Portfolio Construction And Analysis

Presented by
Pranav Bhagat(03)
Darshit Desai(08)
Ratul Ghosh(12)
Sagar Ghutkude(13)
Aanchal Narula(30)
Madhur Sawant(43)
Khushbu Shah(46)

Flow of Presentation

Introduction to Portfolio Construction

Portfolio Risk and Returns
Portfolio Optimization
Portfolio Management Strategies
Portfolio Performance Measurement

Introduction
Traditional Investments
- Security Analysis
- Portfolio Management
Security Analysis involves estimating the merits of individual
investments
Portfolio Management deals with the construction and maintenance
of collection of investments
Aims at reducing risks rather than increasing returns
Portfolio construction is a part of portfolio management
Portfolio Construction is a disciplined personalized process
In constructing a portfolio, the individual risk & return characteristic
of underlying investment must be considered along with clients
unique needs, goals and risk considered

Brief History
1952

1964

1980

1986

-Publication of
Harry
Markowitz
thesis, Portfolio
Selectiion

- William
Sharpe came
out with
CAPM model
-Introduced
Alpha and Beta

- AG Becker
introduced
concept of
Investment
Style

- Gary
Brinson
introduced
Determinants
of Portfolio
Performance

Importance of Portfolio Construction

Planning investment with financial planner helps in
reaching the investment objectives
Individual investor focus more on right fund manager and
securities
Portfolio constructions helps in attaining investment
objectives with minimum risk
2 types of investors- Private investors and Professional
investors
They build their portfolio in 2 different ways
- Bottom Up Approach
- Top down Approach

Conservative Vs Aggressive Investors

Investment Consulting Process

It formalizes investing just like an architect
Developing a blue print based on your needs and goals, investment
parameters
The Investment Consulting Process is as follows
Establishing of Goals and Objectives

Asset Allocation

Manager Search and Selection

Performance Monitoring

Determine Investment Parameters

Cash Flow needs

Risk Tolerance
Performance Objectives
Time Horizon
Investments Restriction

Define Investment Strategies

Formulating Policy Statements
Optimize Risk and Reward tradeoff
Determining Asset Allocation
Implement Investment Strategy

Portfolio Construction
Evaluation of Investment Structure
Manager Selection

Measure Performance

Determine Performance benchmark

Evaluate Relative and Absolute Returns
Provide Ongoing Review and
Adjustment
Ongoing review of Objectives and Strategies
Changing Clients circumstances
Changing Financial market conditions

Major Blunders in Portfolio

Construction

One sided approach

Lumpy Risks
Liquidity Problem
Home bias problem
Failure to monitor portfolio regularly
Portfolio drift
Awkward issue of no loss control

Important Terms

Important Terms

Value
Investing

Cumulative
Returns

Deep Value

Rolling
Period Return

Relative
Value

Standard
Deviation

Growth
Interest

Beta

GARP

Alpha

 Value investing is the art of buying stocks which trade at a

significant discount to their intrinsic value. Value investors achieve
this by looking for companies on cheap valuation metrics, typically
low multiples of their profits or assets, for reasons which are not
justified over the longer term.
Deep value investing -means finding companies that are genuine
bargains that can pay back phenomenally over the long term. They
are firms so cheap that even if they were to close tomorrow their
assets would pay you out at a profit.
Relative Value- A method of determining an asset's value that takes
into account the value of similar assets. In contrast, absolute value
looks only at an asset's intrinsic value and does not compare it to
other assets. Calculations that are used to measure the relative value
of stocks include the enterprise ratio and price-to-earnings ratio.
Beta is a historical measure of volatility. Beta measures how an
asset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark
(i.e. an index).
Alpha is a historical measure of an assets return on investment
compared to the risk adjusted expected return.

