Unit-5

What is Portfolio Management?

Portfolio management’s meaning can be explained as the process of managing individuals’

investments so that they maximise their earnings within a given time horizon. Furthermore, such
practices ensure that the capital invested by individuals is not exposed to too much market risk.

The entire process is based on the ability to make sound decisions. Typically, such a decision relates
to – achieving a profitable investment mix, allocating assets as per risk and financial goals and
diversifying resources to combat capital erosion.

Primarily, portfolio management serves as a SWOT analysis of different investment avenues with
investors’ goals against their risk appetite. In turn, it helps to generate substantial earnings and protect
such earnings against risks.

Objectives of Portfolio Management

The fundamental objective of portfolio management is to help select best investment options as per
one’s income, age, time horizon and risk appetite.

Some of the core objectives of portfolio management are as follows –

Types of Portfolio Management

In a broader sense, portfolio management can be classified under 4 major types, namely –
Portfolio evaluating refers to the evaluation of the performance of the investment
portfolio. It is essentially the process of comparing the return earned on a portfolio with
the return earned on one or more other portfolio or on a benchmark portfolio.

Portfolio performance evaluation essentially comprises of two functions, performance

measurement and performance evaluation. Performance measurement is an accounting
function which measures the return earned on a portfolio during the holding period or
investment period. Performance evaluation, on the other hand, address such issues as
whether the performance was superior or inferior, whether the performance was due to
skill or luck etc.

The ability of the investor depends upon the absorption of latest developments which
occurred in the market. The ability of expectations if any, we must able to cope up with
the wind immediately. Investment analysts continuously monitor and evaluate the result
of the portfolio performance. The expert portfolio constructor shall show superior
performance over the market and other factors. The performance also depends upon the
timing of investments and superior investment analysts capabilities for selection. The
evolution of portfolio always followed by revision and reconstruction. The investor will
have to assess the extent to which the objectives are achieved. For evaluation of portfolio,
the investor shall keep in mind the secured average returns, average or below average as
compared to the market situation. Selection of proper securities is the first requirement.

Portfolio Performance Evaluation Methods

The objective of modern portfolio theory is maximization of return or minimization of risk.

In this context the research studies have tried to evolve a composite index to measure risk
based return. The credit for evaluating the systematic, unsystematic and residual risk goes
to Sharpe, Treynor and Jensen.

The portfolio performance evaluation can be made based on the following methods:

1. Sharpe’s Measure
2. Treynor’s Measure
3. Jensen’s Measure

1. Sharpe’s Measure

Sharpe’s Index measure total risk by calculating standard deviation. The method adopted
by Sharpe is to rank all portfolios on the basis of evaluation measure. Reward is in the
numerator as risk premium. Total risk is in the denominator as standard deviation of its
return. We will get a measure of portfolio’s total risk and variability of return in relation to
the risk premium. The measure of a portfolio can be done by the following formula:

SI =(Rt — Rf)/σf
Where,

• SI = Sharpe’s Index
• Rt = Average return on portfolio
• Rf = Risk free return
• σf = Standard deviation of the portfolio return.

2. Treynor’s Measure

The Treynor’s measure related a portfolio’s excess return to non-diversifiable or

systematic risk. The Treynor’s measure employs beta. The Treynor based his formula on
the concept of characteristic line. It is the risk measure of standard deviation, namely the
total risk of the portfolio is replaced by beta. The equation can be presented as follow:

Tn =(Rn – Rf)/βm

Where,

• Tn = Treynor’s measure of performance

• Rn = Return on the portfolio
• Rf = Risk free rate of return
• βm = Beta of the portfolio ( A measure of systematic risk)

3. Jensen’s Measure

Jensen attempts to construct a measure of absolute performance on a risk adjusted basis.

This measure is based on Capital Asset Pricing Model (CAPM) model. It measures the
portfolio manager’s predictive ability to achieve higher return than expected for the
accepted riskiness. The ability to earn returns through successful prediction of security
prices on a standard measurement. The Jensen measure of the performance of portfolio
can be calculated by applying the following formula:

Rp = Rf + (RMI — Rf) x β

Where,

• Rp = Return on portfolio
• RMI = Return on market index
• Rf = Risk free rate of return
Meaning of Portfolio Revision

A portfolio is a mix of securities selected from a vast universe of securities. Two variables
determine the composition of a portfolio; the first is the securities included in the portfolio
and the second is the proportion of total funds invested in each security.

Portfolio revision involves changing the existing mix of securities. This may be effected
either by changing the securities currently included in the portfolio or by altering the
proportion of funds invested in the securities. New securities may be added to the
portfolio or some of the existing securities may be removed from the portfolio. Portfolio
revision thus leads to purchases and sales of securities. The objective of portfolio revision
is the same as the objective of portfolio selection, i.e. maximizing the return for a given
level of risk or minimizing the risk for a given level of return. The ultimate aim of portfolio
revision is maximization of returns and minimization of risk.

