Chapter 9:

Portfolio Management
Portfolio management is a complex process or activity that may be divided into eight broad
phases:
1. Specification of investment objectives and constraints
2. Quantification of capital market expectations
3. Asset allocation
4. Formulation of portfolio strategy
5. Selection of securities
6. Portfolio execution
7. Portfolio rebalancing
8. Performance evaluation
The first four phases viz., specification of investment objectives and constraints,
quantification of capital market expectations, asset allocation, and formulation of portfolio
strategy may be collectively referred to as investment policy and strategy. The next four
phases viz., selection of securities, portfolio execution, portfolio revision, and portfolio
SPECIFICATION OF INVESTMENT OBJECTIVES AND CONSTRAINTS
The first step in the portfolio management process is to specify the investment policy which
summarizes the objectives, constraints, and preferences of the investor.

The investment policy may be expressed as follows:

Objectives
• Return requirements
• Risk tolerance
Constraints and Preferences
• Liquidity
• Investment horizon
• Taxes
• Regulations
• Unique circumstances
QUANTIFICATION OF CAPITAL MARKET EXPECTATIONS
After specifying your investment objectives and constraints, you have to address the
following questions:

1. What asset classes should be included or excluded from the portfolio?

2. What weights (or proportions) should be assigned to the selected asset classes?
3. Which specific securities or investments should be held, within each asset class,
and in what amounts?

The first two questions relate to asset allocation and the third question relates to
security selection.
ASSET ALLOCATION: STRATEGIC ASSET ALLOCATION
While strategic asset allocation is concerned with establishing the long-term asset mix of a
portfolio, the other types of asset allocation refer to what the portfolio manager does in
response to evolving market conditions.

While there are alternative ways of measuring the importance of asset allocation, academics
and practitioners alike generally agree that the asset allocation decision is by far the most
important decision made by an investor.
FORMULATION OF PORTFOLIO STRATEGY
After you have chosen a certain asset mix, you have to formulate an appropriate portfolio
strategy for each of the two components of the portfolio viz., stocks (equities) and bonds.
Two broad choices are available with respect to equity portfolio strategy, a passive portfolio
strategy or an active portfolio strategy.
Passive Portfolio Strategy
Passive equity portfolio strategy seeks to design a portfolio meant to replicate the
performance of a specific index. The passive strategy rests on the tenet that the capital market
is fairly efficient with respect to the available information. Hence, the search for superior
returns through an active strategy is considered futile.
Active Portfolio Strategy
Most investors (individual as well as institutional) are not satisfied with a passive equity
strategy that merely seeks to replicate the performance of a benchmark index. They strive to
outperform a benchmark index, net of transaction costs, on a risk-adjusted basis.

Active managers follow a variety of approaches which fall into three broad categories:
Fundamental approach
Sector rotation
Security selection
Use of a specialised investment concept
Technical approach
Contrarian strategy
Momentum strategy
Sector Rotation :Sector rotation involves shifting the weightings of different sectors and
industries based on their assessed outlook. For example, if you believe that the financial
services and pharmaceutical sectors would do well compared to other sectors in the
forthcoming period (on year, two years, or whatever), you may overweight these sectors in
your portfolio, relative to their position in the market portfolio.
Stock Picking: Perhaps the most commonly used vector by those who follow an active
portfolio strategy, stock picking involves identifying individual stocks that appear to be under-
valued. Such stocks are over-weighted in the portfolio, relative to their position in the market
portfolio. Likewise, stocks which are perceived to be over-valued will be under-weighted
relative to their position in the market portfolio.
Use of a Specialised Investment Concept :A related approach to achieve superior returns is to
employ a specialised concept or philosophy. As Charles D. Ellis put it, a possible way to
enhance returns “is to develop a profound and valid insight into the forces that drive a
particular sector of the market or a particular group of companies or industries and
Some of the concepts that have been exploited successfully by investment practitioners are:
• Growth stocks
• Value stocks
• Asset-rich stocks
• Technology stocks
• Cyclical stocks
Technical Analysis: Contrarian Strategy Technical analysis involves a study of internal market
data such as prices and volumes to determine the direction of future price movement.
Technical analysts use either a contrarian strategy or a momentum strategy.
A contrarian strategy presupposes that the best time to buy a stock is when the majority of
other investors are bearish about it; likewise, the best time to sell a stock is when the
majority of other investors are bullish about it. This strategy is based on the premise that
stock returns are mean-reverting.
Technical Analysis: Momentum Strategy In contrast to the contrarian strategy, a momentum
strategy assumes that recent trends in prices will continue. Stocks that have been hot are
expected to stay hot, whereas stocks that have been cold are expected to stay cold. While
there may be valid economic reasons for the persistence of recent trends (such as
acceleration of revenues and earnings during favourable times), it may also simply be a
reflection of market’s underreaction to the arrival of new information.
This implies that the market absorbs new information, positive or negative, gradually
SELECTION OF SECURITIES
Security selection in portfolio management is the crucial step of choosing specific investments
(stocks, bonds, etc.) that align with an investor's goals, risk tolerance, and overall strategy,
involving detailed analysis of individual assets, risk assessment, and diversification to build a
balanced portfolio that maximizes returns for the accepted risk level.

