TECHNIQUES FOR

PORTFOLIO MANAGEMENT
AND EVALUATION
 PORTFOLIO MANAGEMENT PROCESS
• The portfolio management process is a dynamic process which involves the
following basic steps:
1. Identification of the objectives, constraints and preferences of investors for
formulation of investment policy
2. Develop and implement strategies in tune with investment policy formulated.
3. Portfolio Execution
4. Review and monitoring of performance of the portfolio by continuous
overview of the market conditions and performance of companies
5. Evaluation of the portfolio to compare with targets and make some adjustments
for the future
OBJECTIVES OF PORTFOLIO MANAGEMENT
• Stability of Income
• Capital growth
• Liquidity
• Safety
• Tax incentives
 PORTFOLIO EXECUTION
• A diversified portfolio can be constructed by combining
assets with negative correlation. (Refer to Markowitz
Diversification theory)
• Calculations of portfolio risk and return will aid investor in
making decision based on their level of risk tolerance and
desired return as indicated in their investment policy.
-Construction of a diversified portfolio involves allocating
funds/assets into different investments.
Asset allocation techniques can be categorized as:
1. Strategic asset allocation
2. Tactical asset allocation
 STRATEGIC VS TACTICAL ASSET
ALLOCATION
Strategic asset allocation is the long-term mix of assets that is
expected to meet the investor’s long term objectives.
The desired overall risk and return profile of the portfolio is a factor in
determining the strategic asset allocation.
A portfolio with a strategic asset allocation dominated by equities
would be expected to have a higher return and be more volatile than a
portfolio dominated by, say, bonds because bonds generally have lower
risk than equities and thus produce lower returns .
Although the chosen strategic asset allocation is expected to
meet the investor’s objectives over the long term, there are
times when shorter-term fluctuations in asset class returns can
be exploited to potentially increase portfolio returns.
A short-term adjustment among asset classes is known as
tactical asset allocation.
Tactical asset allocation represents an attempt to add value to
a portfolio by deviating from the strategic asset allocation.
Tactical asset allocation is a form of active portfolio
management
 PORTFOLIO MANAGEMENT TECHNIQUES

Beyond deciding on asset allocation, an investor/manager must decide

whether to use a passive or active management approach to asset selection.
■ Passive managers manage a portfolio designed to match the performance of
a specified benchmark.
■ Active managers attempt to add value to a portfolio by selecting
investments that are expected, on the basis of analysis, to outperform a
specified benchmark.
 PASSIVE MANAGEMENT

Passive investment managers seek to match the return and risk of a

benchmark
Passive managers may try to fully replicate the benchmark by holding
all the securities in the benchmark in proportions equivalent to their
weighting in the benchmark.
Passive investment managers attempt to minimise tracking error
Tracking error is the deviation of the return on the portfolio from the
return on the benchmark being tracked
Benchmarks include broad market indices, indices for a specific
market segment, and specifically constructed benchmarks.
Example of broad market indices in Tanzania are the Tanzania All
Share Index DSEI, Industrial & Allied (IA) Index and Banks, Finance
& Investment (BI) Index
Others are NYSE Composite Index, and the Dow Jones Industrial
Average (DJIA)
 CHARACTERISTICS OF A BENCHMARK

1. Investable: A benchmark is a passive investment alternative.

2. Unambiguous in composition: The securities comprising the
benchmark and the weighting scheme must be clearly defined.
3. 4. Attainable by manager: The manager has current investment
knowledge of the securities that make up the benchmark and can invest
in all securities.
4. Specified in advance: The benchmark is operational before the start
of an evaluation period.
5. Objectively constructed: The benchmark is not tilted in favor of or
against the manager.
6. Easily measurable: It is possible to readily observe performance to
calculate the benchmark return on a reasonably frequent basis.
 ACTIVE MANAGEMENT

Active investment managers use a variety of approaches.

