so an investor can continuously make superior returns either by predicting
past behaviour of stocks through technical analysis or by fundamental analysis of internal
company management or by finding out the intrinsic value of shares. Thus, all investors are
in equal category.

(2) All investors before making any investments have a common goal. This is the avoidance
of risk because they are risk averse.

(3) All investors would like to earn the maximum rate of return that they can achieve from
their investments.

(4) The investors base their decisions on the expected rate of return of an investment. The
expected rate of return can be found out by finding out the purchase price of a security
dividend by the income per year and by adding annual capital gains.

It is also necessary to know the standard deviation of the rate of return expected by an
investor and the rate of return which is being offered on the investment. The rate of return
and standard deviation are important parameters for finding out whether the investment is
worthwhile for a person.

(5) Markowitz brought out the theory that it was a useful insight to find out how the security
returns are correlated to each other. By combining the assets in such a way that they give the
lowest risk maximum returns could be brought out by the investor.
(6) From the above, it is clear that every investor assumes that while making an investment
he will combine his investments in such a way that he gets a maximum return and is
surrounded by minimum risk.

(7) The investor assumes that greater or larger the return that he achieves on his investments,
the higher the risk factor surrounds him. On the contrary, when risks are low the return can
also be expected to be low.

(8) The investor can reduce his risk if he adds investment to his portfolio.

(9) An investor should be able to get higher return for each level of risk “by determining the
efficient set of securities”.

Markowitz Model:
Markowitz approach determines for the investor the efficient set of portfolio through three
important variables, i.e., return, standard deviation and coefficient of correlation. Markowitz
model is called the “Full Covariance Model”.

Through this method the investor can, with the use of computer, find out the efficient set of
portfolio by finding out the trade-off between risk and return, between the limits of zero and
infinity. According to this theory, the effects of one security purchase over the effects of the
other security purchase are taken into consideration and then the results are evaluated.

The Effect of Combining Two Securities:

It is believed that holding two securities is less risky than having only one investment in a
person’s portfolio. When two stocks are taken on a portfolio and if they have negative
correlation, then risk can be completely reduced because the gain on one can offset the loss
on the other.

The effect of two securities can also be studied when one security is more risky when
compared to the other security. The following example shows a return of 13%. A
combination of A and E will produce superior results to an investor rather than if he was to
purchase only Stock-A and one-third of stock consists of Stock-B, the average return of the
portfolio is weighted average return of each security in the portfolio.

The return on the portfolio on combining the two securities will be

Rp = R1X1 + R2X2
RP = 0.10(0.25)+ 0.20(0.75)

= 17.5%
THE EFFICIENT FRONTIER IS THE 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. Portfolios that cluster to the right of the efficient
frontier are also sub-optimal, because they have a higher level of risk for the defined rate of
return.

Since the efficient frontier is curved, rather than linear, a key finding of the concept was the
benefit of diversification. Optimal portfolios that comprise the efficient frontier tend to have a
higher degree of diversification than the sub-optimal ones, which are typically less diversified.
The efficient frontier concept was introduced by Nobel Laureate Harry Markowitz in 1952 and
is a cornerstone of modern portfolio theory.
Optimal Portfolio

One assumption in investing is that a higher degree of risk means a higher potential return.
Conversely, investors who take on a low degree of risk have a low potential return. According
to Markowitz's theory, there is an optimal portfolio that could be designed with a perfect
balance between risk and return. The optimal portfolio does not simply include securities with
the highest potential returns or low-risk securities. The optimal portfolio aims to balance
securities with the greatest potential returns with an acceptable degree of risk or securities with
the lowest degree of risk for a given level of potential return. The points on the plot of risk
versus expected returns where optimal portfolios lie is known as the efficient frontier.

Selecting Investments

Assume a risk-seeking investor uses the efficient frontier to select investments. The investor
would select securities that lie on the right end of the efficient frontier. The right end of the
efficient frontier includes securities that are expected to have a high degree of risk coupled with
high potential returns, which is suitable for highly risk-tolerant investors. Conversely,
securities that lie on the left end of the efficient frontier would be suitable for risk-averse
investors.