 Growth At A Reasonable Price - GARP

An equity investment strategy that seeks to combine tenets of both growth
investing and value investing to find individual stocks. GARP investors
look for companies that are showing consistent earnings growth above
broad market levels (a tenet of growth investing ) while excluding
companies that have very high valuations (value investing
Cumulative Return
The aggregate amount that an investment has gained or lost over time,
independent of the period of time involved. Presented as a percentage, the
cumulative return is the raw mathematical return of the following
calculation
Rolling Returns
The annualized average return for a period ending with the listed year.
Rolling returns are useful for examining the behavior of returns for holding
periods similar to those actually experienced by investors.
Standard Deviation
A measure of the dispersion of a set of data from its mean. The more
spread apart the data, the higher the deviation. Standard deviation is
calculated as the square root of variance.

Sharpe Ratio & Information Ratio

While selecting funds most simple approach would be
performance that is returns
But reliabilty of scheme is also important that is volatility
A scheme giving good returns but extremely volatile may not
favor large number of investors
Sharpe Ratio expresses this measure
The ratio will be high if returns are high and volatility is low
A good fund will have a high ratio
This can be explained with the help of drawing an analogy
with cricket

Analogy
Imagine a cricket series just got over and we are
analyzing the score of Sehwag, Dhoni and Sreesanth
1.Sehwag (0, 0, 120, 160) Average- 70, Standard
Deviation- 71.41
2.Dhoni (60, 60, 70, 70) Average- 65, Standard
Deviation- 10
3.Sreeasnth (0, 0, 5, 20) Average- 6.25, Standard
Deviation- 8.19
Here Sharpe Ratio will be
Sehwag - 70-6.25/71.41= 0.9
Dhoni - 65-6.25/10 = 5.8

 Mathematically, Sharpe Ratio= (Rp-r)/Sp

Where, Rp = Return of the fund or the portfolio, r
= Risf free rate,
Sp = Volatility of the the funds
Higher the Sharpe Ratio better is the fund
While calculating Sharpe Ratio we compared the
average of batsman with that of bowler
In the world of finance the bowler is the risk free
investment ie government bonds

 Hence we should compare average of batsman with another

batsman who could be treated as benchmark
Similarly in funds we compare the performance with
benchmark funds performance both for return as well as
volatility
This is called Information Ratio
Now lets assume Dravid is the benchmark batsman for India in
this series
In our example Information Ratio would compare performance
of batsman (Sehwag and Dhoni ) with Dravid
Dravid (80, 75, 85, 70) Average-77.5 Standard Deviation5.59
Both average and s.d are better and hence he is the benchmark

 Thus, Information Ratio =

Difference in average of players compared to
benchmark/ Difference in standard deviation of
player compared with benchmark
Thus IR of Dhoni is 0.34
IR measures the excess return of an investment
manager divided by the amount of risk the manager
takes relative to a bencmark
Whereas SR compares the performance of an asset
against the return of a risk free instrument

Qualitative Risk Parameters

Qualitative Risk Analysis is concerned with
discovering the probability of a risk event occurring
& the impact the risk will have if it does occur.
All risks have both probability & impact. Probability
is the likelihood that a risk event will occur, and
impact is the significance of the consequences of the
risk event.
Impact typically affects the following project
elements: Schedule, Budget, Resources, Deliverables,
Costs, Quality, Scope, Performance.

Market Sentiments
Market sentiment is the general prevailing attitude
of investors as to anticipated price development in a
market.
This attitude is the accumulation of a variety
of fundamental and technical factors, including price
history, economic reports, seasonal factors, and
national and world events.

 For example, if investors expect upward price

movement in the stock market, the sentiment is said
to be bullish.
On the contrary, if the market sentiment is bearish,
most investors expect downward price movement.
Market sentiment is usually considered as
a contrarian indicator: what most people expect is a
good thing to bet against.
Market sentiment is used because it is believed to be
a good predictor of market moves, especially when it
is more extreme.
Very bearish sentiment is usually followed by the
market going up more than normal, and vice versa.

