Chapter-3

Portfolio Revision and Evaluation

Meaning Of 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 of time to maximize returns
and minimize risk is called as Portfolio revision.
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., maximising the
return for a given level of risk or minimising the risk for a given level of return. The ultimate aim of
portfolio revision is maximisation of returns and minimisation of risk.
Need Of Portfolio Revision:
a) 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.
b) 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.
c) Financial market is subject to risks and uncertainty. An individual might sell off some of his
assets owing to fluctuations in the financial market.
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:
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 revisions also not clearly established. Different
approaches may be adopted for the purpose. The difficulty of carrying out portfolio revision itself
may act as constraint to portfolio redivision.

Meaning of Portfolio Evaluation:

Portfolio evaluation is the last step in the process of portfolio management. It is the stage when we
examine to what extent the objective has been achieved. It is basically the study of the impact of
investment decisions. Without portfolio evaluation, portfolio management would be incomplete.
Portfolio evaluation refers to the evaluation of the performance of the portfolio. It is essentially the
process of comparing the return earned on a portfolio with the return earned on one or more other
portfolios or on a benchmark portfolio.
Portfolio evaluation essentially comprises two functions:
➢ Performance measurement: Performance measurement is an accounting function which
measures the return earned on a portfolio during the holding period or investment period.
➢ Performance evaluation: Performance evaluation, on the other hand, addresses such issues as
whether the performance was superior or inferior, whether the performance was due to skill or
luck, etc.

Need Of Portfolio Evaluation:

Investment may be carried out by individuals on their own. The funds available with individual investors
may not be large enough to create a well-diversified portfolio of security. Moreover, the time, skill and
other resources at the disposal of individual investors may not be sufficient to manage the portfolio
professionally. Institutional investors such as mutual funds and investment companies are better
equipped to create and manage well diversified portfolios in a professional fashion. Hence, small
investors may prefer to entrust their funds with mutual funds or investment companies to avail the
benefits of their professional services and thereby achieve maximum return with minimum risk and
effort.
Evaluation is an appraisal of performance. Whether the investment activity is carried out by individual
investors themselves or through mutual funds and investment companies, different situations arise where
evaluation of performance becomes imperative. These situations are discussed below:
Self-Evaluation: Where individual investors undertake the investment activity on their own, the
investment decisions are taken by them. They construct and manage their own portfolio of securities. In
such a situation, an investor would like to evaluate the performance of his portfolio in order to identify
the mistakes committed by him. This self-evaluation will enable him to improve his skills and achieve
better performance in future.
Evaluation of portfolio managers: A mutual fund or investment company usually creates different
portfolios with different objectives aimed at different sets of investors. Each such portfolio may be
entrusted to different professional portfolio managers who are responsible for the investment decisions
regarding the portfolio entrusted to each of them. In such a situation, the organisation would like to
evaluate the performance of each portfolio so as to compare the performance of different portfolio
managers.
Evaluation of mutual funds: In India, at present, there are many mutual funds as also investment
companies operating both in the public sector as well as in the private sector. These compete with each
other for mobilising the investment funds with individual investors and other organisations by offering
attractive returns, minimum risk, high safety and prompt liquidity. Investors and organisations desirous
of placing their funds with these mutual funds would like to know the comparative performance of each
so as to select the best mutual fund or investment company. For this, evaluation of the performance of
mutual funds and their portfolios becomes necessary.
Evaluation Perspective: A portfolio comprises several individual securities. In the building up of the
portfolio several transactions of purchase and sale of securities take place. Thus, several transactions in
several securities are needed to create and revise a portfolio of securities. Hence, the evaluation may be
carried out from different perspectives or viewpoints such a transactions view, security View or portfolio
view.
Transaction view: An investor may attempt to evaluate every transaction of purchase and sale of
securities. Whenever a security is bought or sold, the transaction is evaluated as regards its correctness
and profitability.
Security view: Each security included in the portfolio has been purchased at a particular price. At the
end of the holding period, the market price of the security may be higher or lower than its cost price or
purchase price. Further, during the holding period, interest or dividend might have been received in
respect of the security. Thus, it may be possible to evaluate the profitability of holding each security
separately. This is evaluation from the security viewpoint.
Portfolio view: A portfolio is not a simple aggregation of a random group of securities. It is a
combination of carefully selected securities, combined in a specific way so as to reduce the risk of
investment to the minimum. An investor may attempt to evaluate the performance of the portfolio as a
whole without examining the performance of individual securities within the portfolio. This is evaluation
from the portfolio view.
Though evaluation may be attempted at the transaction level, or the security level, such evaluations
would be incomplete, inadequate and often misleading. Investment is an activity involving risk. Proper
evaluation of the investment activity must, therefore, consider return along with risk involved. But risk
is best defined at the portfolio level and not at the security level or transaction level. Hence, the best
perspective for evaluation is the portfolio view.

