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Security Analysis and Portfolio Management

Session 2
RISK
An Investor’s view of Risk
Types of investment risk

1. Market risk
Because of economic developments or other events that affect the entire market.

TYPES:

Equity risk – applies to an investment in shares.

Market price of shares varies all the time depending on demand and supply.
Equity risk is the risk of loss because of a drop in the market price of shares.

Interest rate risk – applies to debt investments such as bonds.

Risk of losing money because of a change in the interest rate.
For example, if the interest rate goes up, the bond yield will drop.

Currency risk – applies when you own foreign investments.

Risk of losing money because of a movement in the exchange rate.
For example, Currency risk pertains to foreign exchange investments. The risk of losing money on foreign
exchange investments because of movement in the exchange rates is currency risk. For example, if the US
dollar depreciates to Indian Rupee, the investment in US dollars will be of less value in Indian Rupee.
 An Investor’s view of Risk
2. Liquidity risk
Risk of being unable to sell your investment at a fair price and get your money out when you want
to.
To sell the investment, you may need to accept a lower price.

3. Concentration risk
Risk of loss because your money is concentrated in 1 investment or type of
investment.

When you diversify your investments, you spread the risk over different types of
investments, industries and geographic locations.
4. Credit risk
Risk that the government entity or company that issued the bond will run into financial
difficulties and
won’t be able to pay the interest or repay the principal at maturity.
Credit risk applies to debt investments such as bonds.
You can evaluate credit risk by looking at the credit rating of the bond.
For example, long-term Canadian government bonds have a credit rating of
AAA,
which indicates the lowest possible credit risk.
 An Investor’s view of Risk
5. Reinvestment risk
Risk of loss from reinvesting principal or income at a lower
interest rate. Suppose you buy a bond paying 5%.
Reinvestment risk will affect you if interest rates drop and you
have to reinvest the regular interest payments at 4%.
Reinvestment risk will not apply if youintend to spend the
regular interest payments or the principal at maturity.
7. Horizon risk
Risk that your investment horizon may be shortened because of
an unforeseen event, for example, the loss of your job.
This may force you to sell investments that you were
expecting to hold for the long term. If you must sell at
time when the markets are down, you a may lose
money.
 An Investor’s view of Risk

8. Longevity risk
Risk of outliving your savings. This risk is particularly
relevant for people who are retired, or are nearing
retirement.

9. Foreign investment risk

Risk of loss when investing in foreign countries.
When you buy foreign investments, you face risks
that do not exist in India, for example, US elections.
 Portfolio Risk
• Market risk /Systematic risk
• Risk that the value of an investment will decrease due to
changes in market factors………because it relates to factors,
such as a recession, that impact the entire market

• Diversified risk
• Return from one industry compensates for the loss if any that
may occur due to the holding of a security representing
another industry

• There we do Risk adjusted economic valuation of

our investments by using treynor and sharpe ratio
 Volatility Measure of Risk

CASE Exercise in Excel

Alpha, Returns, Standard Deviation and Beta

of individual stock:

Excel Demo…Decision Making(regression and SD)

Excess return OR Abnormal rate of return OR Active return
Alpha is a Measure of performance, indicating when a strategy, trader, or portfolio manager has
managed to beat the market return over some period.
Represented as a single number (like +3.0 or -5.0),
*how the portfolio or fund performed compared to the referenced benchmark index
(i.e., 3% better or 5% worse). Y = A + BX
TATA MOTORS RETURN = 2 -1 Market Return
• Alpha :
Beta -
– Positive or negative More than 1
– Result of active investing. =1
less than 1

Alpha is often used in conjunction with beta (Greek letter β).

Measures broad market's overall volatility or risk (systematic market risk)

• Often considered to represent the value that a portfolio manager adds to or subtracts from a fund's
return.
• Return on an investment that is not a result of general movement in the greater market.
Alpha of zero means?????
Portfolio or fund is tracking perfectly with the benchmark index and that the manager has not
added

ALPHA!!!!
or lost any additional value compared to the broad market.
 CASE 1: Alpha
Suppose that Jim, a financial advisor, charges 1% of a portfolio’s value
for his services and that during a 12-month period Jim managed to
produce an alpha of 0.75 for the portfolio of one of his clients,
Frank.

While Jim has indeed helped the performance of Frank’s portfolio, the fee
that Jim charges is in excess of the alpha he has generated, so Frank’s
portfolio has experienced a net loss.
For investors, example highlights the
importance of considering fees in
conjunction with performance returns and
alpha.
• EMH:

• Market prices incorporate all available information at all times, and so securities
are always properly priced.

• There is no way to systematically identify and take advantage of mispricing's

in the market because they do not exist.

• If mispricing are identified, they are quickly arbitraged away and so

persistent patterns of market anomalies that can be taken advantage tend to
be few and far between.

• Empirical evidence comparing historical returns of active mutual funds

relative to their passive benchmarks indicates that fewer than 10% of all
active funds are able to earn a positive alpha over a 10-plus year time period,
and this percentage falls once taxes and fees are taken into consideration.