Accounting scandals
Accounting scandals are political and/or business
scandals which arise with the disclosure of financial
misdeeds by trusted executives of corporations or
governments.
Such misdeeds typically involve complex methods for
misusing or misdirecting funds, overstating revenues,
understating expenses, overstating the value of corporate
assets or underreporting the existence of liabilities,
sometimes with the cooperation of officials in other
corporations or affiliates.
In public companies, this type of creative accounting" can
amount to fraud, and investigations are typically launched by
government oversight agencies, such as the Securities and
Exchange Board of India (SEBI).

Satyam scandal
The Satyam Computer Services scandal was a corporate
scandal that occurred in India in 2009 where chairman Ramalinga
Raju confessed that the company's accounts had been falsified.
The Global corporate community was shocked and scandalized
when the chairman of Satyam, Ramalinga Raju resigned on 7
January 2009 and confessed that he had manipulated the accounts
by US$1.47-Billion.
The Indian arm of PwC was fined $6 million by the SEC (US
Securities and Exchange Commission) for not following the code of
conduct and auditing standards in the performance of its duties
related to the auditing of the accounts of Satyam Computer
Services.
Satyam's shares fell to 11.50 rupees on 10 January 2009, their
lowest level since March 1998, compared to a high of 544 rupees in
2008

Minority Shareholder Rights

(Companies Act 2013)
The Companies Act 2013, expected to be fully operational by April
2014, goes a long way in protecting shareholders' interests and
removes administrative burden in several areas.
The Act would protect minority shareholders, investor protection
and better framework for insolvency regulation, besides institutional
structure.
Provisions such as class action suit, approval of auditors by
shareholders will bring in more transparency.
Small investors who at present are not able to get compensation in
cases of fraud due to the absence of any such law will be able to
fight for justice with such suits.
This suit is brought by one party on behalf of a group of individuals
to file for claims against erring companies in a court.

Systematic Risk
The risk inherent to the entire market or an entire market segment.
This type of risk is both unpredictable and impossible to completely
avoid.
Putting some assets in bonds and other assets in STOCKS can
mitigate systematic risk because an interest rate shift that makes
bonds less valuable will tend to make stocks more valuable, and vice
versa, thus limiting the overall change in the portfolios value from
systematic changes.
Systematic risk underlies all other investment risks.
The Great Recession provides a prime example of systematic risk.
Anyone who was invested in the market in 2008 saw the values of
their investments change because of this market-wide economic
event, regardless of what types of securities they held.

Returns Benchmarking
A benchmark is a feasible alternative to a portfolio against
which performance is measured.
Investors look to broad indexes as benchmarks to help
them gauge not only how well the markets are performing, but
also how well they, as investors, are performing.
For those who own stocks, they look to indexes like the S&P
500, the Dow Jones Industrial Average (DJIA) and the Nasdaq
100 to tell them "where the market is".
Most investors hope to meet or exceed the returns of these
indexes over time.
The problem with this expectation is that they immediately put
themselves at a disadvantage because they are not comparing
apples to apples.

How it works
Let's assume you compare the returns of
your stock portfolio, which is a broadly diversified
collection of small-cap stocks and is managed by
Company XYZ, with the Russell 2000 index, which
you feel is an accurate universe of feasible
alternative investments.
If Company XYZ's portfolio returns 5.5% in a year
but the Russell 2000 (the benchmark) returns 5.0%,
then we would say that your portfolio beat its
benchmark.

Portfolio Optimization
Definition
Portfolio optimization is the process of choosing the
proportions of various assets to be held in a portfolio,
in such a way as to the portfolio better than any other
according to some criterion.

Efficient portfolios
It is assumed that an investor wants to maximize a
portfolio's expected return contingent on any given
amount of risk.
All efficient portfolios are well-diversified.

Modern Portfolio Theory

Modern portfolio theory has had a marked impact on
how investors perceive risk, return and portfolio
management.
The theory demonstrates that portfolio diversification
can reduce investment risk.
MTP has Shortcomings in the real world

The Efficient Frontier

How to identify the best level of diversification?
For every level of return, there is one portfolio that
offers the lowest possible risk, and for every level of
risk, there is a portfolio that offers the highest return.

