INVESTMENT

MANAGEMENT
JACKSON DAVID

MODULE 4

INVESTMENT MANAGEMENT

A generic term that most commonly refers to

the buying and selling of investments within a
portfolio.
Can also include banking and budgeting
duties, as well as taxes.
Most often refers to portfolio management
and the trading of securities to achieve a
specific investment objective.

PORTFOLIO MANAGEMENT

The art and science of making decisions

about
o
o
o
o

investment mix and policy,

matching investments to objectives,
asset allocation for individuals and institutions, and
balancing risk against performance.

PORTFOLIO MANAGEMENT PROCESS

1.Specification of investment objectives and

constraints
Choice of asset mix
Formulation of portfolio strategy
Selection of securities
Portfolio execution
Performance Evaluation
Portfolio Revision

2.
3.
4.
5.
6.
7.

MODERN PORTFOLIO THEORY (MPT)

Put forth by Harry Markowitz in his paper

"Portfolio Selection," (published in 1952 by the

Journal of Finance)
Based on the idea that risk-averse investors can
construct portfolios to optimize or maximize
expected return based on a given level of
market risk, emphasizing that risk is an inherent
part of higher reward.
One of the most important and influential
economic theories dealing with finance and
investment.

PORTFOLIO SELECTION

Suggests that it is possible to construct an

"efficient frontier" of optimal portfolios, offering
the maximum possible expected return for a
given level of risk.
Says that it is not enough to look at the expected
risk and return of one particular stock.
By investing in more than one stock, an investor
can reap the benefits of diversification,
particularly a reduction in the riskiness of the
portfolio.
MPT quantifies the benefits of diversification

MARKOWITZ DIVERSIFICATION

A strategy that seeks to combine in a portfolio

assets with returns that are less than

perfectly positively correlated, in an effort to
lower portfolio risk (variance) without
sacrificing return.
occurs when one uses mathematical models
to find the securities to place in a portfolio
such that the portfolio has the highest
possible return for its level of risk.

Expected return of a security - projected

Sum over all states of nature, the product of the

probability of a state of nature and the return

projected in that state.
Ps is the probability for a particular state of
nature and Rs is the returns in that state
State
Ps
Good 30%
Average 50%
Poor 20%

Rs
20%
15%
-4%

Ps * Rs
0.3(0.2)
+0.5(0.15)
+0.2(-0.04)

E ( R) Ps Rs
s 1

12.70%

Variance and Standard Deviation

Calculation of risk measures based on afore

mentioned returns
State
Ps
Good 30%
Average 50%
Poor 20%

Ps * Rs
(Rs E(R))2 * Ps
0.3(0.2)
0.3(0.2-0.127)2
+0.5(0.15) +0.5(0.15-0.127)2
+0.2(-0.04) +0.2(-0.04-0.127)2
12.70%
0.0074
Mean
Variance

Rs
20%
15%
-4%

[ Rs E ( R)] Ps
2

s 1

8.63%
Standard
Deviation

EXPECTED RETURN OF PORTFOLIO

Weighted average of the expected returns of

the individual securities in the portfolio

( ) =
o
o
o
o

=1 ( )

is expected return of portfolio

is weight of security i in the portfolio
( ) is the expected return of security i
n is the number of securities in portfolio

Expected return eg.

Four securities A,B,C & D with expected

returns of 12%, 15%, 18% and 20%

Proportion of these in portfolio are 20%, 30%,
30% and 20% respectively

Expected return is
o 12% (.20) + 15% (.30) + 18% (.30) + 20% (.20)
= 16.3%

Portfolio Risk

Portfolio risk in NOT the weighted average of

risk of individual securities

Another factor, viz. correlation is relevant

Due to this, investors can achieve the benefit
of risk reduction through diversification

COVARIANCE

Covariance is a measure of the degree to

which returns on two risky assets move in
tandem.
A positive covariance means that asset
returns move together.
A negative covariance means returns move
inversely

Coefficient of Correlation

Is the covariance of two securities divided by product of

standard deviations of the two

Can vary between -1.0 and +1.0

A value of -1.0 means perfect negative correlation ie.
Perfect co movement in opposite directions
0 means no co movement
Value of +1.0 means perfect positive correlation ie
perfect co movement in same direction

PORTFOLIO RISK

It is the sum of weighted variance of securities

plus the weighted co variance between the
securities

= + +
o 2 = variance of the portfolio
o = weights of security a,b in portfolio
o 2 2 =variance of returns of security a,b
o = covariance of the returns of security a,b [Cova,b]

The above formula gives variance, to find

Standard Deviation, find the square root of this

PORTFOLIO RISK 3 security case

Variance, where portfolio consists of three

securities a, b & c

+ + + +
+

EXAMPLE OF PORTFOLIO RISK

A portfolio consists of two securities 1 and 2

in proportion 0.6 and 0.4.