Limitations

The efficient frontier and modern portfolio theory have many assumptions that may not
properly represent reality. For example, one of the assumptions is that asset returns follow a
normal distribution. In reality, securities may experience returns that are more than three
standard deviations away from the mean more than 0.03% of the observed values.
Consequently, asset returns are said to follow a leptokurtic distribution, or heavy tailed
distribution.

Additionally, Markowitz's theory assumes investors are rational and avoid risk when possible,
there are not large enough investors to influence market prices, and investors have unlimited
access to borrowing and lending money at the risk-free interest rate. However, the market
includes irrational and risk-seeking investors, large market participants who could influence
market prices, and investors do not have unlimited access to borrowing and lending money.

Sharpe’s single index model

Sharpe W.E. (1964) justified that portfolio risk is to be identified with respect to their return
co-movement with the market and not necessarily with respect to within the security co-
movement in a portfolio. He therefore concluded that the desirability of a security for its
inclusion is directly related to its excess return to beta ratio,
R (i) – R (f)/ β (i)
Where
R (i) = expected return on security i R (f) = return on a riskless securityΒ (i) = beta of
security
This ranking order gives the best securities that are to be selected for the portfolio.
Cut-off Rate:
The number of securities that are to be selected depends on the cut-off rate. The cut-off rate is
determined such that all securities with higher ratios are included into the portfolio. The cut-
off rate for the selection of a security into a portfolio is determined as:

Where σm2 = market variance Ri = security return Rf = risk free returnβI = security betaσei2
= security error variance
The final cutoff rate C* is one where the cut-off value is highest and the next inclusion of a
security reduces the cut-off value noticeably. Percentage of investment in each security The
percentage of investment in each of the securities in a portfolio with optimal C* cut-off rate is
decided as follows:
ω (i) = Z I Σn(i =1) Zi Where Zi =βσ/ iei
Illustration : The following securities are available for investment for an investor. Select the
optimal portfolio using the Sharpe’s Single Index Portfolio Selection method. Assume the
risk free rate of return as 5 per cent and the standard deviation of the market return as 25 per
cent.

Solution: The selection of the portfolio from these securities will be by building the
following table. The table ranks the securities on the basis of the Sharpe measure of excess
returns relative to beta risk:

Columns: (1) (Ri – Rf) (2) (Βi/σei2) (3) (1)*(2) (4) Cumulative of column 3 values (5) σm2 *
(4) (6) (Βi2/σei2) (7) Cumulative of column 6 values (8) 1 + [σm2 * (7)] (9) Ci = (5)/ (8)
The ranking of securities on the basis of their risk related returns is then followed by the
computation of Ci for a portfolio of the combined securities. The maximum Ci or C* is that
amount after which the inclusion of other securities do not contribute to increased returns
with respect to the risk inherent in that security. In the example, inclusion of the first four
securities is optimal for the investor, since after that, the Ci values ((column (9)) are less. The
quantum of investment in these securities J, D, F and G are determined using the following
Table:

The proportion of investments in each security is determined as follows:

ωf = (0.0263/0.0295) = 89.21%ωj = (0.0015/0.0295) = 5.17%ωd = (0.0008/0.0295) =
2.87%ωd = (0.0008/0.0295) = 2.87%ωg = (0.0008/0.0295) = 2.76%
THE CAPITAL ASSET PRICING MODEL (CAPM) is a model that describes the
relationship between systematic risk and expected return for assets, particularly stocks. CAPM
is widely used throughout finance for the pricing of risky securities, generating expected
returns for assets given the risk of those assets and calculating costs of capital.

The capital asset pricing model (CAPM) is used to calculate the required rate of return for
any risky asset. Your required rate of return is the increase in value you should expect to see
based on the inherent risk level of the asset.

HOW IT WORKS (EXAMPLE):

As an analyst, you could use CAPM to decide what price you should pay for a particular stock.
If Stock A is riskier than Stock B, the price of Stock A should be lower to compensate investors
for taking on the increased risk.

