Chapter 6: Portfolio Management
1. INTRODUCTION
• Investment in securities (bonds, debentures, shares) is rewarding but risky.
• "Don’t put all eggs in one basket" principle: diversification optimizes risk-return.
• Portfolio investment reduces risk without diluting returns.
• Return and risk characterize every investment.
• Risk: deviation of actual return from expected return; measurable by standard deviation/variance.
2. ACTIVITIES IN PORTFOLIO MANAGEMENT
Three major activities for optimal portfolio formation:
1. Selection of securities.
2. Construction of all feasible portfolios from selected securities.
3. Deciding weights/proportions of securities to form an optimal portfolio matching investor’s risk
appetite.
3. OBJECTIVES OF PORTFOLIO MANAGEMENT
• Security/Safety of Principal & purchasing power.
• Stability of Income for planning reinvestment or consumption.
• Capital Growth through reinvestment or buying growth securities.
• Marketability: ease of buying/selling securities for flexibility.
• Liquidity: nearness to cash to seize opportunities.
• Diversification: reduce risk by spreading investments across industries/securities.
• Favourable Tax Status: minimize tax burden to improve effective yield.
4. PHASES OF PORTFOLIO MANAGEMENT
4.1 Security Analysis
• Classify and analyze securities: equity, preference shares, bonds, convertible debentures, etc.
• Identify underpriced and overpriced securities using:
o Fundamental Analysis: intrinsic value based on EPS, dividend payout, management
quality, industry factors.
o Technical Analysis: price movements and patterns to predict future prices.
• Diversify by selecting securities with low or negative correlations to reduce unsystematic risk.
• Random Walk Theory: price movements are random, so neither Fundamental nor Technical
analysis guarantees sustained gains.
• Efficient Market Hypothesis: markets are nearly efficient; opportunities for sustained gains
decline over time.
4.2 Portfolio Analysis
• Combine chosen securities to form portfolios.
• Portfolio return = weighted average of individual returns.
• Portfolio risk depends on variances and covariances among securities.
• Feasible Portfolios: all portfolios constructed from selected securities.
4.3 Portfolio Selection
• Identify Efficient Portfolios: highest return for given risk or lowest risk for given return.
• Use Markowitz Portfolio Theory (Modern Portfolio Theory) to select optimal portfolio suiting
investor’s risk tolerance.
4.4 Portfolio Revision
• Continuous monitoring and adjustment necessary due to dynamic markets and investor needs.
• Revision involves adding/selling securities to maintain optimality.
• Requires scientific and objective approach.
4.5 Portfolio Evaluation
• Quantitative measurement of return and risk over investment period.
• Identifies weaknesses and improves investment process.
• Ongoing process integrated with analysis, construction, revision.
5. PORTFOLIO THEORIES
5.1 Traditional Approach
• Focus on investor’s profile (age, income needs, risk tolerance, tax status).
• Define portfolio objectives (maximize wealth subject to risk).
• Investment strategy balances fixed interest, equities, income vs growth, taxes, transaction costs.
• Diversification reduces volatility.
• Selection based on fundamental/technical analysis, expert advice, asset backing, dividend
growth, management quality.
• Criticism: Markowitz showed blind diversification is suboptimal; specific selection based on risk-
return tradeoff is necessary.
5.2 Modern Approach (Markowitz Model or Risk-Return Optimization)
• Developed by Harry Markowitz in 1950s.
• Portfolio risk reduced and returns optimized by combining securities with low or negative
correlations.
• Focus on portfolio mean (expected return) and variance (risk).
• Mean Variance Analysis: technique to select right portfolio mix.
• Investors focus on contribution of a security to overall portfolio risk, not individual asset risk.
6. RISK ANALYSIS
6.1 Concept of Risk and Return
• Risk: uncertainty in actual vs expected return.
• Expected return: investor’s forecast.
• Realized return: actual return.
• Risk = variability in returns, measured by standard deviation or variance.
6.2 Types of Risk
6.2.1 Systematic Risk (Market Risk)
• Affects all securities; macroeconomic in nature.
• Not diversifiable.