CML (Capital Market Line)

A line used in the capital asset pricing model to
illustrate the rates of return for efficient portfolios
depending on the risk-free rate of return and the level
of risk (standard deviation) for a particular portfolio.
CML is considered to be superior to the efficient
frontier

Risk Free rate

It is the market off which other assets are priced;
companies pay an extra spread over the risk-free rate,
equities offer a "risk premium" in the form of a
higher long-term return to compensate for their
higher short-term volatility.
Local government bond that constitutes the risk-free
rate

Methods of portfolio optimization

Traditional measure
standard deviation
Sortino ratio
CVaR (Conditional Value at Risk)

Optimization constraints
Regulation and taxes
Transaction costs

Mathematical tools used in portfolio

optimization

Quadratic programming
Nonlinear programming
Mixed integer programming
Meta-Heuristic Methods

Issues with portfolio optimization

Investment is a forward looking activity
Financial crises are characterized by a significant
increase in correlation of stock price movements
which may seriously degrade the benefits of
diversification.

4 Steps To Building A Profitable

Portfolio

Determining the Appropriate Asset Allocation for You

Achieving the Portfolio Designed in Step 1
Reassessing Portfolio Weightings
Rebalancing Strategically

Broad Overview of Investment

Strategies
Active Management Strategies
Fundamental Analysis
Top Down (asset class rotation, sector rotation)
Bottom Up (stock undervaluation/overvaluation)
Technical Analysis

Contrarian (e.g. overreaction)

Continuation (e.g. price momentum)
Passive Management Strategies

Efficient Markets Hypothesis

Buy and Hold
Indexing

 Portfolio Management Strategies refer to the approaches that

are applied for the efficient portfolio management in order to
generate the highest possible returns at lowest possible risks.
There are two basic approaches for portfolio management
including Active Portfolio Management Strategy and Passive
Portfolio Management Strategy.

Active Portfolio Management Strategy

The Active portfolio management relies on the fact that particular

style of analysis or management can generate returns that can beat

the market. It involves higher than average costs and it stresses on
taking advantage of market inefficiencies. It is implemented by the
advices of analysts and managers who analyze and evaluate market
for the presence of inefficiencies.

The active management approach of the portfolio management

involves the following styles of the stock selection.

Top-down Approach:
In this approach, managers observe the market as a whole and decide
about the industries and sectors that are expected to perform well in
the ongoing economic cycle. After the decision is made on the
sectors, the specific stocks are selected on the basis of companies that
are expected to perform well in that particular sector.

Bottom-up:
In this approach, the market conditions and expected trends are
ignored and the evaluations of the companies are based on the
strength of their product pipeline, financial statements, or any other
criteria. It stresses the fact that strong companies perform well
irrespective of the prevailing market or economic conditions.

Fundamental Strategies
Tactical Asset Allocation
- Asset Class Rotation: Shifts funds between stocks, bonds and
other securities depending on market forecasts and estimated
returns.
Sector, Industry or Style Rotation Strategy
- Shifts funds between different equity sectors and industries
(financial stocks, technology stocks, consumer cyclicals,
durable goods) or among investment styles (e.g., large
capitalization, small capitalization, value growth)
Individual Stock Selection
- Buy low, Sell High

44

Technical Strategies
Contrarian investment strategy
- Best time to buy a stock is when the majority of other
investors are selling.
- Buy low, sell high. Hope asset prices are mean
reverting.
- Overreaction hypothesis.
Price momentum strategy
Earnings momentum strategy

45

Benefits of Active Portfolio Management Strategy

The active portfolio management strategy allows the portfolio managers to select a variety
of investments rather than investing in the market as a whole. There may be different kinds
of motivations for the investors to follow active management strategy.

In order to generate profits, the investors consider that some market segments are less
efficient than others.
Portfolio Manager may manage the volatility or risks of market by investing in less-risky
and high-quality companies instead of investing in market as a whole.
Investors may take additional risk for achieving higher-than-market returns.
Those investments which are not vastly correlated to the market function as portfolio
diversifier and decrease the portfolio volatility as a whole.

