UNIT 4

PORTFOLIO MANAGEMENT

Meaning

Portfolio Management is the process of planning, selecting, managing, monitoring,

and revising a combination of financial assets such as shares, bonds, mutual funds,
gold, etc., in order to maximize return and minimize risk according to the investor’s
objectives.

Example

An investor invests:

 50% in equity mutual funds

 30% in debt instruments
 10% in gold
 10% in bank fixed deposits

This combination forms a portfolio.

PROCESS

1. Understanding Investor Objectives

 Identify whether the investor wants income, growth, capital appreciation, or

safety.
 Depends on age, income, and future goals.

Example:
A 25-year-old professional aims for wealth creation, while a 60-year-old retiree
prefers regular income.

2. Risk Assessment

 Measure the investor’s risk-taking capacity (low, moderate, high).

 Helps in deciding asset allocation.

Example:
A government employee may prefer low risk, while a young entrepreneur may
accept high risk.
3. Investment Policy Formulation

 Create rules regarding asset mix, risk limits, and return expectations.
 Acts as a guideline for investment decisions.

Example:
“Not more than 60% of funds will be invested in equity.”

4. Market Analysis

 Study economic conditions, interest rates, inflation, and market trends.

 Helps identify favorable investment opportunities.

Example:
During economic growth, equity markets perform better than debt.

5. Security Analysis

 Analyze individual securities using fundamental or technical analysis.

 Helps select quality securities.

Example:
Analyzing TCS based on profits, balance sheet, and growth prospects.

6. Portfolio Construction

 Combine selected securities into a balanced portfolio.

 Focus on risk reduction and return optimization.

Example:
Buying shares of TCS, HDFC Bank, government bonds, and gold ETFs.

7. Portfolio Implementation

 Actual execution of buying and selling securities.

 Invest funds as per the portfolio plan.
Example:
Investing ₹5 lakh into equity funds and ₹3 lakh into debt funds.

8. Portfolio Monitoring

 Regularly track portfolio performance.

 Compare with benchmarks like Nifty or Sensex.

Example:
Reviewing mutual fund returns every quarter.

9. Portfolio Evaluation

 Measure performance in terms of risk and return.

 Identify underperforming investments.

Example:
If a stock gives lower returns than market average, it is reviewed.

10. Portfolio Revision

 Make changes due to market conditions or change in investor goals.

 Ensures portfolio remains optimal.

Example:
Shifting from equity to debt as retirement approaches.

Portfolio Selection

Portfolio selection is the process of choosing the best combination of securities to

maximize return for a given level of risk.

Key Points

1. Uses Modern Portfolio Theory (MPT) → helps select assets with optimal risk-
return trade-off.
2. Focus on diversification → allocate across sectors, industries, and asset
classes.
3. Security screening and analysis → based on fundamentals, technicals, and
credit ratings.
1. Return Potential

 Choose securities with good expected returns.

 Based on earnings growth and future prospects.

Example:
Selecting Infosys shares due to strong IT growth.

2. Risk Level

 Securities should match the investor’s risk tolerance.

 Avoid excessive risky investments.

Example:
A conservative investor avoids volatile small-cap stocks.

3. Liquidity

 Select securities that can be easily converted into cash.

 Important for emergency needs.

Example:
Listed shares are more liquid than real estate.

4. Stability of Income

 Preference for securities offering regular income.

 Suitable for retirees.

Example:
Government bonds and dividend-paying shares.

5. Growth Potential

 Select securities with long-term growth prospects.

 Helps in wealth creation.
Example:
Investing in FMCG or IT sector companies.

Portfolio Revision
Portfolio revision refers to adjusting or rebalancing the portfolio by adding/removing
investments based on performance or market changes.

Key Points

1. Market-driven revision → due to economic changes, interest rates, or

corporate results.
2. Goal-driven revision → investor’s income, risk, or goals change.
3. Periodic rebalancing → monthly, quarterly, or annual adjustments.

1. Change in Market Conditions

 Revise portfolio during economic slowdown or boom.

 Protects from losses.

Example:
Reducing equity exposure during recession.

2. Change in Investor Objectives

 Modify portfolio when goals change.

