Risk Adjusted Performance: Sharpe

Portfolio performance evaluation

Unit V

Phases Of Portfolio Management

SPECIFICATION OF INVESTMENT OBJECTIVES AND CONSTRAINTS

CHOICE OF ASSET MIX

FORMULATION OF PORTFOLIO STRATEGY

SELECTION OF SECURITIES PORTFOLIO EXECUTION

PORTFOLIO REVISION PORTFOLIO EVALUAYION

Portfolio performance Evaluation

• At one time, investors evaluated portfolio performance almost entirely on the basis of the rate of return. They were aware of the concept of risk but did not know how to quantify or measure it, so they could not consider it explicitly. Developments in

portfolio theory in the early 1960s showed

• investors how to quantify and measure risk in terms of the variability of returns.

Risk-adjusted Performance evaluation method

• Sharpe index

• Treynor measure

• Jensen measure

1) Sharpe Index

r_p = Average return on the portfolio r_f = Average risk free rate

sp = Standard deviation of portfolio return

Risk Adjusted Performance: Sharpe

p f

p

r

r

s



2) Treynor Measure

Risk Adjusted

Performance: Treynor

p

f

p

r

r





r_p = Average return on the portfolio r_f = Average risk free rate

p = Weighted average  for portfolio

Risk Adjusted Performance: Jensen

3) Jensen’s Measure

a_p = alpha for the portfolio

r_p = Average return on the portfolio r_f = Average risk free rate

_p = Weighted average  for portfolio

r_m = Average return on market index portfolio

 





p

 r

 r   r  r

a

Returns of Mutual Funds

Treynor Measure

Sharpe measure

Active Vs passive portfolio strategy

• Proponents of the efficient market hypothesis believe that active management is largely

wasted effort and unlikely to justify the

expenses incurred. Therefore, they advocate a passive investment strategy that makes no

attempt to outsmart the market. A passive strategy aims only at establishing a well-

diversified portfolio of securities without attempting to find under- or overvalued stocks.

Active Vs passive portfolio strategy

• Passive management is usually characterized by a buy -and-hold strategy. Because the efficient market theory indicates that stock prices are at fair levels, given all available information, it

makes no sense to buy and sell securities

frequently, which generates large brokerage fees without increasing expected performance.

• One common strategy for passive management is to create an index fund, which is a fund designed to replicate the performance of a broad-based

index of stocks

Active Portfolio strategy

• Market timing

• Sector rotation

• Security selection

• Use of specialized concepts

Market timing

• Market timers change the beta on the

portfolio according to forecasts of how the market will do. They change the beta on the overall portfolio, either by changing the beta on the equity portfolio (by using options or futures or by swapping securities) or by

changing the amount invested in short-term bonds

Security selection

• The search for undervalued securities and the methods of forming these securities into

optimum portfolios.. Investors practicing

security selection are betting that the market weights on securities are not the optimum

proportion to hold in each security. They

increase the weight (make a positive bet) for undervalued securities and decrease it for overvalued securities. Most active stock managers practice security selection

Sector rotation

• 1. broad industrial classification (e.g., industrial, financial, utilities)

• 2. major product classification (e.g., consumer goods, industrial goods, services)

• 3. perceived characteristics (e.g., growth,

cyclical, stable); other characteristics used to divide stocks into sectors are size, yield, or

quality.

• 4. according to sensitivity to basic economic

phenomena (e.g., interest-sensitive stocks,stocks sensitive to changes in exchange rates)

The costs of Active portfolio strategy

• 1. The cost of paying the forecasters either in the form of salaries or in the higher

management fees charged by active managers relative to passive managers.

• 2. The cost of diversifiable risk. Active portfolios, by their nature, have more

diversifiable risk than an index fund (which has close to zero). The investor must be

compensated for taking this

The costs of Active portfolio strategy

• 3. The cost of higher transaction cost. Active decisions require turnover as opposed to the very low turnover of the buy and hold strategies of an index fund.

• 4. For the taxable investor, an early incidence of capital

gains tax. Under current tax laws capital gains or losses are realized for tax purposes either because the fund sells

stocks or the investor sells all or part of his share in the

fund. An index fund has a very low level of turnover, so the taxable investor pays minimal capital gains taxes until he sells off part of the fund.

• An actively managed portfolio usually has a much higher turnover, and so capital gains taxes can be incurred by the investors even when the investors wish to leave their

money fully invested.

Benefits and risks of global investing

• Benefits:

1) Attractive opportunities 2) Diversification

• Risks:

1. Political risks 2. Currency risk 3. Custody risk 4. Liquidity risk 5. Volatility risk

Benefits of Global investing

• Attractive opportunities: When domestic market becomes stretched in valuation, savvy investors are aware that

attractive opportunities are available outside.

• Diversification benefits: diversification across nations whose economic cycles do not move in perfect lockstep, investors can achieve a better risk- return tradeoff.

• Empirical evidence supports this hypothesis as it has been found that returns from different national equity markets are weakly correlated.

• However, in periods of high market volatility such financial crisis of 2008, almost all the market developed and

emerging decline simultaneously.

Risks in global investing

• Political risk: Many national markets,

particularly emerging markets are vulnerable to political risk that may result from coup,

assassination, social unrest and so on.This can lead to unexpected change in the polices of the government toward foreign investors. In extreme case may result in expropriation of the assets owned by foreigners.

Risks in global investing

• Currency risk: Exchange rate changes over time. An Indian investors who invests in US equities will have to bear the risk of dollar declining against rupee.

• Custody risk: In many countries, the domestic investors enjoy a certain degree of protection against frauds, bankruptcies and broker

misdeeds. this protection may not be available to foreign investors.

Risks in global investing

• Liquidity risk: in many emerging market

trading is concentrated on a small proportion of listed securities. others securities are not traded frequently and hence somewhat

illiquid.

• Market Volatility: emerging markets are more volatile than developed markets. So global

investors have to bear higher market volatility.