PORTFOLIO EXECUTION
By the time this phase of portfolio management is reached, several key issues have been
sorted out. Investment objectives and constraints have been specified, asset mix has been
chosen, portfolio strategy has been developed, and specific securities to be included in the
portfolio have been identified. The next step is to implement the portfolio plan by buying
and/or selling specified securities in given amounts. This is the phase of portfolio execution
which is often glossed over in portfolio management literature.
However, it is an important practical step that has a significant bearing on investment results.

Further, it is neither simple nor costless as is sometimes naively felt. For effectively handling
the portfolio execution phase, you should understand what the trading game is like, what is
the nature of key players (transactors) in this game, who are the likely winners and losers in
this game, and what guidelines should be borne in mind while trading.

PORTFOLIO REVISION
Irrespective of how well you have constructed your portfolio, it soon tends to become
inefficient and hence needs to be monitored and revised periodically. As Robert D. Arnott
says: “Portfolios do not manage themselves. Nor can weather the ages unaltered.
With each passing day, portfolios that we carefully crafted yesterday become less-than
optimal. Change is the investor’s only constant.”
Over time several things are likely to happen. The asset allocation in the portfolio may have
drifted away from its target; the risk and return characteristics of various securities may have
altered; finally, the objectives and preferences of the investor may have changed.

Given the dynamic developments in the capital market and changes in your circumstances,
you have to periodically monitor and revise your portfolio.

This usually entails two things, viz. portfolio rebalancing and portfolio upgrading.

Portfolio Rebalancing

Portfolio rebalancing involves reviewing and revising the portfolio composition (i.e. the
stock-bond mix). There are three basic policies with respect to portfolio rebalancing:
buy and hold policy, constant mix policy, and portfolio insurance policy.
Under the buy and hold policy, the initial portfolio is left undisturbed. It is essentially a ‘buy
and hold’ policy. Irrespective of what happens to relative values, no rebalancing is done. For
example, if the initial portfolio has a stock-bond mix of 50:50 and after six months the stock-
bond mix happens to be, say, 70:50 because the stock component has appreciated and the
bond component has stagnated, the portfolio mix is allowed to drift. Put differently, no
changes are effected.
The constant mix policy calls for maintaining the proportions of stocks and bonds in line with
their target value. For example, if the desired mix of stocks and bonds is say 50:50, the
constant mix policy calls for rebalancing the portfolio when relative values of its components
change, so that the target proportions are maintained. This is perhaps the most sensible
portfolio rebalancing policy.
The portfolio insurance policy calls for increasing the exposure to stocks when the portfolio
appreciates in value and decreasing the exposure to stocks when the portfolio depreciates in
value. The basic idea is to ensure that the portfolio value does not fall below a floor level.
Portfolio Upgrading
While portfolio rebalancing involves shifting from stocks to bonds or vice versa, portfolio
upgrading calls for re-assessing the risk-return characteristics of various securities (stocks as
well as bonds), selling over-priced securities, and buying underpriced securities. It may also
entail other changes the investor may consider necessary to enhance the performance of the
portfolio.