Investors may follow a strategy for avoiding certain industries in comparison to the market
as a whole.
Investors that follow actively-managed fund are more aligned for achieving their specific
investment goals.

Passive Portfolio Management Strategy

A financial strategy in which an investor invests in accordance with a pre-determined
strategy that doesn't entail any forecasting.
The idea is to minimize investing fees and to avoid the adverse consequences of failing
to correctly anticipate the future.

Passive management is most common on the equity market, where index funds track
a stock market index
One of the largest equity mutual funds, the Vanguard 500, is a passive management
fund.
The two firms with the largest amounts of money under management, Barclays Global
Investors and State Street Corp., primarily engage in passive management strategies.

Passive asset management is based on the belief that:

Markets are efficient.
Market returns cannot be surpassed regularly over
time.
Low-cost investments held for the long-term will
provide the best returns

METHODS
Efficient market theory: This theory relies on the fact that the
information that affects the markets is immediately available and
processed by all investors. Thus, such information is always considered
in evaluation of the market prices. The portfolio managers who follows
this theory, firmly believes that market averages cannot be beaten
consistently.
Indexing: It is done by retail investors by buying one or more index
funds. An investment portfolio tracks an index and achieves low
turnover, very low management fees and good diversification.
The low management fees enable the investor to receive higher returns in
comparison to similar fund investments with higher management fees or
transaction costs. Passive management is widely used in the equity
market and involves tracking of stock market index by index funds.

Patient Portfolio: This type of portfolio involves making investments in wellknown stocks. The investors buy and hold stocks for longer periods. In this
portfolio, the majority of the stocks represent companies that have classic growth
and those expected to generate higher earnings on a regular basis irrespective of
financial conditions.
Aggressive Portfolio: This type of portfolio involves making investments in
expensive stocks that provide good returns and big rewards along with carrying
big risks. This portfolio is a collection of stocks of companies of different sizes
that are rapidly growing and expected to generate rapid annual earnings growth
over the next few years.
Conservative Portfolio: This type of portfolio involves the collection of stocks
after carefully observing the market returns, earnings growth and consistent
dividend history.

Implementation of Passive portfolio

management strategy
Index funds refer to the collective investment
schemes that utilize passive investment strategies for
tracking the performance of a stock market index.
An index fund can be implemented by buying
securities in the similar proportion as present in the
stock market index.
The sampling involves purchasing each type of stocks
from various sectors in the index but do not include
some quantity of stocks of every individual stock.

Advantages
Low cost: Provides meaningful and specific
incremental advantage.
Reduced uncertainty of decision errors: By making
investments, investors are exposed to market risks and
passive investment strategy reduces the uncertainty of
decision errors.
Style consistency: Indexing enables the investors to
control their overall allocation by selecting the
appropriate indexes.
Tax efficiency: Indexing is considered as more tax
efficient especially in cases of larger-cap indexes that
involve less trading and which are fairly stable.

Portfolio Performance Measurement

Performance evaluation is a critical aspect of
portfolio management
Proper performance evaluation should involve a
recognition of both the return and the riskiness of the
investment

 Risk : It is the amount of volatility of returns in a

portfolio measured by standard deviation. Volatility is
used as a proxy for risk. Volatility is a measure of
how much a given number can vary over time and the
wider the range of possibilities

Return : It is ultimately the rate of growth of your

portfolio. Given enough time a high-risk portfolio
will earn higher returns than a low-risk portfolio.

 High Risk :High risk means there is a strong chance

that you could lose a substantial amount (or all) of
your investment.
Low risk : Low risk means when it is thought to be
just a small chance of losing some or all of your
money.

