Portfolio Evaluation & Revision

SAPM Unit 5
Portfolio Evaluation
• Portfolio evaluation 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 evaluation comprises of 2 functions performance
measurement and evaluation. While evaluating the performance of a
portfolio, the return earned on the portfolios has to be evaluated in the
context of the risk associated with that.
1. One approach would be to group portfolios into equivalent risk classes
and then compare returns of portfolio within each risk category.
2. Second approach would be to specifically adjust the return for the
riskiness of the portfolio by developing risk adjusted return measures and
use these for evaluating portfolios across differing risk level.

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Methods of Portfolio Evaluation
• In order to determine the risk-adjusted returns of investment
portfolios, several eminent authors have worked since 1960s
to develop composite performance indices to evaluate a
portfolio by comparing alternative portfolios within a particular
risk class. The most important and widely used measures of
performance are:
I. The Sharpe Measure
II. The Treynor Measure
III. Jenson Model
IV. Fama Model

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Risk Adjusted Return
• The performance of a fund should be assessed in terms of return
per unit of risk. The funds that provide the highest return per unit
of risk would be considered the best performer.
• For well diversified portfolios in all asset categories, the standard
deviation is the relevant measure of risk. When evaluating
individual stocks and not so well diversified portfolios, the
relevant measure of risk is the systematic or market risk, which
can be assessed using the beta co-efficient (β). Beta signifies the
relationship between covariance (stock, market) and variance of
market.
• Two well-known measures of risk-adjusted return are:
• Sharpe’s Ratio and
• Treynor’s Composite Performance Measure
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I. Treynor’s Composite Performance Measure

• A ratio developed by Jack Treynor that measures returns

earned in excess of that which could have been earned on
a riskless investment per each unit of market risk.
• Treynor is a measurement of the returns earned in
excess of that which could have been earned on an
investment that has no diversifiable risk (e.g., Treasury bills
or a completely diversified portfolio), per each unit of
market risk assumed.
• The Treynor ratio relates excess return over the risk-free
rate to the additional risk taken; however, systematic risk is
used instead of total risk. The higher the Treynor ratio, the
better the performance of the portfolio under analysis.
• The Treynor ratio is calculated as:
(Average Return of the Portfolio - Average Return of the Risk-
Free Rate) / Beta of the Portfolio
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II. Sharpe’s Ratio
• It was developed by Nobel laureate William F. Sharpe.
The Sharpe ratio is the average return earned in
excess of the risk-free rate per unit of volatility or
total risk.
• Subtracting the risk-free rate from the mean return,
the performance associated with risk-taking activities
can be isolated.
• One intuition of this calculation is that a portfolio
engaging in “zero risk” investment, such as the
purchase of Treasury bills (for which the expected
return is the risk-free rate), has a Sharpe ratio of
exactly zero. Generally, the greater the value of the
Sharpe ratio, the more attractive the risk-adjusted
return.
• Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard
deviation of portfolio return

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Comparison of Sharpe and Treynor

• Sharpe and Treynor measures are similar in a way, since they both divide
the risk premium by a numerical risk measure.
• The total risk is appropriate when evaluation is done of the risk return
relationship for well-diversified portfolios.
• On the other hand, the systematic risk is the relevant measure of risk
when evaluation is done of less than fully diversified portfolios or
individual stocks.
• The Sharpe measure evaluates the portfolio manager on the basis of both
rate of return and diversification (as it considers total portfolio risk in the
denominator).
• If investor had a fully diversified portfolio, then both the Sharpe and
Treynor measures will give him the same ranking. A poorly diversified
portfolio could have a higher ranking under the Treynor measure than for
the Sharpe measure.
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III. Jenson’s Model
• Jenson's model proposes another risk adjusted
performance measure.
• This measure was developed by Michael
Jenson and is sometimes referred to as the
Differential Return Method.
• This measure involves evaluation of the
returns that the fund has generated vs. the
returns actually expected out of the fund given
the level of its systematic risk.
• The surplus between the two returns is called
Alpha, which measures the performance of a
fund compared with the actual returns over the
period. Required return of a fund at a given
level of risk.

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III. Jenson’s Model
• A risk-adjusted performance measure that represents the average
return on a portfolio over and above that predicted by the capital asset
pricing model (CAPM), given the portfolio's beta and the average
market return.
• This is the portfolio's alpha. In fact, the concept is sometimes referred to
as "Jensen's alpha."
• The basic idea is that to analyze the performance of an investment
manager investor must look not only at the overall return of a
portfolio, but also at the risk of that portfolio. For example, if
there are two mutual funds that both have a 12% return, a rational
investor will want the fund that is less risky.
• Jensen's measure is one of the ways to help determine if a portfolio is
earning the proper return for its level of risk. If the value is
positive, then the portfolio is earning excess returns. In other words, a
positive value for Jensen's alpha means a fund manager has "beat the
market" with his or her stock picking skills.
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IV. Fama’s Decomposition of Portfolio
Return
• The Eugene Fama model is an extension of Jenson model.
This model compares the performance, measured in terms
of returns, of a fund with the required return
commensurate with the total risk associated with it.
• The difference between these two is taken as a measure of
the performance of the fund and is called net selectivity.
• Required return can be calculated as:
• Ri = Rf + Si/Sm*(Rm - Rf)
• Where, Sm is standard deviation of market returns. The
net selectivity is then calculated by subtracting this
required return from the actual return of the fund.
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Portfolio Revision
• The art of changing the mix of securities in a portfolio is
called a portfolio revision.
• The process of addition of more assets in an existing
portfolio or changing the ratio of funds invested is called
as portfolio revision.
• Portfolio revision involves:
1. Addition of new securities
2. Remaining old securities
3. Changing the mix of securities