MEASURING RETURNS - (SHARPE, TREYNOR AND JENSEN RATIOS)

Introduction:
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:
(1) The Treynor Measure
(2) The Sharpe Measure
(3) Jensen Measure

1) The Treynor Measure: Developed by Jack Treynor, this performance measure evaluates funds on
the basis of Treynor's Index. This Index is a ratio of return generated by the fund over and above
risk-free rate of return (generally taken to be the return on securities backed by the government, as
there is no credit risk associated), during a given period and systematic risk associated with it (beta).
Symbolically, it can be represented as: Treynor's Index (Ti) = (Ri -Rf) / Bi.
Where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the fund.
All risk-averse investors would like to maximize this value. While a high and positive Treynor's
Index shows a superior risk- adjusted performance of a fund, a low and negative Treynor's index is
an indication of unfavorable performance.

2) The Sharpe Measure: In this measure, performance of a fund is evaluated on the basis of Sharpe
Ratio, which is a ratio of returns generated by the fund over and above risk-free rate of return and
the total risk associated with it. According to Sharpe, it is the total risk of the fund that the investors
are concerned about. So, the measure evaluates funds on the basis of reward per unit of total risk.
Symbolically, it can be written as: Sharpe Index (Si) = (Ri - Rf) / Si
While a high and positive Sharpe Ratio shows a superior risk- adjusted performance of a fund, a low
and negative Sharpe Ratio is an indication of unfavorable performance.

3) Jenson's measure 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 fund at a given level of risk (Bi) can be calculated as:
Rp = Rf + Bi (Rm - Rf)

Where, Rm is average market return during the given period. After calculating it, alpha can be
obtained by subtracting required return from the actual return of the fund. Higher alpha represents
superior performance of the fund and vice versa. Limitation of this measure is that it considers only
systematic risk not the entire risk associated with the fund and an ordinary investor cannot mitigate
unsystematic risk, as his knowledge of market is primitive.

Practical Questions:
Q.1) Compare portfolio performance using Sharpe and Treynor measures for the following portfolio.
Portfolio Name Average Return Standard Deviation Beta
Portfolio X 14% 0.25 1.25
Portfolio Y 10% 0.15 1.10
Market Index 12% 0.25 1.20
The risk-free rate of return is 8%.
Q.2) Following information given in respect of three mutual fund and market.
Portfolio Name Average Return Standard Deviation Beta
Portfolio P 12% 18% 1.10
Portfolio Q 10% 15% 0.90
Portfolio R 13% 20% 1.20
Market Index 11% 17% 1.00
The mean risk-free rate 6%. Calculate Sharpe's Measure and Treynor's Measure and rank the mutual
funds.

Q.3) Following information given in respect of three mutual fund and market.
Portfolio Name Average Return Standard Deviation Beta
Portfolio X 12% 25% 1.30
Portfolio Y 15% 30% 0.80
Portfolio Z 10% 20% 1.20
Market Index 12% 25% 1.40
The mean risk-free rate 8%. Calculate Sharpe's Measure and Treynor's Measure and rank the mutual
funds.