Factors to consider in Measuring

Portfolio Performance
Differential Risk Levels: In order to Evaluate portfolio
performance properly, we must determine whether the returns
are large enough given the risk involved.
Differential Time Periods : In order to evaluate performance of
two funds of same type with different time periods, time element
must be adjusted.
Appropriate Benchmarks: In evaluating portfolio performance
to compare the returns, the portfolio must be evaluated with the
returns that could have been obtained from a comparable
alternative.

Traditional
Performance Measures
Sharpe Measure
Treynor Measures
Jensen Measure

Sharpe and Treynor Measures

The Sharpe measure evaluates return relative
to total risk
Appropriate for a well-diversified portfolio,
but not for individual securities
The Treynor measure evaluates the return
relative to beta, a measure of systematic risk
It ignores any unsystematic risk

Sharpe and Treynor Measures

The Sharpe and Treynor measures:
Sharpe measure
Treynor measure

R Rf

R Rf

where R average return

R f risk-free rate

standard deviation of returns

beta

Jensen Measure
The Jensen measure is also based on CAPM.
Named after its creator, Michael C. Jensen.
The Jensen measure is a risk-adjusted performance
measure that represents the average return on a
portfolio over and above that predicted by the capital
asset pricing model (CAPM), given the portfolio's
beta and the average market return.

This measure of return is also known as alpha.

Jensen Measure

Measuring Returns
How to measure returns generated by an investment
manager?

Two ways to measure returns:

1. Dollar Weighted Rate of Return
2. Time Weighted Rate of Return

Measuring Returns
Dollar weighted rate of return is the internal rate of
return (IRR) of an investment
In investment management industry, time weighted
rate of return is preferred
Rate does not depend on when investment is
made (timing of cashflows)
Since different clients will invest at different
times, need a measure that is independent of
timing

PROBLEM
Four years ago, this investor put $200,000 in a
portfolio aligned with her long-term goals. This
portfolio then grew by 10% a year for 4 years. At the
start of the 5th year the investor received a large
inheritance, worth $1,000,000, and added it to the
account. During this same year the market happened
to decline, and the portfolio lost 10%. The portfolio
value historically would look like this:

Solution-dollar Weighted Rate Of

Return

SOLUTION
Because her account was so much larger during the
market decline of the 5th year, the investor has
actually lost money ($1,163,538 - $1,200,000 = $36,462) when compared to her total contributions.
However, the statement shows a positive timeweighted annualized rate of return. How can this be
correct?

Solution-time Weighted Rate Of

Return

FORMULA
TWRR = (1+10%) x (1+10%) x (1+10%) x (1+10%)
x (1+(-10%)) -1 = 32% cumulative return. Total
returns greater than 1 year are then annualized.
The annualized return is calculated as (1 + total
return)^(1/(Time/365))
= (1+ 32%) ^ ((1/1825/365)) -1 = 5.67%.

SOLUTION
The answer lies in the time-weighted rate of return calculation,
where each annual period counts equally. With this
performance measure, the portfolios positive performance
during the first 4 years would account for the 4/5s of the
return, with the last year being the last 1/5. The performance
will show a positive 5.67% annualized return; reflecting the
overall portfolio performance during the entire 5 year period
because each years return has an equal weight in the total
return calculation. Also, the timing of the cash inflow to the
portfolio, of which the portfolios money managers had no
control, does not influence the return.

SOLUTION
If you were to use dollar-weighted calculations, the 5th years
performance would overwhelm the return number, because the
value was so much higher during that one year. In this scenario
the portfolios previous 4 years of positive performance would
have less weight, and the focus would almost entirely be on
the 5th year, during which the market happened to decline. In
this scenario the DWRR would be (1.86%), since the
portfolios money managers performance is dominated by the
timing of the cash flow received.

FORMULA
DWRR = Initial cash flow + (CashFlow1) / (1 +
Return)^1 + (CashFlow2) / (1+Return)^2 +
(CashFlowN) / (1+Return)^N
In this scenario the DWRR would =
$-200,000 + ($-1,000,000) / (1+R)^4 + ($1,163,538) /
(1+R)^5, solving for return = (1.86%).

Pros And Cons

Pros And Cons

THANK YOU