You may hesitate to revise your portfolio or be too slow in doing so. You may not like to incur
the costs of trading like commission costs, taxes, and adverse market impacts. These costs
often look very obvious. However, remember that there are costs of non-trading which,
though subtle, may be significant. Your portfolio may drift into an asset mix that may no longer
be appropriate to your needs; you may hold over-priced investments, offering inferior returns;
you may forego opportunities of making promising investments.
You should learn how to weigh the opportunity cost of non-trading against the explicit costs
of trading. In essence, portfolio revision calls for developing an appropriate response to the
tension between the ‘apparent’ cost of trading and the ‘subtle’ cost of inaction.

PERFORMANCE EVALUATION

The key dimensions of portfolio performance evaluation are rate of return and risk.

Institutional money managers, pension fund managers, and mutual fund managers manage
large amounts of money for other people. Are they doing a good job? How does their
performance compare with a passively managed portfolio—that is, one in which the investor
holds just the market portfolio? Evaluating the performance of a portfolio is of interest to all
investors and money managers. Because active management costs significantly more than
passive management, we expect active managers to perform better than passive managers
The Capital Asset Pricing Model (CAPM) is a foundational financial model used to determine
the theoretically appropriate required rate of return for a risky asset, given its sensitivity to
systematic market risk (beta). It posits a linear relationship where higher risk demands higher
expected returns.

The CAPM Formula

The formula for the Capital Asset
Pricing Model is widely used in finance
to Calculate the expected return of an
Investment:
The model shows that the primary determinant of expected return for a security is its beta, or
how well the security correlates with the market. The higher the beta of an asset, the higher its
expected return will be. Assets with a beta greater than 1 have an expected return that is higher
than the market return, whereas assets with a beta of less than 1 have an expected return that
is less than the market return.

The capital asset pricing model is one of the most significant innovations in portfolio theory. The
model is simple, yet powerful; is intuitive, yet profound; and uses only one factor, yet is broadly
applicable. The CAPM was introduced independently by William Sharpe, John Lintner, Jack
Treynor, and Jan Mossin and builds on Harry Markowitz’s earlier work on diversification and
modern portfolio theory. The model provides a linear expected return–beta relationship that
precisely determines the expected return given the beta of an asset. In doing so, it makes the
transition from total risk to systematic risk, the primary determinant of expected return.
The CAPM asserts that the expected returns of assets vary only by their systematic risk as
measured by beta. Two assets with the same beta will have the same expected return
irrespective of the nature of those assets. Given the relationship between risk and return, all
assets are defined only by their beta risk.

In this chapter, performance evaluation is based only on the CAPM. However, it is easy to
extend this analysis to multifactor models that may include industry or other special factors.
Four ratios are commonly used in performance evaluation.
[Link] Ratios
Performance has two components, risk and return. Although return maximization is a
laudable objective, comparing just the return of a portfolio with that of the market is not
sufficient. Because investors are risk averse, they will require compensation for higher risk in
the form of higher returns.

A commonly used measure of performance is the Sharpe ratio, which is defined as the
portfolio’s risk premium divided by its risk:

Sharpe ratio uses the total risk of the

portfolio, not its systematic risk.
The Sharpe ratio, however, suffers from two limitations. First, it uses total risk as a
measure of risk when only systematic risk is priced. Second, the ratio itself (e.g., 0.2 or 0.3) is
not informative.

To rank portfolios, the Sharpe ratio of one portfolio must be compared with the Sharpe ratio
of another portfolio. Nonetheless, the ease of computation makes the Sharpe ratio a popular
tool.
2. Treynor ratio
The Treynor ratio is a simple extension of the Sharpe ratio and resolves the Sharpe
ratio’s first limitation by substituting beta risk for total risk. The Treynor ratio is:

Just like the Sharpe ratio, the numerators must be positive for the Treynor ratio to give
meaningful results. In addition, the Treynor ratio does not work for negative-beta assets that is,
the denominator must also be positive for obtaining correct estimates and rankings.