The standard deviations are 10 and 16
respectively.
Coefficient of correlation between the returns
of two securities is 0.5.
What is the standard deviation of the portfolio
return?

Answer

Variance
2 = (0.62 102 ) + (0.42 162 ) + (2 0.6 0.4 0.5 10 16)
=115.36

Standard Deviation
= 115.36 = 10.7%

EXAMPLE 2

Two securities A & B, with below features are to

be combined in a portfolio
Security A
Expected return
Standard deviation

Security B

12%

20%

20%

40%

Coefficient of correlation

-0.20

The following weightages can be considered

Portfolio

% Of A

1.00

0.90

0.759

0.50

0.25

0.00

% of B

0.00

0.10

0.241

0.50

0.75

1.00

Risk for each portfolio

Portfolio

% of A

% of B

Expected
return

Standard
Deviation

1 (only A)

1.00

0.00

12.00%

20.00%

0.90

0.10

12.80%

17.64%

0.759

0.241

13.93%

16.27%

0.50

0.50

16.00%

20.49%

0.25

0.75

18.00%

29.41%

6 (only B)

0.00

1.00

20.00%

40.00%

GRAPHICAL PRESENTATION

FEATURES

Entire curve from A to B is feasible

Portfolio 1 & 2 will not be considered by

investors, since 3 is a much better option with

lower risk and higher returns
Portfolio 3 represents Minimum Variance
Portfolio (MVP)
Curve from 3 to 6 is called efficient frontier
Correlation less than 1 will give benefit of
diversification, as in this case

More than two securities

efficient frontier
Return

Risk

Risk indifference curve

Graphical plotting of risk - reward expectations for

different risk aversion levels
Steeper the slope, higher the risk aversion

Utility indifference curve

Graphical plotting of same risk aversion levels, but with different risk
free rates
All points on a curve gives same satisfaction levels
Higher curves will provide higher satisfaction levels

OPTIMAL PORTFOLIO

Found at the point of tangency between the

efficient frontier and a utility indifference curve.

CAPITAL ASSET PRICING MODEL (CAPM)

Developed by William Sharpe and John Lintner

MPT Deals with reducing risk through diversification, but has no
solution for systematic risk, which is not reduced by diversification
CAPM, therefore, evolved as a way to measure this systematic risk.
Six basic assumptions
o Individuals are risk averse
o They seek to maximise the expected utility of their portfolio over
a single period planning horizon
o Individuals have homogenous expectations
o They can borrow and lend at risk free rates
o The market is perfect no taxes, no transaction costs, is
competitive
o The quantity of risky securities in market is given

CAPITAL MARKET LINE

Capital market line (CML) is the tangent line drawn

from the point of the risk-free asset to the feasible region
for risky assets.

RISK MEASURE BETA

Total risk = Systematic Risk + Diversifiable risk

Although systematic risk affects all investment returns,
some assets are more sensitive to systematic risk than
others
The beta of an asset measures the market risk of that
particular asset as compared to the rest of the market
hence, it also measures volatility of the asset compared to
the general market.
The beta of the index is considered to be 1.
If the beta is greater than 1, then the stock moves more
than the market does in the same direction.
negative beta means negative correlation to the general
market

BETA

The beta coefficient was born out of linear regression

analysis.
It is linked to a regression analysis of the returns of a
portfolio (such as a stock index) (x-axis) in a specific
period versus the returns of an individual asset (y-axis)
in a specific year.

Beta of a security a is =

is the covariance between Return of security a
and return of market portfolio m
2 is the variance of return of market portfolio

Required return using CAPM

CAPM uses the beta of a particular security, the risk-free

rate of return, and the market return to calculate the
required return of an investment to its expected risk.
Required return = risk free rate + risk premium

=Risk-Free Rate + [Beta x (Market Return Risk-Free Rate)]

The term, (Market Return Risk-Free Rate), is simply the required

return on stocks in general because stocks have a certain amount of
risk. Hence, this is called the risk premium

SECURITIES MARKET LINE

When the relative risk premium, represented by beta, is plotted in a graph

against the required return, it yields a straight line known as the security
market line (SML).
This line begins at the risk-free rate and rises with beta.
Capital Market Line is a special case of SML

A graph of a security market line, assuming a market return of 12% and a risk-free rate of 4%. Note that a
beta of 0 is equal to the risk-free rate while a beta of 1 has a relative risk equal to the market.