They may attempt to select assets that will outperform the benchmark.
These active managers focus on selecting individual securities or assets
in an asset class or classes.
Active managers may also try to time a market (buying when they
believe the market is undervalued and selling when they believe the
market is overvalued). E.g. Tactical Allocation
 TASK

• What are the factors that influence the

choice between active and passive portfolio
management?
 PORTFOLIO MONITORING AND REVISION

Portfolio monitoring acknowledges that the markets change

and that must be reviewed periodically to ensure that the
portfolio remains appropriate for the investor's needs.
Having constructed the optimal portfolio, the investor needs
to constantly review the portfolio to ensure it continues to be
optimal. As the economy and financial markets are dynamic,
the changes take place almost daily.
• Needs for revision:
1. Availability of additional investment funds
2. Availability of new investment avenues
3. Change in the risk tolerance
4. Change in time horizon
5. Change in investment goals
6. Change in liquidity needs
7. Change in tax policy on investments
 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. It
has evolved as an important aspect of portfolio management over the
last two decades.
 BENCHMARK COMPARISON

While there are many such methods, the most notable risk
adjusted measures are the Sharpe ratio (S), Treynor ratio (T),
Jensen’s alpha (a),Modigliani and Modigliani (M2), and
Treynor Squared (T2).
Involves comparison of the performance of an investment
portfolio against a broader market index
 SHARPE RATIO
• Sharpe’s ratio shows an excess a return over risk free rate, or risk
premium, by unit of total risk, measured by standard deviation:
• Sharpe’s ratio = (řp– řf) / σp,
• here: řp - the average return for portfolio p during some period of
time;
• řf - the average risk-free rate of return during the period;
• σp - standard deviation of returns for portfolio p during the period
 TREYNOR’S RATIO
• Treynor’s ratio shows an excess actual return over risk free rate, or
risk premium, by unit of systematic risk, measured by Beta:
• Treynor’s ratio = (řp –řf) / βp,
• here: βp – Beta, measure of systematic risk for the portfolio p.
Notes :
Treynor Measure vs. Sharpe Measure: 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 we had a fully diversified portfolio, then
both the Sharpe and Treynor measures will give us the same
ranking. A poorly diversified portfolio could have a higher
ranking under the Treynor measure than for the Sharpe
measure.
 JENSEN’S ALPHA
• Jensen‘s Alpha shows excess actual return over required
return and excess of actual risk premium over required risk
premium. This measure of the portfolio manager’s
performance is based on the CAPM
• Jensen’s Alpha = řp– [řf + βp (řm –řf)]
• řm - the average return on the market in period t;
• (řm –řf) - the market risk premium during period t.
 M-SQUARED MEASURE (M2) OR MODIGLIANI-
MODIGLIANI MEASURE
• M2 measure is an extended and more useful version of the
Sharpe ratio which gives us the risk-adjusted return of the
portfolio by multiplying the Sharpe ratio with the standard
deviation of any benchmark market index and adding risk-
free return thereafter to it.
For the calculation of the M2,
• firstly, the Sharpe ratio (annual) will be calculated. The calculated
Sharpe ratio will then be used for deriving the M squared by
multiplying the Sharpe ratio by the standard deviation of the
benchmark. Here the benchmark will be chosen by the person
calculating the M2 measure
• then adding the risk-free rate of return to the outcome
• M squared measure = SR * σ benchmark + (rf)
 HOME TASK

EXPLAIN THE ADVANTAGES AND

DISADVANTAGES OF USING THE RISK
ADJUSTED MEASURES FOR PORTFOLIO
EVALUATION
 EXAMPLE
Consider two portfolios, A and B. On the basis of information
given below, compare performance of portfolio A and B

Portfolio Rp , % Rf, % Excess return Portfolio

(Rm-Rf), % risk, %

A 21 8 13 10

B 17 8 9 8
Beta are 1.2, 1.5, and 1 respectively for A and B, and market
portfolio. The SD of market portfolio is 9%.