 Life stages affect investment needs.

Example:
After marriage, investor shifts to safer investments.

3. Poor Performance of Securities

 Replace underperforming assets.

 Improves overall returns.

Example:
Selling a stock consistently giving losses.

4. Risk Rebalancing
  Restore original asset allocation.
 Prevents excessive exposure to one asset.

Example:
Reducing equity when it exceeds planned percentage.

5. Corporate Actions

 Revise portfolio due to mergers, bonus, splits.

 Maintains portfolio value.

Example:
Adjusting holdings after a bonus issue.

Portfolio Diversification

Diversification Strategy refers to the practice of spreading investments across

different assets, industries, securities, or geographical regions to reduce risk and
stabilize returns.

👉 Principle: “Do not put all your eggs in one basket.”

DIVERSIFICATION STRATEGY IN PORTFOLIO MANAGEMENT

Strategy Purpose Example

Asset Diversification Reduce risk Equity + Debt

Sector Diversification Avoid sector risk IT + Banking

Security Diversification Reduce company risk Multiple stocks

Geographic Diversification Reduce country risk India + USA

Time Diversification Reduce timing risk SIPs

Mutual Funds – Concept

A Mutual Fund is an investment vehicle that collects money from many investors
and invests it in a diversified portfolio of securities such as shares, bonds, money
market instruments, etc.
It is professionally managed by fund managers and helps investors achieve
diversification with small investments.
A mutual fund is an investment vehicle that pools money from many investors and
invests it in a diversified portfolio of stocks, bonds, and other securities. This pooled
money is managed by professional fund managers who make investment decisions
based on the fund’s objective, helping reduce risk through diversification and aiming
to maximize returns.

Example:
Investing ₹2,000 per month in an Equity Mutual Fund through SIP.

FEATURES OF MUTUAL FUNDS

1. Diversification
Mutual funds spread investments across many securities, reducing risk from
any single asset.
2. Professional Management
Funds are managed by experienced fund managers who make investment
decisions on behalf of investors.
3. Liquidity
In most funds (especially open-ended), investors can redeem units easily at
prevailing NAV.
4. Transparency
Mutual funds publish daily NAVs and regular portfolio disclosures, making
performance easy to track.
5. Risk-Return Alignment
Funds cater to different risk profiles (low, medium, high), allowing investors
to choose according to their risk tolerance.
6. Tax Efficiency
Certain funds like ELSS offer tax benefits, and long-term capital gains may be
taxed favourably.
7. Affordability
Investors can start with small amounts and still get a diversified portfolio.
8. Professional Record Keeping
AMC provides statement of accounts, tax reports, and transaction histories.

TYPES OF MUTUAL FUNDS (14 TYPES)

1. Equity Mutual Funds

 Invest mainly in shares of companies

 High risk, high return
Example: Large Cap Equity Fund
2. Debt Mutual Funds

 Invest in bonds, debentures, government securities

 Low risk, stable returns
Example: Corporate Bond Fund

3. Hybrid Mutual Funds

 Combination of equity and debt

 Balanced risk and return
Example: Balanced Advantage Fund

4. Money Market / Liquid Funds

 Invest in short-term instruments

 High liquidity, low risk
Example: Liquid Fund

5. Index Mutual Funds

 Replicate market indices like Nifty or Sensex

 Passive investment, low cost
Example: Nifty 50 Index Fund

6. Exchange Traded Funds (ETFs)

 Traded on stock exchanges like shares

 Transparent and low expense ratio
Example: Gold ETF

7. Tax Saving Funds (ELSS)

 Provide tax benefit under Section 80C

 3-year lock-in period
Example: ELSS Equity Fund
8. Sectoral Funds

 Invest in a specific sector

 High risk due to concentration
Example: Banking Sector Fund

9. Thematic Funds

 Invest based on a theme

 Risk depends on theme performance
Example: Infrastructure Fund

10. International / Global Funds

 Invest in foreign companies

 Offers global diversification
Example: US Equity Fund

11. Fund of Funds (FoF)

 Invest in other mutual fund schemes

 Helps achieve diversification
Example: FoF investing in multiple equity funds

12. Gilt Funds

 Invest only in government securities

 No credit risk
Example: Gilt Mutual Fund

13. Fixed Maturity Plans (FMPs)

 Closed-ended debt funds

  Fixed investment period
Example: 3-year FMP

14. Solution-Oriented Funds

 Designed for specific goals like retirement or children’s education

 Long-term investment focus
Example: Retirement Mutual Fund

How Mutual Funds Work – Step by Step

Step 1: Pooling of Money

Many investors invest small or large amounts, which are pooled together to form a
large investment corpus.