RISK FREE RATE

Return of security or portfolio which is free

from default risk

Practically constructing such a portfolio is
impractical
In practice two alternatives are used
o Rate of treasury bills
o Rate of long term Govt. bonds

RISK PREMIUM

Based on historical data

Difference between average return on stocks

and the average risk free rate

Longest periods ideal
Both arithmetic mean (average of annual rates
of return) and geometric mean (compounded
annual return) are used
Determinants
o Variance in the underlying economy
o Political risk
o Market structure

Sharpes Single Index Model

the single-index model assumes that there is only 1

macroeconomic factor that causes the systematic
risk affecting all stock returns and this factor can be
represented by the rate of return on a market index, such
as the S&P NIFTY.
According to this model, the return of any stock can be
decomposed into the expected excess return of the
individual stock due to firm-specific factors, commonly
denoted by its alpha coefficient (), which is the return
that exceeds the risk-free rate, the return due to
macroeconomic events that affect the market, and
the unexpected microeconomic events that affect only
the firm.

Sharpes Single Index Model

Where Ri is the return of stock i

i is the alpha of security i
i is the beta of i
RM is the return of market index
ei is the unsystematic risk
The term iRm represents the stocks return due to the
movement of the market modified by the stock's beta (i),
while ei represents the unsystematic risk of the security
due to firm-specific factors.

PORTFOLIO EVALUATION

Process of assessing the performance of the

portfolio over a selected period of time in

terms of returns and risk
Quantitative measurement of actual return
and risk to be followed by assessment of
relative performance
Provides a measure for identifying
deficiencies in the process of portfolio
management

PORTFOLIO EVALUATION TOOLS

RISK ADJUSTED RETURNS USED

THREE POPULAR MEASURES
o SHARPE RATIO
o TREYNOR RATIO
o JENSONS ALPHA

TREYNOR RATIO

o

o Introduced by Jack L. Treynor, based on his own work on

Securities Market Line
o Numerator measures the risk premium; denominator, beta
coefficient value represents the portfolio's return per unit
risk
o Because this measure only uses systematic risk, it
assumes that the investor already has an adequately
diversified portfolio and, therefore, unsystematic risk (also
known as diversifiable risk) is not considered.
o Higher ratio shows better investment portfolio

SHARPE RATIO
o

o Conceived by William Sharpe, this measure closely

follows his work on the capital asset pricing model
o Similar to Treynor ratio, except denominator SD
o Numerator is risk premium and denominator is risk,
measured by standard deviation
o Higher the better

Jensons Measure (Alpha)

o

Portfolio Return [Risk Free Rate + Portfolio Beta (Market Return Risk Free Rate)]

Expected return as per CAPM

o Created by Michael C. Jensen

o The measure calculates the excess return that a
portfolio generates over its expected return.
o Also known as alpha
o Requires the use of a different risk-free rate of return
for each time interval considered, unlike in the case of
earlier measures which uses return for total time
period

PORTFOLIO REVISION

The process of changing the mix of securities

in a portfolio
Needs
o Change in investment preferences
o Change in quantum of investment
o Happenings in the financial markets, economy etc.

High churning (frequent, aggressive changes)

may increase risk

Types of management
o PASSIVE/ACTIVE/FORMULA BASED

PASSIVE PORTFOLIO MANAGEMENT

o Fund manager keeps a portfolio designed to resemble market
returns
o Typically holds a well diversified portfolio with buy and hold
strategy
o Common method is index investing, ie. Buying all stocks in an
index like SENSEX or NIFTY in the exact proportion of each
stock in the index
o Rebalancing done to mirror changes in index
o Safer strategy, low cost
o Drawbacks
Keeping a high number of stocks increases difficulty in
holding and trading
Efficient reinvestment of dividend also could be difficult

ACTIVE PORTFOLIO MANAGEMENT

o Fund manager keeps a specific portfolio based on his forecasts
o Riskier strategy, but could give outperformance compared to
broader markets
o Drawbacks
Could result in losses if fund manager is wrong
Costs for research and manager costs are much higher
Personal biases may come into play
Not effective in mature markets

FORMULA PLANS

The amount to invest in different asset classes,

timing and specific securities are determined

based on rigid theories or formulae
decision-making is taken out of the process
A popular formula is Joel Greenblatts magic
formula, which uses quantitative value
investment stock picking