Module: 06 – Portfolio Evaluation & Revision

1. Meaning:
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 objective of modern portfolio theory is maximization of return or
minimization of risk.
2. Portfolio Performance Evaluation Methods:
The portfolio performance evaluation can be made based on the following
methods:
2.1 Sharpe’s Measure:
Sharpe’s Index measure total risk by calculating standard deviation. The
method adopted by Sharpe is to rank all portfolios based on 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.
2.2 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)
2.3 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
3. Evaluation of Mutual Fund under NAV Method:
Net asset value (NAV) represents a fund's per-share intrinsic value. It is
similar in some ways to the book value of a company. NAV is calculated by
dividing the total value of all the cash and securities in a fund's portfolio,
minus any liabilities, by the number of outstanding shares. The NAV
calculation is important because it tells us how much one share of the fund
should be worth. The actual market value of a fund may differ slightly from
its NAV, which may represent a buying or selling opportunity.

A NAV computation is undertaken once at the end of each trading day based
on the closing market prices of the portfolio's securities. The formula for a
mutual fund's NAV calculation is straightforward:

NAV = (Assets - Liabilities) / Total number of outstanding shares

4. Portfolio Revision: The art of changing the mix of securities in a portfolio
is called as 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. The sale and purchase of assets in an existing portfolio over a
certain period to maximize returns and minimize risk is called as Portfolio
revision.
4.1 Need for Portfolio Revision:
 An individual at certain point of time might feel the need to invest
more. The need for portfolio revision arises when an individual has
some additional money to invest.
 Change in investment goal also gives rise to revision in portfolio.
Depending on the cash flow, an individual can modify his financial
goal, eventually giving rise to changes in the portfolio i.e. portfolio
revision.
  Financial market is subject to risks and uncertainty. An individual
might sell off some of his assets owing to fluctuations in the financial
market.
4.2 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 as under:
 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.
 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.
 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.
 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.

5. Portfolio Revision Strategies

There are two types of Portfolio Revision Strategies.

 Active Revision Strategy: Active Revision Strategy involves frequent

changes in an existing portfolio over a certain period of time for maximum
returns and minimum risks. Active Revision Strategy helps a portfolio
manager to sell and purchase securities on a regular basis for portfolio
revision.
 Passive Revision Strategy: Passive Revision Strategy involves rare
changes in portfolio only under certain predetermined rules. These
predefined rules are known as formula plans. According to passive revision
strategy a portfolio manager can bring changes in the portfolio as per the
formula plans only.

5.1 Formula plan: It is a technique of Portfolio Revision. Formula plans

consist of the basic rules and regulations for purchasing and selling
investments. Formula plans enable the investors to estimate the total amount
that he must spend on purchase of securities. Investors may become emotional
and they may not act rationally while making investments. Investors can earn
superior profit by using formula plan. The formula plan gives a path or course
of action within the framework of the investment objectives of the investor.
The investor can easily act according to the formula given to him without
experiencing the problem of forecasting fluctuations in the future stock prices.
The investor is safeguarded against any possible loss resulting from portfolio
construction.
 (A) Advantages of the formula plan:

1. The investor obtains basic rules and regulations for purchase and sale of
securities.

2. The rules and regulations laid down by the formula plans are rigid and
they enable the investors to overcome emotions and make rational
decisions.

3. The investors can earn higher income from their portfolio by adopting
formula plans.

4. A course of action is determined in the light of the objectives of the

investors.

5. The investor can control buying and selling of securities.

6. Formula plans are helpful in making decisions on the timing of

investment.

(B) Disadvantages of formula plans:

1. The formula plans do not help in the selection of security. The selection
of security is based on the fundamental or technical analysis.

2. Formula plans are highly rigid.

3. The formula plans can be applied for long periods, otherwise the
transaction cost will be high.

4. Formula plans do not help the investors make forecasts of market

movements. Without such forecasts best stocks cannot be identified.

5.2 Types of Formula Plans:

(A) Constant Rupee value plan: The constant rupee value plan indicates that the
rupee value remains constant. in the stock portfolio of the total portfolio.
Whenever the stock value rises the shares of the investor should be sold to
maintain a constant portfolio. Likewise, the investor should buy shares whenever
prices fall in order to maintain a constant portfolio. The investor invests a part of
his funds in the aggressive portfolio and a portion of his total funds should be
invested in a conservative portfolio. This plan provides action points which are
also known as revaluation points. The action points enable the investor to
maintain the constant rupee value by effecting transfers from aggressive to
conservative portfolio and vice versa. The action points work by giving some
specifications to the investor.

Advantages of Constant Rupee Value Plan:

1. It is very simple to operate. The investor need not make any complicated
calculations.

2. This plan brings funds to the investor for investment.

3. Constant rupee value plan specifies the percentage of the aggressive portfolio
for the investment fund. Specified as a percentage to the total fund, the aggressive
portfolio will have a constant amount.

(B) Constant ratio plan: There is a slight difference between the constant rupee
value plan and the constant ratio plan. Constant ratio plan specifies the ratio of
the value in the aggressive portfolio to the value of the conservative portfolio.
The aggressive portfolio is divided by the market value of the total portfolio and
the resultant ratio will be held constant. This can be expressed as a formula.

K = Market value of common stock / Market value of total portfolio

(C) Variable ratio plans: Instead of maintaining a constant rupee amount in stocks
or a constant ratio of stocks to bonds, the variable ratio plan user steadily lowers
the aggressive portion of the total portfolio as stock prices rise, and steadily
increase the aggressive portion as stock prices fall. By changing the proportions
of defensive aggressive holdings, the investor is in effect buying stock more
aggressively as stock prices fall and selling stock more aggressively as stock
prices rise.

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