Portfolio Management and Perfomance Evaluation
Portfolio Management and Perfomance Evaluation
Portfolio Management and Perfomance Evaluation
With a whole spectrum of financial vehicles available to the investor, there should exist a criteria
upon which anybody can hinge on in coming up and reviewing his holdings. The investment or
portfolio or money management process is a five step procedure of managing funds/portfolio and
describes how investors and money managers should go about making decisions.
1. Setting of investment policy.
2. Analysis and evaluation of investment vehicles.
3. Formation of diversified investment portfolio.
4. Portfolio revision
5. Measurement and evaluation of portfolio performance.
These steps can all be viewed as functions of investment management, and they must be
undertaken for each client whose money is being managed.
1. Setting of investment policy- God assigning Adam on what to do with Eden and animals
Is the first and very important step in investment management process. Investment policy includes
setting of investment objectives. The investment policy should have the specific objectives regarding
the investment return requirement and risk tolerance of the investor [defined as the largest
amount of risk that the client is willing to accept for a given increase in expected return]. For
example, the investment policy may define that the target of the investment average return should
be 15 % and should avoid more than 10 % losses.
Identifying investor’s tolerance for risk is the most important objective, because it is obvious that
every investor would like to earn the highest return possible. But because there is a positive
relationship between risk and return, it is not appropriate for an investor to set his/ her investment
objectives as just “to make a lot of money”. Investment objectives should be stated in terms of both
risk and return.
The investment policy should also state other important constraints which could influence the
investment management. Constraints can include any liquidity needs for the investor, projected
investment horizon, as well as other unique needs and preferences of investor. The investment
horizon is the period of time for investments. Projected time horizon may be short, long or even
indefinite.
Setting of investment objectives for individual investors is based on the assessment of their current
and future financial objectives.
The investment policy can include the tax status of the investor. This stage of investment
management concludes with the identification of the potential categories/classes of financial assets
for inclusion in the investment portfolio. The identification of the potential categories is based on
the investment objectives, amount of investable funds, investment horizon, risk tolerance and tax
status of the investor.
As an example, for the investor with low tolerance of risk common stock will be not an appropriate
type of investment.
2. Analysis and evaluation of investment vehicles.
When the investment policy is set up, investor’s objectives defined and the potential categories of
financial assets for inclusion in the investment portfolio identified, then available investment types
can be analyzed. This step involves examining several relevant types of investment vehicles and the
individual vehicles inside these groups.
For example, if the common stock was identified as investment vehicle relevant for investor, the
analysis will be concentrated to the common stock as an investment. The one purpose of such
analysis and evaluation is to identify those investment vehicles that currently appear to be
mispriced. There are many different approaches how to make such analysis. Most frequently two
forms of analysis are used: technical analysis and fundamental analysis-
Investment portfolio is the set of investment vehicles, formed by the investor seeking to realize his
defined investment objectives. In the stage of portfolio formation the issues of selectivity, timing
and diversification need to be addressed by the investor.
Selectivity refers to micro forecasting and focuses on forecasting price movements of individual
assets. Timing involves macro forecasting of price movements of particular type of financial asset
relative to fixed-income securities in general. Diversification involves forming the investor’s
portfolio for decreasing or limiting risk of investment. 2 techniques of diversification:
• random diversification, when several available financial assets are put into the portfolio at
random;
• objective diversification when financial assets are selected to the portfolio following investment
objectives and using appropriate techniques for analysis and evaluation of each financial asset.
Investment management theory is focused on issues of objective portfolio diversification and
professional investors follow settled investment objectives then constructing and managing their
portfolios.
4. Portfolio monitoring, revision and rebalancing.- God destroying the manager [humans] leaving
behind moon etc
This step of the investment management process concerns the periodic revision of the three
previous stages. This is necessary, because over time, investor with long-term investment horizon
may change his/her investment objectives and this, in turn means that currently held investor’s
portfolio may no longer be optimal and even contradict with the new settled investment
objectives.