Although both the Sharpe and Treynor ratios allow for ranking of portfolios, neither ratio gives
any information about the economic significance of differences in performance. For example,
assume the Sharpe ratio of one portfolio is 0.75 and the Sharpe ratio for another
portfolio is 0.80. The second portfolio is superior, but is that difference meaningful? In addition,
we do not know whether either of the portfolios is better than the passive market portfolio. The
remaining two measures, M2 and Jensen’s alpha, attempt to address that problem by comparing
portfolios while also providing information about the extent of the overperformance or
underperformance.

3.M-Squared (M2 )
M2 is a metric used to evaluate the risk-adjusted returns of a portfolio in percentage terms,
relative to a specific benchmark, typically the market portfolio. A higher M2 value indicates
superior risk-adjusted performance.

M2 was created by Franco Modigliani and his granddaughter, Leah Modigliani—hence the
name M-squared. M2 is an extension of the Sharpe ratio in that it is based on total risk, not
beta risk.
M2 gives us rankings that are identical to those of the Sharpe ratio. They are easier to interpret,
however, because they are in percentage terms. A portfolio that matches the performance of
the market will have an M2 of zero, whereas a portfolio that outperforms the market will have
an M2 that is positive. By using M2 , we are not only able to determine the rank of a portfolio
but also which, if any, of our portfolios beat the market on a risk-adjusted basis.
 4. Jensen’s Alpha
Like the Treynor ratio, Jensen’s alpha is based on systematic risk. We can measure a portfolio’s
systematic risk by estimating the market model, which is done by regressing the portfolio’s
daily return on the market’s daily return. The coefficient on the market return is an estimate
of the beta risk of the portfolio. We can calculate the risk-adjusted return of the portfolio
using the beta of the portfolio and the CAPM.

The difference between the actual portfolio return and the calculated risk-adjusted return is a
measure of the portfolio’s performance relative to the market portfolio and is called Jensen’s
alpha. By definition, αm of the market is zero.
The sign of αp indicates whether the portfolio has outperformed the market. If αp is positive,
then the portfolio has outperformed the market; if αp is negative, the portfolio has
underperformed the market. Jensen’s alpha is commonly used for evaluating most institutional
managers, pension funds, and mutual funds. Values of alpha can be used to rank different
managers and the performance of their portfolios, as well as the magnitude of
underperformance or over performance.

For example, if a portfolio’s alpha is 2 percent and another portfolio’s alpha is 5 percent, the
second portfolio has outperformed the first portfolio by 3 percentage points and the market by
5 percentage points. Jensen’s alpha is the maximum amount that you should be willing to pay
the manager to manage your money.
When do we use total risk performance measures like the Sharpe ratio and M2 , and when do
we use beta risk performance measures like the Treynor ratio and Jensen’s alpha?

Total risk is relevant for an investor when he or she holds a portfolio that is not fully
diversified, which is not a desirable portfolio. In such cases, the Sharpe ratio and M2 are
appropriate performance measures.

Performance measures relative to beta risk—Treynor ratio and Jensen’s alpha—are relevant
when the investor holds a well-diversified portfolio with negligible diversifiable risk.
Let us begin with an analysis of the risk-free asset. Because the risk-free asset has zero risk
and a beta of zero, calculating the Sharpe ratio, Treynor ratio, or M2 is not possible because
they all require the portfolio risk in the denominator. The risk-free asset’s alpha, however, is
zero.

Turning to the market portfolio, we see that the absolute measures of performance, the
Sharpe ratio and the Treynor ratio, are positive for the market portfolio. These ratios are
positive as long as the portfolio earns a return that is in excess of that of the risk-free asset.
M2 and αi are performance measures relative to the market, so they are both equal to zero
for the market portfolio.

All three managers have Sharpe and Treynor ratios greater than those of the market, and all
three managers’ M2 and αi are positive; therefore, the pension fund should be satisfied with
their performance. Among the three managers, Manager X has the worst performance,
If the pension fund were to choose only one fund
manager to manage all its assets, it should
choose Manager Y.

If the pension fund is well diversified and only

the systematic risk of the portfolio matters, the
fund should choose Manager Z.

The graph confirms these observations in that all

three managers outperform the benchmark
because all three points lie above the SML.
Among the three portfolios, Z performs the best
when we consider risk-adjusted returns because
it is the point that is located northwest relative to
END