Step 2: Appointment of Fund Manager

The Asset Management Company (AMC) appoints a professional fund manager to
manage the pooled money.

Step 3: Investment as per Objective

The fund manager invests the money in stocks, bonds, or other securities according
to the fund’s objective (equity, debt, hybrid, etc.).

Step 4: Diversification of Portfolio

Money is spread across multiple securities to reduce risk and stabilize returns.

Step 5: Allotment of Units

Investors are allotted units based on the NAV. Ownership depends on the number of
units held.

Step 6: NAV Calculation

NAV is calculated daily based on the market value of the fund’s assets.

Step 7: Earning Returns

Returns are generated through capital appreciation and income like dividends or
interest.

Step 8: Reinvestment or Payout

Returns are either reinvested to buy more units or paid to investors, depending on
the option chosen.
Step 9: Buying and Selling Units
Investors can buy or redeem units at the prevailing NAV; options like SIP and SWP
are available.

Step 10: Fees and Taxation

Expense ratio and exit load are charged, and returns are taxed as per mutual fund tax
rules.

Below is a clear, structured, exam-oriented explanation of the Markowitz Model,

covering meaning, assumptions, and how it helps in selecting an optimal portfolio
and balancing risk–return.

Markowitz Model (Modern Portfolio Theory)

Meaning

The Markowitz Model, proposed by Harry Markowitz (1952), is a portfolio selection

theory that explains how investors can maximize returns for a given level of risk or
minimize risk for a given level of return through diversification.
It measures risk using variance or standard deviation of returns and emphasizes the
correlation between securities.

Core idea: Portfolio risk depends not only on individual securities but also on how
their returns move relative to each other.

Assumptions of the Markowitz Model

1. Investors are rational and aim to maximize expected returns for a given risk.
2. Investors are risk-averse and prefer lower risk for the same return.
3. Returns are normally distributed.
4. Risk is measured by variance or standard deviation of returns.
5. Investors consider only expected return and risk while making decisions.
6. Securities can be divided into fractional units.
7. There are no taxes, transaction costs, or inflation.
8. All investors have complete and identical information.

How the Markowitz Model Is Used to Select an Optimal Portfolio

Step 1: Identify Available Securities

Select different securities with varying returns and risks (e.g., stocks, bonds).

Step 2: Estimate Expected Returns

Calculate the expected return of each security based on past performance.

Step 3: Measure Risk

Calculate variance or standard deviation of returns for each security.

Step 4: Analyze Correlation

Measure how securities move relative to each other (positive, negative, or zero
correlation).

Step 5: Construct Efficient Portfolios

Create different combinations of securities to identify portfolios with:

 Maximum return for a given risk, or

 Minimum risk for a given return

Step 6: Draw the Efficient Frontier

The efficient frontier represents the set of optimal portfolios offering the best
possible return for each level of risk.

Step 7: Select the Optimal Portfolio

Investors choose a portfolio on the efficient frontier based on their risk tolerance:

 Risk-averse → lower risk portfolio

 Risk-taker → higher return portfolio

How the Markowitz Model Balances Risk and Return

1. Diversification Reduces Risk

Combining securities with low or negative correlation lowers overall portfolio
risk.
2. Trade-off Between Risk and Return
Higher expected returns are associated with higher risk; the model helps find
the best balance.
3. Focus on Portfolio Risk
Risk is analyzed at the portfolio level, not individual security level.
 4. Optimal Risk Allocation
Assets are weighted to achieve the most efficient risk-return combination.

Example (Simple)

An investor invests in:

 Stock A (High return, high risk)

 Stock B (Low return, low risk)

If both stocks are not perfectly correlated, combining them reduces overall risk while
maintaining reasonable returns—this forms an optimal portfolio.