Investor should form the new portfolio by selling some assets in his portfolio and buying the others
that are not currently held. It could be that over time the prices of the assets changed, meaning that
some assets that were attractive at one time may no longer be so. Thus investor should sell one
asset and buy the other more attractive in this time according to his/ her evaluation.
The decisions to perform changes in revising portfolio depend, upon other things, in the transaction
costs incurred in making these changes. For institutional investors portfolio revision is continuing
and very important part of their activity. But individual investor managing their portfolios must
perform portfolio revision periodically as well. Periodic re-evaluation of the investment objectives
and portfolios based on them is necessary, because financial markets change, tax laws and security
regulations change, and other events alter stated investment goals.
Portfolio revision is the process of selling certain securities in portfolio and purchasing new ones to
replace them. The objective is to increase the net utility of the client after adjusting for transaction
costs [increase risk adjusted return on the portfolio]
With the passage of time, a previously purchased portfolio that is currently held will often be
viewed as suboptimal by the investment manager, meaning that the portfolio is no longer viewed as
the best one for the client. Either the weights in the different securities have changed as their
market prices have changed, or the client's attitude toward risk and return has changed or, more
likely, the manager's forecasts have changed. In response, the manager could identify a new optimal
portfolio and then make the necessary revisions to the current portfolio so that subsequently the
new optimal portfolio will be held.
The main reasons for the necessity of the investment portfolio revision:
• As the economy evolves, certain industries and companies become either less or more attractive as
investments;
• The investor over the time may change his/her investment objectives and in this way his/ her
portfolio is no longer optimal;
• 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.
NB: A revision can be viewed as bringing certain kinds of benefits; either it will increase the
expected return of the portfolio or it will reduce the standard deviation of the portfolio, or it will
do both.
Three areas to monitor when implementing investor’s portfolio monitoring:
1. Changes in market conditions;
2. Changes in investor’s circumstances;
3. Asset mix in the portfolio.
The need to monitor changes in the market is obvious. Investment decisions are made in dynamic
investment environment, where changes occur permanently. The key macroeconomic indicators
(such as GDP growth, inflation rate, interest rates, others), as well as the new information about
industries and companies should be observed by investor on the regular basis, because these
changes can influence the returns and risk of the investments in the portfolio. Investor can monitor
these changes using various sources of information, especially specialized websites.
It is important to identify the major changes in the investment environment and to assess whether
these changes should negatively influence investor’s currently held portfolio. If it is so, the investor
must take an actions to rebalance his portfolio. When monitoring the changes in the investor’s
circumstances, the following aspects must be taken into account:
• Change in wealth • Change in time horizon
• Change in liquidity requirements • Change in tax circumstances
• Change in legal considerations • Change in other circumstances and investor’s needs.
Constant proportion portfolio. A constant proportion portfolio is one in which adjustments are
made so as to maintain the relative weighting of the portfolio components as their prices change.
Investors should concentrate on keeping their chosen asset allocation percentage (especially those
following the requirements for strategic asset allocation). There is no one correct formula for when
to rebalance. One rule may be to rebalance portfolio when asset allocations vary by 10% or more.
But many investors find it bizarre that constant proportion rebalancing requires the purchase of
securities that have performed poorly and the sale of those that have performed the best.
Constant Beta portfolio. The base for the rebalancing portfolio using this alternative is the target
portfolio Beta. Over time the values of the portfolio components and their Betas will change and this
can cause the portfolio Beta to shift.
For example, if the target portfolio Beta is 1.10 and it had risen over the monitored period of time to
1.25, the portfolio Beta could be brought back to the target (1.10) in the following ways:
• 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 rather than a long-term;
• Put additional money into the stock 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.
• Sell high Beta stocks in portfolio and hold cash. As with the first alternative, this way reduces the
equity holdings in the investor’s portfolio which may be not appropriate.
• Sell high Beta stocks and buy low Beta stocks. The stocks bought could be new additions to the
portfolio, or the investor could add to existing positions.