Constraints in Portfolio Revision:

Portfolio revision is the process of adjusting the existing portfolio in accordance with the
changes in financial markets and the investor‘s position so as to ensure maximum return
from the portfolio with the minimum of risk. Portfolio revision or adjustment necessitates
purchase and sale of securities. The practice of portfolio adjustment involving purchase
and sale of securities gives rise to certain problems which act as constraints in portfolio
revision. Some of these are as under:

1. Transaction cost: Buying and selling of securities involve transaction costs such as
commission and brokerage. Frequent buying and selling of securities for portfolio revision
may push up transaction costs thereby reducing the gains from portfolio revision. Hence,
the transaction costs involved in portfolio revision may act as a constraint to timely revision
of portfolio.
2. Taxes: Tax is payable on the capital gains arising from sale of securities. Usually, long-term
capital gains are taxed at a lower rate than short-term capital gains. To qualify as long-
term capital gain, a security must be held by an investor for a period of not less than 12
months before sale. Frequent sales of securities in the course of periodic portfolio revision
or adjustment will result in short-term capital gains which would be taxed at a higher rate
compared to long-term capital gains. The higher tax on short-term capital gains may act
as a constraint to frequent portfolio revision.
3. Statutory stipulations: The largest portfolios in every country are managed by
investment companies and mutual funds. These institutional investors are normally
governed by certain statutory stipulations regarding their investment activity. These
stipulations often act as constraints in timely portfolio revision.
 4. Intrinsic difficulty: Portfolio revision is a difficult and time consuming exercise. The
methodology to be followed for portfolio revision is also not clearly established. Different
approaches may be adopted for the purpose. The difficulty of carrying out portfolio
revision itself may act as a constraint to portfolio revision.

Portfolio Revision Strategies

Two different strategies may be adopted for portfolio revision, namely an active revision
strategy and a passive revision strategy. The choice of the strategy would depend on the
investor‘s objectives, skill, resources and time.

Active revision strategy involves frequent and sometimes substantial adjustments to the
portfolio. Investors who undertake active revision strategy believe that security markets
are not continuously efficient. They believe that securities can be mispriced at times giving
an opportunity for earning excess returns through trading in them. Moreover, they believe
that different investors have divergent or heterogeneous expectations regarding the risk
and return of securities in the market. The practitioners of active revision strategy are
confident of developing better estimates of the true risk and return of securities than the
rest of the market. They hope to use their better estimates to generate excess returns.
Thus, the objective of active revision strategy is to beat the market.

Active portfolio revision is essentially carrying out portfolio analysis and portfolio
selection all over again. It is based on an analysis of the fundamental factors affecting the
economy, industry and company as also the technical factors like demand and supply.
Consequently, the time, skill and resources required for implementing active revision
strategy will be much higher. The frequency of trading is likely to be much higher under
active revision strategy resulting in higher transaction costs.

Passive revision strategy, in contrast, involves only minor and infrequent adjustment to
the portfolio over time. The practitioners of passive revision strategy believe in market
efficiency and homogeneity of expectation among investors. They find little incentive for
actively trading and revising portfolios periodically.

Under passive revision strategy, adjustment to the portfolio is carried out according to
certain predetermined rules and procedures designated as formula plans. These formula
plans help the investor to adjust his portfolio according to changes in the securities
market.
What is the difference between portfolio management and mutual
funds?

The purpose of mutual funds and portfolio management is the same i.e., Invest money to

get better returns. Although portfolio management and mutual funds are the ways to

invest in the market in an indirect way still there are significant differences between them.

Portfolio Management and Mutual Funds work on different investment models all the

investors need to understand the core difference between them so that investors can make

informed investment decisions.

Portfolio Management

Portfolio Management is considered as art and science of selecting investments to meet

the long-term financial goals keeping in mind the risk capacity of individual, company, or

institution. Portfolio Management involves SWOT analysis across the investments so that

one can selectively decide which investment avenues suit the profile and can provide

maximum returns.

Portfolio Management is done by licensed professionals who manage the

portfolio of their clients. The ultimate goal of portfolio managers is to gain

maximum returns on investments with appropriate risk exposure. In an Active

portfolio, Portfolio Managers strategically buy and sell the stocks and assets to beat

the market returns.

 Mutual Funds

Mutual Fund is a type of investment instrument that is made up of a pool of money

collected from various investors to invest in stocks, bonds, and other assets. Mutual

funds are operated by professionals who allocate the funds and try to produce

maximum gains for the fund's investors. Mutual funds give chance to small and

medium investors to professionally manage their funds into equities, bonds, or

other securities. Every investor gets returns in proportion to investment done. The

performance of Mutual Funds is tracked as a change in market capitalization of

funds which is derived from the performance of underlying investments.

Differences

Fee Structure

Portfolio Management services charge a very high fee as compared to Mutual

Funds. In Portfolio Management charges include fixed fee, performance fee,

fund management fee whereas in mutual funds charges are fixed and they

depend upon the amount of individual investment.

Risk
Portfolio Management is done on a concentrated portfolio of around 30 stocks

which makes them riskier than mutual funds because Mutual funds offer

diversification by investing in a huge number of stocks and different funds.

Tax

Mutual Funds are exempted from tax liability whereas in the case of Portfolio

Management investors have to pay capital gain tax.

Size of Investment

One must choose the type of investment instrument as per the risk appetite of an

individual. In portfolio Management minimum investment size is Rs 25 Lakh

whereas in mutual funds you can invest in a systematic investment plan with juts Rs

500. Portfolio Management services generally belong to high net worth individuals

whereas mutual funds serve to a wide range of investors.

Transparency

Mutual funds are tightly regulated by SEBI whereas Portfolio Management services

are not that transparent as compared to mutual funds.