Portfolio Evaluation Ratios

Portfolio evaluation ratios are used to judge how well a portfolio or fund manager
has performed, considering both returns and risk. Simply earning high returns is not
enough; returns must be evaluated relative to the risk taken.

1. Treynor Ratio – Explanation

The Treynor Ratio evaluates portfolio performance based on systematic risk (market
risk), which is measured using beta.
It assumes that the portfolio is already well diversified, so unsystematic risk is
negligible.

This ratio tells us how much extra return the portfolio generates for each unit of
market risk taken.
A higher Treynor ratio indicates that the portfolio has been rewarded well for the
risk assumed.

👉 Best suited for diversified mutual funds or large portfolios.

2. Sharpe Ratio – Explanation

The Sharpe Ratio measures the portfolio’s performance by considering total risk,
which includes both systematic and unsystematic risk.
Risk is measured using standard deviation of returns.

It explains how much extra return an investor receives for the total risk taken.
A higher Sharpe ratio means the portfolio delivers better risk-adjusted returns.

👉 Suitable for individual portfolios or poorly diversified portfolios.

3. Jensen’s Alpha – Explanation

Jensen’s Alpha measures the manager’s ability to earn returns higher than
expected as per the Capital Asset Pricing Model (CAPM).

It compares:

 Actual portfolio return

 Expected return based on market risk

If the portfolio earns more than the expected return, alpha is positive, showing
superior management skill.
If it earns less, alpha is negative, indicating underperformance.

👉 Used to evaluate fund manager performance.

4. Information Ratio – Explanation

The Information Ratio evaluates how consistently a portfolio outperforms its

benchmark index.

It measures:

 Extra return over the benchmark

 Consistency of that extra return

A higher Information Ratio shows that the portfolio not only beats the benchmark
but does so regularly and efficiently.

👉 Commonly used to assess actively managed mutual funds.

How to Review a Portfolio and Analyze a Fund

Portfolio review helps an investor check whether a fund is performing well, aligned
with goals, and taking acceptable risk. It involves three major aspects: investment
strategy, performance, and risk profile.

1. Analysis of Investment Strategy

This step checks how the fund invests money.

 Fund Objective:
Verify whether the fund’s objective (growth, income, balanced) matches the
investor’s goals.
 Asset Allocation:
Analyze how much the fund invests in equity, debt, or other assets and
whether it is consistent with the stated strategy.
 Sector & Security Selection:
Review exposure to different sectors and top holdings to ensure proper
diversification.

Example:
An equity growth fund should mainly invest in stocks and not heavily in debt
instruments.

2. Analysis of Portfolio Performance

This step evaluates how well the fund has performed.

  Return Comparison:
Compare fund returns with its benchmark index and peer funds over short-
term and long-term periods.
 Consistency of Returns:
Check whether the fund delivers stable returns across different market
conditions.
 Risk-Adjusted Performance:
Use measures like Sharpe, Treynor, or Jensen’s Alpha to assess returns
relative to risk.

Example:
A fund outperforming its benchmark consistently indicates good management.

3. Analysis of Risk Profile

This step measures how much risk the fund takes.

 Volatility:
Examine standard deviation to understand fluctuations in returns.
 Market Risk (Beta):
Analyze how sensitive the fund is to market movements.
 Downside Risk:
Check the fund’s performance during market downturns to assess capital
protection.

Example:
A fund with high returns but very high volatility may not suit risk-averse investors.

4. Review of Fund Management and Costs

 Fund Manager Performance:

Assess the experience and track record of the fund manager.
 Expense Ratio:
Higher expenses reduce net returns; compare with similar funds.

5. Portfolio Rebalancing Decision

Based on the review:

  Continue if fund aligns with goals and risk tolerance
 Reduce exposure if risk is too high
 Exit if performance consistently underperforms benchmark

Conclusion

Reviewing a portfolio involves analyzing the investment strategy, performance, and

risk profile of a fund to ensure it meets financial goals efficiently. Regular review
helps investors optimize returns, manage risk, and take timely corrective action.