Portfolio Management

Options and Performance

Measurement of Portfolios
 Investment Process
Investment Process consists of selecting the right asset mix based on
various parameters/ criteria set by the Investment Manager by balancing
between Risk- Return keeping in mind the Investment Philosophy.

 Defined  Research and

Analysis on Shortlisting of Portfolio
Investment basket of securities Construction
Philosophy securities/papers

 Churning of Evaluation of Comparing to

portfolio Portfolio benchmark

Portfolio Managment and Mutual Funds IBS Se 2

m IV 2021
 Key Portfolio Performance Characteristics

Portfolio is superior or inferior is based on following components:

1. Risk-adjusted returns
2. Asset allocation viz; stocks, bonds and money market instruments
3. Sector selection within asset class
4. security selection within sector
Portfolio Evaluation Techniques
• Sharpe’s Performance Index
• Treynor’s Performance Index
• Jensen’s performance Index
• Tracking Error
• Information Ratio
Sharpe’s Performance Index
• It measures the risk premium of the portfolio relative to the total amount of risk in the portfolio.
• Risk premium is the difference between the portfolio’s average rate of return and the risk less
rate of return
Sharpe’s Formula
St= Rp-Rf/ σp
Where;
Rp is portfolio average return
Rf is risk free rate of return
σp is standard deviation of portfolio return
The larger St, better the fund has performed.
 Problem: Evaluate which portfolio is better as per Sharpe Ratio from the given data:
Portfolio return of A,B and C are 16,20 and 18 respectively. Portfolio standard
deviation of A,B and C are 4,8 and 3 respectively. Risk free return is 12%.

Solution:
Portfolio A
St= Rp-Rf/ σp
=16-12/4=1
Portfolio B
St= Rp-Rf/ σp
=20-12/8=1
Portfolio C
St= Rp-Rf/ σp
=18-12/3=2
According to Sharpe Performance Index Portfolio C is better as its index is higher compared to A
and B.
Treynor’s Performance Index
• The relationship between market returns and fund’s return is given by
characteristic line. Rp=α+(βRm+ep)

Where; Rp is portfolio return

α, β are coefficients to be estimated
Rm is market return
ep is residual error

• The fund’s performance is measured relative to market performance.

• In ideal scenario, the rate of return rises faster than the market performance
when markets are moving up and declines slowly when market are moving down.
• Treynor measures the performance of the fund with characteristic line which is
Treynor’s Formula
As Sharpe takes total risk . Treynor does not take total risk in
denominator . It only takes market related risk (systematic)Beta in the
denominator which is given by;
Treynor’s Ratio
Tn = (Portfolio average return – risk free rate of interest)/ Beta
coefficient of portfolio

Tn= Rp-Rf/ βp
The larger the Treynor the better the fund. Larger Treynor is better as it earned more risk premium per unit of systematic

risk
Problem: Evaluate which portfolio is better as per Treynor Ratio from the given data:
Portfolio return of A and B are 6 and 3.3 respectively. Portfolio systematic risk of A
and B are 1 and 2.85 respectively. Risk free return is 3%.

Portfolio A
Tn= Rp-Rf/ βp
=6-3/1=3
Portfolio B
Tn= Rp-Rf/ βp
=3.3-3/2.85=0.105
As per Treynor Ratio the higher the better portfolio. So A is higher than
B.
Jensen’s Performance Index

• The absolute risk adjusted return measure was developed by Michael

Jensen.
• It is measure of absolute performance because a definite standard is
set and against that the performance is measured.
• The standard is based on manager’s predictive ability.
• The basic model of Jensen is
Jensen Model
Rp = α+β(Rm- Rf)
Rp is portfolio average return
α is the intercept β is systematic risk
Rm is market return

α p represent forecasting ability of the manager. Then equation becomes;

Rp - Rf = α+β(Rm- Rf)
Or
Rp = α+ Rf +β(Rm- Rf)
Problem: Eavluate the best portfolio using Jensen Model from the following data:
market return is 16% and Rf is 10%

Portfolio Portfolio Return Beta Coefficient

A 18 1.2
B 15 0.8
C 21 1.5
Solution:

Using Jensen Model

Rp - Rf = α+β(Rm- Rf)
Portfolio A
18-10= α+1.2(16-10)
α= 1.2
Portfolio B
15-10= α+0.8(16-10)
α= 0.2
Portfolio C
21-10= α+1.5(16-10)
α= 2
Portfolio C is better as returns are higher.
Problem:

Mr. Ajay is having units in a mutual fund for past 5 years. He wants to evaluate its performance by comparing it
to the market.

