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Portfolio revision, reconstruction and Evaluation

Himanshu Puri Faculty DIAS

PORTFOLIO REVISION
AND

RECONSTRUCTION

Why Portfolio Revision?


The needs of the beneficiary will change
The relative merits of the portfolio components will change

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

Profit taking with winners is a logical consequence of portfolio rebalancing

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

Change in Client Objectives


The clients investment objectives may change occasionally:
E.g., a church needs to generate funds for a renovation and changes the objective for the fund from growth of income to income
Reduce the equity component of the portfolio

Change in Market Conditions


Many fund managers seek to actively time the market When a portfolio managers outlook becomes bearish, he may reduce his equity holdings

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
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Risk-Adjusted Measures of Portfolio Performance


Sharpes Ratio Defined as the ratio of excess returns earned over the risk free rate to the risk of the portfolio.

Sp

RP RF

Example
Risk-free rate 3% 7% 5% 5%

Portfolio Return A B 10% 12%

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

So what it does it mean to an investor?

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

beta 1.5 0.5

Sharpe 1.83 2.25

Rank 3 2

Treynor 7.3 18.0

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

beta 1.5 0.5 1 0.5 2

A = .14 {.05+1.5(.10-.05)} = 1.5%

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

The return for this portfolio is =5+1.22*6=12.34%

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

The difference i.e. 14%-12.34%=1.66% is due to fund managers skill.

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.