The CAPM formula is:

ra = rrf + Ba (rm-rrf)

where:

rrf = the rate of return for a risk-free security

rm = the broad market's expected rate of return

Ba = beta of the asset

CAPM can be best explained by looking at an example.

Assume the following for Asset XYZ:

rrf = 3%
rm = 10%
Ba = 0.75

By using CAPM, we calculate that you should demand the following rate of return to invest in
Asset XYZ: ra = 0.03 + [0.75 * (0.10 - 0.03)] = 0.0825 = 8.25%

The inputs for rrf , rm and Ba are determined by the analyst and are open to interpretation.

Beta (Ba) -- Most investors use a beta calculated by a third party, whether it's an
analyst, broker or Yahoo! Finance.

You can calculate beta yourself by running a straight-line statistical regression on data points
showing price changes of a broad market index versus price changes in your risky
asset. Note that beta can be different depending on what time frame you pull your data from.
Beta calculated with 10 years of data is different from beta calculated with 10 months of data.
Neither is right or wrong – it depends totally on the rationale of the analyst.

Market return (rm) – Your input of market rate of return, rm, can be based on past returns or
projected future returns. Economist Peter Bernstein famously calculated that over the last 200
years, the stock market has returned an average of 9.6% per year. Whether or not you want to
use this as your projection of future stock market returns is up to you as an analyst.

Risk-free return (rrf): U.S. Treasury bills and bonds are most often used as the proxy for the
risk-free rate. Most analysts try to match the duration of the bond with the projection horizon
of the investment. For example, if you're using CAPM to estimate Stock XYZ's required rate
of return over a 10 year time horizon, you'll want to use the 10-year U.S. Treasury bond rate as
your measure of rrf.

WHY IT MATTERS:

CAPM is most often used to determine what the fair price of an investment should be. When
you calculate the risky asset's rate of return using CAPM, that rate can then be used to discount
the investment's future cash flows to their present value and thus arrive at the investment's fair
value.

By extension, once you've calculated the investment's fair value, you can then compare it to
its market price. If your price estimate is higher than the market's, you could consider
the stock a bargain. If your price estimate is lower, you could consider the stock to
be overvalued.
ARBITRAGE PRICING THEORY:

Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset.
The theory assumes an asset's return is dependent on various macroeconomic, market and
security-specific factors.

HOW IT WORKS (EXAMPLE):

APT is an alternative to the capital asset pricing model (CAPM). Stephen Ross developed the
theory in 1976.

The APT formula is: E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn

where:
E(rj) = the asset's expected rate of return
rf = the risk-free rate
bj = the sensitivity of the asset's return to the particular factor
RP = the risk premium associated with the particular factor

The general idea behind APT is that two things can explain the expected return on a financial
asset: 1) macroeconomic/security-specific influences and 2) the asset's sensitivity to those
influences. This relationship takes the form of the linear regression formula above.

There are an infinite number of security-specific influences for any given security
including inflation, production measures, investor confidence, exchange rates, market indices
or changes in interest rates. It is up to the analyst to decide which influences are relevant to
the asset being analyzed.

Once the analyst derives the asset's expected rate of return from the APT model, he or she
can determine what the "correct" price of the asset should be by plugging the rate into a
discounted cash flow model.

Note that APT can be applied to portfolios as well as individual securities. After all, a
portfolio can have exposures and sensitivities to certain kinds of risk factors as well.

WHY IT MATTERS:

The APT was a revolutionary model because it allows the user to adapt the model to the
security being analyzed. And as with other pricing models, it helps the user decide whether a
security is undervalued or overvalued and so he or she can profit from this information. APT
is also very useful for building portfolios because it allows managers to test whether their
portfolios are exposed to certain factors.

APT may be more customizable than CAPM, but it is also more difficult to apply because
determining which factors influence a stock or portfolio takes a considerable amount of
research. It can be virtually impossible to detect every influential factor much less determine
how sensitive the security is to a particular factor. But getting "close enough" is often good
enough; in fact studies find that four or five factors will usually explain most of a security's
return: surprises in inflation, GNP, investor confidence and shifts in the yield curve.