Fund Market
Return 25 21
σ 22 19
Rf 2 2
β 1.1

Find Sharpe and Treynor indices and also provide your comments.
Solution:
Sharpe’s Formula
St= Rp-Rf/ σp
=25-2/22=1.045
St for market= 21-2/19=1
Sharpe index for fund is higher than the market and it indicates that the fund has outperformed the
index.
Treynor’s Ratio

Tn= Rp-Rf/ βp
= 25-2/1.1=20.91
Tn for market =21-2/1=19
Where; β for market index is 1.
According to Treynor index, the portfolio has performed better than the market. Portfolio is well
Problem: Find the Treynor, Sharpe and Jensen from the data given. Which fund is
superior with justification? SOLVE THIS

Fund A Fund B Fund C Market Risk Free

Mean 17.1 14.5 13 11 8.6
Returns(Rp/Rm/Rf)
Standard 28.1 19.7 22.8 20.5
Deviation(σp)
Beta (βp) 1.2 0.92 1.04 1
Tracking Error
• It is a standard deviation of return of the portfolio to the benchmark/index to which it is marked
to.
• Low tracking error means a portfolio is closely following its benchmark. High tracking errors
indicates the opposite.

• The tracking efficiency of the portfolio can be calculated as;

Tracking Error=ω=✓Var(Rp-Rb)

Where; Rp is Portfolio return

Rb is benchmark return
ω=✓ (Rp1-Rb1)2+(Rp2-Rb2)2+….+(Rpn-Rbn)2/n-1

Tracking error= ✓Σ(Rd-Rbar)2/n-1

Where R bar is mean of difference Rd-Rb
Problem: From the data find the tracking error:

Scheme Return(%) (Rp) Market Return(%)(Rb)

15 18
10 9
12 13
17 19
Solution
Scheme Market Return(%) Rd=Rp-Rb Rd-Rbar (Rd-Rbar)2
Return(%) (Rp) (Rb) Rd=return
between the
portfolio and
the benchmark
15 18 -3 1.75 3.0625
10 9 1 2.25 5.0625
12 13 -1 0.25 0.0625
17 19 -2 -0.75 0.5625
Average Difference -1.25 summation 8.75
Rbar of (Rd-Rbar)2

Tracking error= ✓Σ(Rd-Rbar)2/n-1

=✓(8.75/4-1)
=1.70%
Low tracking error means a portfolio is closely following its benchmark. High tracking
errors indicates the opposite.
Information Ratio
• It calculates return of the portfolio wrt tracking error
• TE is not equal to zero
• Formula;
IR = Rp- Rm/ Tracking Error
Where Rp is portfolio return
Rm is market return
• Problem : Varun is willing to invest his money in a hedge fund. He
considers the LNM Fund and ABC Fund. In order to choose the right
fund, Varun wants to compare the information ratios for the two
funds. The benchmark for the ratio’s calculation is the Nifty 50. The
information about the funds is summarized in the table below:

LNM Fund ABC Fund

Fund Return (%) 11 12
Nifty 50(%) 8 8
Σ (%) 6 9

Solution:
IR (LNM Fund)= 11-8/6= 50%
IR(ABC)= 12-8/9=44%
The LNM Fund shows a higher ratio than the ABC Fund. This indicates that the LNM
Fund can more consistently generate excess returns, as compared to LNM Fund.
Assignments - CEC 3
1. GROUP 1.( 1-11) MFs – Debt- Analysis of 5 schemes- Overnight Fund, Liquid, Ultra Short Term
fund, Money Market Fund. Top5 schemes in each of these categories based on various criteria
like; expense ratios, sharpe ratio, tracking error, average maturity, modified duration, YTM,
Rating of the scheme, exposure to sectors(manufacturing, financial services, banking, psu/FI).
From above parameters select the top 3 schemes in the category with rationales mentioned.
2. GROUP 2(12-22). MFs – Debt- Analysis of 5 schemes- Short Term Duration Fund, Banking and
PSU Debt Fund, Bond Fund - Top5 schemes in each of these categories based on various
criteria like; expense ratios, sharpe ratio, tracking error, average maturity, modified duration,
YTM, Rating of the scheme, exposure to sectors(manufacturing, financial services, banking,
psu/FI). From above parameters select the top 3 schemes in the category with rationales
mentioned.
3. GROUP 3.(23-33)MFs- Equity- Analysis of 5 schemes- Large cap, mid cap, multicap, midcap-
small cap. Top 5 schemes in each of these categories based on various parameters like; treynor
ratio, tracking error, performance, TER, load factor, IR. From above parameters select top 3
schemes in the category.
4. GROUP 4.(34-44)MFs- Equity- Analysis of 5 schemes- Flexicap, ETF, Large and Mid Cap,
infrastructure funds. Top 5 schemes in each of these categories based on various parameters
like; treynor ratio, tracking error, performance, TER, load factor, IR. From above parameters
select top 3 schemes in the category.
5. GROUP 5(45-55) -SEBI circulars since August 2018 for MFs/PMS. Find
what are the circular saying about and implications on the industry and
investor. Govt and RBI measures since Covid period for the economy
and its sector and asset class impact.