Indexing. This alternative for rebalancing the portfolio is more frequently used by institutional
investors (often mutual funds), because their portfolios tend to be large and the strategy of
matching a market index are best applicable for them. Managing index based portfolio investor (or
portfolio manager) eliminates concern about outperforming the market, because by design, it seeks
to behave just like the market averages. Investor attempts to maintain some predetermined
characteristics of the portfolio, such as Beta of 1.0. The extent to which such a portfolio deviates
from its intended behaviors called tracking error.
Revising a portfolio is not without costs for an individual investor. These costs can be direct costs –
trading fees and commissions for the brokers who can trade securities on the exchange. With the
developing of alternative trading systems (ATS) these costs can be decreased. It is important also,
that the selling of securities may have income tax implications which differ from country to country.
5. Measurement and evaluation of portfolio performance.-[in the cool of the day Adam was in a
naked position and fired out of the garden]
This is the last step in investment management process involves determining periodically how the
portfolio performed, in terms of not only the return earned, but also the risk of the portfolio. For
evaluation of portfolio performance appropriate measures of return and risk and benchmarks are
needed. A benchmark is the performance of predetermined set of assets, obtained for comparison
purposes. The benchmark may be a popular index of appropriate assets – stock index, bond index.
The benchmarks are widely used by institutional investors evaluating the performance of their
portfolios.
Portfolio evaluation
The evaluation of portfolio performance is essentially concerned with comparing the return earned
on some portfolio with the return earned on one or more other portfolios. It is important that the
portfolios chosen for comparison are truly comparable. This means that they not only must have
similar risk but also must be bound by similar constraints. For example, an institution that restricts
its managers to investing in bonds rated AA or better should not evaluate its managers by comparing
their performance to the performance of portfolios that are unconstrained. Although such a
comparison would be useful in evaluating the relevance of the constraint, it would not be relevant
for evaluating the manager. Often the return earned by a fund is compared to the return earned by
a portfolio of similar risk. In other comparisons an explicit risk–return trade-off is developed so that
comparisons can be made across funds with very different risk levels. In either case, it is necessary to
be more precise about what is meant by risk and return.
Portfolio performance measures
Portfolio performance evaluation involves determining periodically how the portfolio performed in
terms of not only the return earned, but also the risk experienced by the investor. Such information
can be used to alter the constraints placed on the manager, the investment objectives given to the
manager, or the amount of money allocated to the manager. For portfolio evaluation appropriate
measures of return and risk as well as relevant standards (or “benchmarks”) are needed.
In general, 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. The market value of the portfolio at the end
of the period is calculated in the same way, only using end-of-period prices of the securities held in
the portfolio.
The return on the portfolio (rp):
𝑹𝒑=(𝑽b−𝑽e)/𝑽e
As a second example, consider table below. This table shows two different patterns of inflows and
outflows. In both cases, over the entire period, the inflows the outflows are the same. Furthermore,
the rate of return earned by each fund is identical in each period. However, the ending value is
very different because the fund manager of fund A had the good luck to have the funds in the period
that was highly profitable. If we just looked at the ending value compared to the beginning value
over the full period, fund A’s performance would look superior.
However, the period-by-period return is identical and (ignoring risk for the moment) so is the
manager’s performance. Unless the inflows and outflows are under the control of the manager
(and in most cases they are not), the manager should not be rewarded or penalized for the good or
bad fortune of having extra funds available at a particular time.
We eliminate the effect of having different amounts of funds available if we calculate the rate of
return in each time period and then compound the return to determine it in the overall period.
When the rate of return is calculated this way, it is called the time-weighted rate of return.
For fund A the return in the first period is (240-200)/200 = 20%. In the second period the return is
(126-140)/140=-10%. In the third period the return is (138.60-126)/126=10%. The overall return is
the product of 1 plus each of the three one-period returns minus 1, or (1.20)(0.90)(1.10) -1 = 0.188,
or 18.8%. This return is the same for A and B. Because the manager’s performance was identical, this
is appropriate.
Also, in the first example, the time-weighted rate of return would show the actual 10% return that
was earned for each period. It would not penalize the manager for the net outflows encountered. To
calculate the time-weighted rate of return requires knowledge of the value of the fund anytime
there is a cash inflow or an outflow.