Q.4) You are asked to analyse the two-portfolio having the following characteristic.
Portfolio Name Observed Return Standard Deviation Beta
Portfolio X 0.16 0.04 1.40
Portfolio Y 0.13 0.02 1.60
The risk-free rate of return is 0.08 and the return on market portfolio is 0.15 with standard
deviation 0.04. Compute the appropriate measure of performance of these portfolios and
comment on their respective performance. Use Sharpe's Measure and Treynor's Measure.
Q.5) Three mutual funds have reported the following rates of return and risk over the last five year.
Mutual Fund Average Return Standard Deviation Beta
Sparrow Ltd 14% 0.16 1.10
Heron Ltd. 12% 0.15 1.20
Vulture Ltd. 11% 0.11 0.85
Evaluate the portfolio performance using Sharpe and Treynor's Index which portfolio has
performed better. Assume risk free rate of return as 8%.
Q.6) The detail of three portfolio are given below. Compare these portfolio on performance using
Sharpe's and Treynor's Measure.
Portfolio Average Return Standard Deviation Beta
A 16% 25% 1.00
B 12% 30% 1.25
B 11% 25% 1.30
Market Index 13% 35% 1.15
The risk-free rate of return is 10%.
Q.7) The actual results of the portfolios and the market index during the last three years are given
below:
Portfolio Average Return Beta
A 15% 1.20
B 16% 1.50
B 12% 0.80
Market Index 13% 1.00
The risk-free rate of return is 9%. You are required to rank these portfolio's according to
Jensen's Measure of Portfolio Return.
Q.8) Calculate Jensen’s Measure and Rank the securities X, Y, Z.
Portfolio Average Return Beta
A 15% 1.20
B 16% 1.50
B 12% 0.80
Market Index 13% 1.00
Risk Free rate of return is 8%.
Q.9) Calculate Jensen’s Measure and Rank the securities X, Y, Z.
Portfolio Average Return Beta
1 15% 1.50
2 12% 0.90
3 10% 1.20
Market Index 12% 1.00
Risk Free rate of return is 7%.
Q.10) Calculate Jensen’s Measure and Rank the securities X, Y, Z.
Portfolio Average Return Beta
1 10% 0.67
2 12% 0.90
3 15% 1.25
Market Index 10% 1.00
Risk Free rate of return is 5%.
Q.11) The risk-free rate is 8%. You are required to compare these portfolios on performance using the
Sharpe's, Treynor's and Jensen's Measure and rank them. Following are the details of three
portfolio:
Portfolio Average Return Standard Deviation Beta
A 13% 25% 1.25
B 12% 25% 0.75
B 11% 20% 1.00
Market Index 11% 25% 1.10
Q.12) From the following calculate.
(a) Sharpe's Ratio
(b) Treynor's Ratio
(c) Jensen's Ratio

Mutual
Market Risk Free Standard
Year Fund Beta
Index Return Deviation
Return
1 6.85 1.32 14.31 4.35 0.80
2 1.20 1.27 18.95 3.85 0.90
3 21.00 1.25 14.50 6.15 1.20
4 10.18 1.10 9.25 7.50 1.40
5 17.65 0.95 20.00 6.00 1.50
Average 11.38 1.18 15.40 5.57 1.16

Q.13) From the following calculate.

(a) Sharpe's Ratio
(b) Treynor's Ratio
(c) Jensen's Ratio
Mutual Market Risk Free Standard
Year
Fund Return Beta Index Return Deviation
1 7.85 1.33 14.31 5.35 0.90
2 2.50 1.28 18.95 4.85 0.80
3 22.50 1.26 14.50 5.15 1.25
4 9.25 1.11 9.25 6.50 1.35
5 16.25 0.97 20.00 7.00 1.45

Q.14) From the following calculate.

(a) Sharpe's Ratio
(b) Treynor's Ratio
(c) Jensen's Ratio

Mutual Market Risk Free Standard

Year
Fund Return Beta Index Return Deviation
1 8.85 1.35 14.30 5.30 0.90
2 3.50 1.20 18.90 4.80 0.80
3 23.50 1.30 14.50 6.15 1.20
4 10.25 1.10 10.25 6.90 1.30
5 18.25 0.90 25.00 7.50 1.40