Alpha does not exists!!!

CASE 2: Two historical examples for fixed income ETF and equity
ETF

The iShares Convertible Bond ETF (ICVT) is a fixed income investment with low risk.
It tracks a customized index called the Bloomberg Barclays U.S. Convertible Cash
Pay Bond
> $250MM Index.

ICVT had a relatively low annual standard deviation of 4.72%. Year-to-date, as of

November 15, 2017, its return was 13.17%. The Bloomberg Barclays U.S. Convertible
Cash Pay Bond had a return of 3.06% over the same period.
Therefore, the alpha for ICVT was 10.11% in comparison to the Bloomberg
Barclays
U.S. Convertible Cash Pay Bond and for a relatively low risk with a standard
deviation of 4.72%.
However, since the Bloomberg Barclays U.S. Convertible Cash Pay Bond is not the
proper benchmark for ICVT (it should be the Bloomberg Barclay's Convertible
bond index), this alpha may not be as large as initially thought, and in fact may
be misattributed since convertible bonds have far riskier profiles than cash.

Seeking Investment Alpha

CASE 3:

Wisdom Tree U.S. Quality Dividend Growth Fund (DGRW) is an equity

investment with higher market risk that seeks to invest in dividend growth
equities.
Its holdings track a customized index called the Wisdom Tree U.S. Quality Dividend
Growth Index. It has a three-year annualized standard deviation of 10.58%, higher
than ICVT.

Its year-to-date return as of November 15, 2019 is 18.24% which is higher than the S&P 500 at
14.67%, so it has an alpha of 3.57% in comparison to the S&P 500. But, again, the S&P 500
may not be the correct benchmark for this ETF, since dividend-paying growth stocks are a very
particular subset of the overall stock market, and may not even be inclusive of the 500 most
valuable stocks in America.

Statistics show that over the past ten years, 83% of active funds in the
U.S. fail to match their chosen benchmarks.
Experts attribute this trend to many causes, including:

(i) Growing expertise of financial advisors

(ii) Advancements in financialtechnology and
software that advisors have at their disposal
(iii) Increasing opportunity for would-be investors
to engage in
(iv) Shrinking proportion
• the market due toofthe
investors
growth taking
of the on risk in their
Internet
(v) portfolios,
Growing andamount of money being invested in pursuit of alpha
(vi) Active portfolio managers seek to generate alpha in diversified
portfolios, with diversification intended to eliminate unsystemati
c risk.
1. A basic calculation of alpha subtracts the total return of an investment from a
comparable benchmark in its asset category. This alpha calculation is primarily
only used against a comparable asset category benchmark,.
– Therefore, it does not measure the outperformance of equity ETF versus a fixed income
benchmark. This alpha is also best used when comparing performance of similar asset
investments.
• Thus, the alpha of the equity ETF, DGRW, is not relatively comparable to the
alpha of the fixed income ETF, ICVT.

2. Advanced technique. Jensen’s alpha :

– Takes into consideration CAPM theory and risk-adjusted measures by utilizing the risk free rate and
beta.
– Alphacanbecalculatedusingvariousdifferent indexbenchmarkswithinanasset class.
– In some cases there might not be a suitable pre-existing index,
in which case advisors may use algorithms to simulate an index
for comparative alpha calculation purposes.

Alpha Considerations
• Measure of volatility, or systematic risk, of an individual stock.

• Beta
Represents slope of the line through a regression of data points from an individual stock's
returns against those of the market.

• Can be earned through passive index investing.

• Commonly used to rank active mutual funds.

• Beta is used in CAPM, which calculates the expected return of an asset using beta and expected
market returns.

• Systematic risk(un-diversifiable risk)

– Financial crisis in 2008 event when no amount of diversification could prevent investors
from losing value in their stock portfolios.
– COVID

• Unsystematic or diversifiable risks:

– Surprise announcement
– Unsystematic risk can be partially mitigated through diversification.
• What Beta Describes?
– Activity of a security's returns responding to swings in the market.
• For beta to provide any insight, the “market” used as a benchmark should be related to the stock.
– For example, calculating a bond ETF’s beta by using the S&P 500 as the benchmark isn’t
helpful because bonds and stocks are too dissimilar.
• Beta of 1.0,
– Price activity is strongly correlated with the market.
– Adding a stock to a portfolio with a beta of 1.0 doesn’t add any risk to the portfolio, but it also
doesn’t increase the likelihood that the portfolio will provide an excess return.

• A beta value of less than 1.0

– Security is theoretically less volatile than the market.

• A beta that is greater than 1.0,

Security's price is theoretically more volatile than the market.
Adding the stock to a portfolio will increase the portfolio’s risk, but also increase its
expected return.

• A beta of -1.0
• Stock is inversely correlated to the market benchmark as if it were an opposite, mirror image of the
benchmark’s trends.

Deciphering Beta Values

• https://economictimes.indiatimes.com/markets/stocks/news/investors-give-value-stocks-a-
second-look-as-bond-yields-rally/articleshow/85322249.cms