NB: the other measure though at times very inappropriate is the dollar weighted return [internal
rate of return].
Measures of Risk
Once the periodic returns for a portfolio during a time interval (say, quarterly returns for a four
years) have been measured, the next step is to determine whether these returns represent superior
or inferior performance. This step requires an estimate of the portfolio's risk level during the time
interval. There are two possible measures of risk that can be used: total risk or non-diversifiable
risk. As discussed in earlier chapters, total risk is normally measured by standard deviation of return,
whereas non-diversifiable risk is normally measured by the beta coefficient.
The essential idea behind performance evaluation is to compare the returns which were obtained on
portfolio with the results that could be obtained if more appropriate alternative portfolios had been
chosen for the investment. Such comparison portfolios are often referred to as benchmark
portfolios. In selecting them investor should be certain that they are relevant, feasible and known in
advance. The benchmark should reflect the objectives of the investor.
It is important to analyze risk appropriately. The key issue here is determining the impact of the
portfolio on the client's overall level of risk. If the client has many other assets, then the market risk
of the portfolio provides the relevant measure of the portfolio's impact on the client's overall level of
risk. If, however, the portfolio provides the client's sole support, then its total risk is the relevant
measure of risk. Risk-adjusted performance evaluation is generally based on one of these two
viewpoints, taking either market risk or total risk into consideration.
To adjust the return for risk before comparison and ranking of performance, risk adjusted measures
of performance can be used:
Sharpe’s ratio;
Treynor’s ratio [excess return to beta measure/reward to volatility];
Jensen’s Alpha.
Excess return relative to duration measure
Sharpe’s ratio (or reward-to-variability ratio) shows excess return over risk free rate, or risk
premium, by unit of total risk, measured by standard deviation:
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.
The Sharpe measure is suitable for an individual with a portfolio that is not well diversified hence the
use of total portfolio risk.
Treynor’s ratio [reward to volatility] shows excess actual return over risk free rate, or risk premium,
by unit of systematic risk, measured by Beta:
where:
βp – Beta, measure of systematic risk for the portfolio p.
Like the Sharpe ratio, a higher value of the Treynor ratio suggests better performance. Treynor
measure is suitable for an individual with a well-diversified portfolio.
Jensen‘s Alpha shows excess actual return over required return and excess of actual risk premium
over required risk premium. This measure of the portfolio manager’s performance is based on the
CAPM.
In case of the risk measure being relative duration, the relevant alpha will be from the equation,
Rp = Rf + (Rm - Rf)Dp/Dm
It is important to note, that if a portfolio is completely diversified, all of these measures (Sharpe,
Treynor’s ratios and Jensen’s alpha) will agree on the ranking of the portfolios. The reason for this
is that with the complete diversification total variance is equal to systematic variance. When
portfolios are not completely diversified, the 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.
NB: One measure of a portfolio's risk-adjusted performance is the difference between its average
return (arp) and the return on its corresponding benchmark portfolio, denoted arbp This difference is
generally referred to as the portfolio's ex post alpha (or differential return), and is denoted αp:
A positive value of alpha for a portfolio would indicate that the portfolio had an average return
greater than the benchmark return, suggesting that its performance was superior. On the other
hand, a negative value of alpha would indicate that the portfolio had an average return less than the
benchmark return, suggesting that its performance was inferior.
Excess return relative to duration measure- a measure suitable for bond portfolios;
=𝑅𝑝−𝑅𝑓
𝐷𝑝/𝐷𝑚
Where 𝐷𝑝/𝐷𝑚 is the duration of bond portfolio relative to duration of the market.
It is important to point out that investment management process is a continuing process influenced
by changes in investment environment and changes in investor’s attitudes as well. Market
globalization offers investors new possibilities, but at the same time investment management
become more and more complicated with growing uncertainty.
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. The fixed-weightings approach in strategic asset allocation is used. Investor
using this approach allocates a fixed percentage of the portfolio to each of the asset classes, of
which typically are three to five. Example of asset allocation in the portfolio might be as follows:
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 moves to maintain the desired fixed-
percentage allocation.