• Includes:
o Interest Rate Risk: inverse relationship between interest rate and bond prices.
o Purchasing Power Risk (Inflation Risk): inflation erodes real returns.
o Market Risk: price movements in line with market trends (bullish/bearish).
6.2.2 Unsystematic Risk (Specific/Idiosyncratic Risk)
• Company-specific.
• Diversifiable by portfolio.
• Includes:
o Business Risk: variability in operating profits.
o Financial Risk: risk due to leverage (debt in capital structure).
6.3 Diversification of Risk
• Unsystematic risk can be reduced/eliminated by combining many securities.
• Systematic risk remains regardless of diversification.
• Portfolio total risk = systematic risk + unsystematic risk.
6.4 Risk & Return Quantification
6.4.1 Expected Return
• Weighted average of possible returns with probabilities.
• Simple average used if historical data.
6.4.2 Risk (Variance and Standard Deviation)
• Measures variability of returns from expected return.
• Calculated using probabilities or historical data.
• Standard deviation is square root of variance.
• Relevant risk is systematic risk (measured by Beta), as unsystematic risk can be diversified.
6.4.3 Measurement of Systematic Risk (Beta)
• Beta (β) measures sensitivity of security’s returns to market returns.
• Calculated via:
o Correlation Method: β = correlation between stock and market × (stock standard
deviation / market standard deviation).
o Regression Method: slope coefficient (β) from regression of stock returns on market
returns.
• Interpretation:
o β = 1: security’s risk equals market risk.
o β > 1: more volatile than market.
o β < 1: less volatile.
o β = 0: independent of market.
7. PORTFOLIO ANALYSIS (Return and Risk)
7.1 Portfolio Return
• Weighted average of individual security returns.
7.2 Portfolio Risk (Variance and Standard Deviation)
• Variance = weighted sum of variances + weighted sum of covariances.
• Covariance measures how two securities move together.
• Correlation coefficient (r) ranges from -1 (perfect negative) to +1 (perfect positive).
7.3 Impact of Correlation on Portfolio Risk
7.3.1 Perfect Positive Correlation (r = +1)
• Portfolio risk is weighted average of individual risks.
• No risk reduction by diversification.
7.3.2 Perfect Negative Correlation (r = -1)
• Portfolio risk can be reduced to zero with proper weighting.
• Maximum diversification benefit.
7.3.3 Zero Correlation (r = 0)
• Portfolio risk less than weighted average risk.
• Diversification reduces risk.
7.4 Portfolio with More Than Two Securities
• Risk reduces as number of securities increases.
• Diminishing marginal benefit beyond 25-30 securities due to positive correlation among
securities.
8. MARKOWITZ MODEL OF RISK-RETURN OPTIMIZATION
8.1 Assumptions
• Investors consider expected return and variance.
• Investors are rational and risk averse.
• Diversification reduces risk.
• Returns are probabilistically distributed.
8.2 Efficient Frontier
• Set of portfolios offering maximum return for given risk or minimum risk for given return.
• Investors select portfolios on efficient frontier based on individual risk tolerance (utility function).
• Optimal portfolio lies at tangency of efficient frontier and investor’s highest indifference curve.
9. CAPITAL MARKET THEORY
• Combines risk-free asset and market portfolio.
• Capital Market Line (CML): line from risk-free rate tangent to market portfolio in risk-return
space.
• Expected portfolio return:
𝐸(𝑅𝑚 ) − 𝑅𝑓
𝐸(𝑅𝑝 ) = 𝑅𝑓 + 𝜎𝑝
𝜎𝑚
• Slope of CML = reward-to-variability ratio = market risk premium per unit total risk.
10. SINGLE INDEX MODEL (SHARPE INDEX MODEL)
• Assumes co-movement of stocks due to market index.
• Security return:
𝑅𝑖 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑚 + 𝜖𝑖
• Systematic risk = explained by market index variance × β².
• Unsystematic risk = residual variance 𝜖𝑖2 .
• Portfolio variance formula accounts for weighted betas and residual variances.
11. CAPITAL ASSET PRICING MODEL (CAPM)
• Relates expected return to systematic risk (beta).
• Formula:
𝑅𝑗 = 𝑅𝑓 + 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 )
• Assumptions include efficient markets, rational investors, no transaction costs,
borrowing/lending at risk-free rate.