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Constraints in Portfolio Revision
• 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 discussed below:
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.
2. Taxes: Tax is payable on the capital gains arising from sale of
securities.
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
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is also not clearly established.
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Different approaches may be
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adopted for the purpose. The difficulty of carrying out portfolio revision
Need of Portfolio Revision
• The primary factor necessitating portfolio revision is changes in the
financial markets since the creation of the portfolio. The need for
portfolio revision may arise because of some investor related factors
also. These factors may be listed as:
1. Availability of additional funds for investment
2. Change in risk tolerance
3. Change in the investment goals
4. Need to liquidate a part of the portfolio to provide funds for
some alternative use
• The portfolio needs to be revised to accommodate the changes in the
investor‘s position.
• Thus, the need for portfolio revision may arise from changes in the
financial market or changes in the investor‘s position, namely his
financial status and preferences.
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Portfolio Revision Strategies

• Active Strategies: In involves frequent changes in an

existing portfolio over a certain period of time for
maximum returns and minimum risks. It involves timing
of the market investment.
• Passive Strategies: It involves rare changes in
portfolio only under certain pre defined rules. As per the
passive revision strategy a portfolio manager can surely
changes in the portfolio as per the formula plans only.

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Formula Plans
• Certain mechanical revision techniques or procedures have been developed to
enable the investors to benefit from price fluctuations in the market by buying
stocks when prices are low and selling them when prices are high. These
techniques are referred to as formula plans.
• The use of formula plans demands that the investor divide his investments funds
into two portfolios, one aggressive and the other conservative or defensive.
• The aggressive portfolio usually consists of equity shares while the defensive
portfolio consists of bonds and debentures. The formula plans specify
predetermined rules for the transfer of funds from the aggressive portfolio to the
defensive portfolio and vice versa.
• There are different formula plans for implementing passive portfolio revision.
1. Constant Rupee Value Plan
2. Constant Ratio Plan
3. Rupee Cost Averaging

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1. Constant Rupee Value Plan
• In this, the investor construct 2 portfolios, one aggressive consisting of equity shares and
the other defensive consisting of bonds and debentures.
• The purpose of this plan is to keep the value of the aggressive portfolio constant i.e., at
the original amount invested in the aggressive portfolio.
• As share price fluctuate, the value of aggressive portfolio increases. The investor has to
sell some of the shares from his portfolio to bring down the total value of the aggressive
portfolio at the level of his original investment. The sale proceeds will be invested in the
defensive portfolio by buying bonds and debentures.
• On the contrary, when the share price are falling the total value of the aggressive portfolio
would also decline.
• To keep the total value of aggressive portfolio at its original level, the investors has to buy
some shares from the market to be included in this portfolio. For this purpose, a part of
defensive portfolio will be liquidated to raise the money needed to by additional shares.

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2. Constant Ratio Plan
• Here again the investor would construct two portfolio, one
aggressive and the other defensive with his investment funds.
• The ratio between the investments in the aggressive portfolio
and the defensive portfolio would be predetermined such as 1:1
or 5:1.
• The purpose of this plan is to keep this ratio constant by re-
adjusting the two portfolios when the share price fluctuate
between 2 times.
• For this purpose a revision point will also have to be determined.
The revision point may be fixed as ± .10 for ex. This means
when the ratio between the values of the aggressive portfolio or
the defensive portfolio moves up by .10 points or moves down
by .10 points. The portfolio would be adjusted by transfer of the
funds from one to other.
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3. Rupee Cost Averaging
• This is different from previous two formula plans. All above
formula plans assumes that stock prices fluctuate up & down in
cycles.
• Rupee cost averaging utilize this cyclic movement in share price
to construct a portfolio at low cost.
• The plan stipules that the investor invest a constant sum, such
as Rs. 5,000, 20,000 etc. in a share or portfolio share regularly
at periodical intervals. Regardless of the price of the shares at
the time of investment.
• The periodic investment is to be continued over a day period of
time to cover a complete cycle of share price movements.
• If the plan is implemented over a complete cycle of stock prices,
the investor will obtain his shares at a lower average cost per
share than the average price prevailing in the market.
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Value at Risk

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Portfolio Optimization
• Portfolio optimization is nothing but a process where an investor
receives the right guidance with respect to selection of assets
from the range of other options and in this theory
projects/programs are not valued on an individual basis rather the
same is valued as a part of a particular portfolio.
• An optimal portfolio is said to be the one that has the highest Sharpe
ratio, which measures the excess return generated for every unit of
risk taken.
• Portfolio optimization is based on Modern Portfolio Theory (MPT). The
MPT is based on the principle that investors want the highest return
for the lowest risk. To achieve this, assets in a portfolio should be
selected after considering how they perform relative to each other,
i.e.; they should have a low correlation. Any optimal portfolio based on
the MPT is well-diversified in order to avoid a crash when a particular
asset or asset class underperforms.
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 Example #1
If we take an example of Apple and Microsoft
based on their monthly returns for the year 2018,
the following graph shows the Efficient Frontier
for a portfolio consisting only of these two stocks:

The X-axis is the standard deviation, and the y-axis is the portfolio
return for the level of risk. If we combine this portfolio with a
risk-free asset, the point on this graph where the Sharpe ratio is
maximized represents the optimal portfolio. It is the point at
which the capital allocation line is tangential to the efficient
frontier. The reason behind this is that at that point, the Sharpe
ratio (which measures the increase in expected return for every
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