• Only non-diversifiable risk (systematic) is rewarded.
• Beta interpretation:
o β = 1: risk equals market.
o β > 1: riskier than market.
o β < 1: less risky.
• Security Market Line (SML): graphical representation of CAPM.
• Used to identify undervalued (expected return > required return), overvalued, or fairly valued
stocks.
12. ARBITRAGE PRICING THEORY (APT)
• Multi-factor model alternative to CAPM.
• Expected return:
𝐸(𝑅𝑖 ) = 𝑅𝑓 + 𝛽1 𝜆1 + 𝛽2 𝜆2 + ⋯ + 𝛽𝑛 𝜆𝑛
• 𝜆𝑛 : risk premium for factor n.
• 𝛽𝑛 : sensitivity to factor n.
• Factors include inflation, GDP growth, interest rates, etc.
• Allows multiple macroeconomic factors to explain returns.
13. PORTFOLIO EVALUATION METHODS
13.1 Sharpe Ratio
• Measures risk premium per unit of total risk (standard deviation).
• Formula:
𝑅𝑝 − 𝑅𝑓
𝑆=
𝜎𝑝
• Higher ratio indicates better risk-adjusted performance.
13.2 Treynor Ratio
• Measures risk premium per unit of systematic risk (beta).
• Formula:
𝑅𝑝 − 𝑅𝑓
𝑇=
𝛽𝑝
• Useful when portfolio is well-diversified.
13.3 Jensen’s Alpha
• Difference between actual portfolio return and CAPM expected return.
• Indicates portfolio manager’s skill.
• Positive alpha: outperformance; negative alpha: underperformance.
14. SHARPE’S OPTIMAL PORTFOLIO
• Securities ranked by Treynor ratio (excess return to beta).
• Cut-off point 𝐶 ∗ calculated to select securities.
• Weights determined by formula involving beta, unique risk, and market variance.
• Portfolio constructed from securities above cut-off.
15. FORMULATION OF PORTFOLIO STRATEGY
15.1 Active Portfolio Strategy
• Seeks to outperform market.
• Involves:
o Market Timing
o Sector Rotation
o Security Selection
o Specialized Investment Concepts (growth stocks, cyclical stocks, etc.)
15.2 Passive Portfolio Strategy
• Assumes market efficiency.
• Focuses on:
o Well-diversified portfolio.
o Minimal changes (index funds).
• Index funds mimic market index weights.
15.3 Selection of Securities
• Bonds: focus on yield, default risk, tax impact, liquidity.
• Stocks: technical, fundamental, or random analysis.
• Choice depends on market efficiency level.
16. PORTFOLIO REVISION AND REBALANCING
Policies:
• Buy and Hold: no rebalancing, risk changes with market.
• Constant Mix: maintain fixed ratio by buying/selling as prices change.
• Constant Proportion Portfolio Insurance (CPPI): set floor value, leverage cushion; buy more as
prices rise, sell as they fall.
17. ASSET ALLOCATION STRATEGIES
• Integrated Asset Allocation: combines market outlook and investor needs.
• Strategic Asset Allocation: periodic adjustment to target mix.
• Tactical Asset Allocation: adjusts for market conditions.
• Insured Asset Allocation: adjusts risk exposure with wealth changes.
18. FIXED INCOME PORTFOLIO
Process:
1. Set objectives.
2. Draft investment policy.
3. Select strategy (active/passive).
4. Select securities.
5. Evaluate performance.
Return Measures:
• Arithmetic average, time-weighted, rupee-weighted, annualized return.
Management Strategies:
• Passive: buy and hold, indexing, immunization, cash flow matching.
• Active: interest rate forecasting, bond swaps, interest rate swaps.
19. ALTERNATIVE INVESTMENT AVENUES
• Includes real estate, gold, private equity, REITs, hedge funds, ETFs, commodities, distressed
securities.
• Features: high fees, limited historic data, illiquidity, less transparency, leverage.
• Real Estate: valuation via sales comparison, income, cost, discounted cash flow.
• Gold: physical bars, sovereign gold bonds, ETFs, e-gold.
• Distressed Securities: invest in near-bankrupt firms for arbitrage gains; risky.