PortfolioManagement

ThecourseonPortfolioManagementintendsto
educatethestudentsamethodofselectingthebest
availablesecuritiesthatwillprovidetheexpected
rateofreturnforanygivendegreeofriskandalsoto
mitigatetherisks.Itisastrategicdecisionwhichis
addressedbythetoplevelmanagersinfinancial
institutions.IthelpsinmakingselectionofDebtvs.
Equity,Growthvs.Safetyandvariousothertrades
offs.

Unit1:IntroductiontoPortfolio
Management
Unit2:InvestmentPolicy
Unit3:CapitalMarket
Expectations
Unit4:AssetAllocation:Policies&
Procedures
Unit5:CapitalMarketTheory
Unit6:ArbitragePricingTheory
Unit7:PortfolioAnalysis
Unit8:OptimalPortfolioSelection
Unit9:PortfolioRevision
Unit10:MeasuringandEvaluating
PortfolioPerformance

Unit 11: EquityPortfolio

Management
Unit 12: FixedIncomePortfolio
Management
Unit 13: PortfolioManagement
UsingFutures
Unit 14: PortfolioManagement
UsingOptions

Unit1:IntroductiontoPortfolioManagement
Contents

Introduction
Objectives
TheNecessityofInvestment
Policy
InputstoaPolicyStatement
InvestmentMotives
RisksinInvestment
NeedforPortfolioManagement
TheProcessofPortfolio
Management
PortfolioManagement:An
Evaluation
EfficientPortfoliosandEfficient
Frontier

Objectives
Afterreadingthischapter,youwill
beconversantwith:
NecessityofInvestmentPolicy
InputstoaPolicyStatement
InvestmentMotives
RisksinInvestment
NeedforPortfolioManagement
ThePortfolioManagement
Process

NecessityofInvestmentPolicy
Aninvestmentpolicystatementactuallyseeksanswerstothe
followingquestions:
Whatwillhappentoaninvestorincaseofadversefinancial
situations?
Whatwillbetheinvestorsreactiontosuchadverseoutcomes?
Howawareistheinvestoraboutinvestmentsandmarkets?
Willtherebeanylegalrestrictionsaffectingtheinvestors
investments?
Thoughitisnotcertainthatfollowinganinvestmentplanwillleadto
successfulinvestmentallthetime,itwillhowevermakethe
portfoliomanagementprocessmoredisciplined.
Thepolicystatementshouldincludeabenchmarkportfolio,ora
standardofcomparison.Itistobeseenthattheriskofthe
benchmark,andtheassetsincludedinthebenchmarkshouldbe
commensuratewiththeinvestorsriskpreferenceandinvestment
needs.

InputstoaPolicyStatement
Thetwomainingredientsofaninvestmentpolicystatementare:
Investmentobjectivesofaninvestor
Investmentconstraintsofaninvestor.

Theinvestmentobjectivesofaninvestornotonlyspecifythe
investorsneedforreturnsbutalsothelevelofriskheiswillingto
takeinordertohavesuchreturns.
Theleveltillwhichapersoncantolerateriskdependsmoreonhis
psychologicalframeofmind,andotherassociatedfactorssuchas
hisinsurancecoverageandcashreserves.
Thelevelofreturncanbeexpressednotonlyintermsof
percentagesbutcanalsobestatedinsubjectivetermssuchas
capitalpreservation,capitalappreciation,currentincomeand
totalreturns.
Theinvestmentobjectivescannotbethesameforalllevelsof
investors.Theyarespecifictotheindividualinvestordepending
upontheleveloftherisktolerance,returnstobegenerated,age,
timehorizonandotherassociatedfactors.

InvestmentMotives
Thecommoninvestmentgoalsofindividualsare

Buyinganewhouse
Financingchildseducation
Savingforindependenceinoldage
Savingforatripabroad
Savingnowtostartaventurelater.

Thegoalsoftheinstitutionsgenerallystemfromtheirsource
offundsandthepromisestheyhavemadetotheprovidersof
funds.Theirgoalsarenormally
Togenerateatleastthepromisedreturnfortheinvestors.(Inthecase
ofamutualfund,apromisedminimumreturnoradefinedbenefit
pensionplan.)
Togeneratethemaximumpossiblereturnforallthesubscribers.(In
caseofadefinedcontributionpensionplan,allmutualfundsin
generalandinsurancecompaniesinparticular.)

RisksinInvestment

Inthecontextofaninvestment,asituationofcertaintyisoneinwhichthe
returnfromtheinvestmentisknownforsure.
Thetermrisk,inthecontextofinvestments,referstothevariabilityofthe
expectedreturns.Itisanattempttoquantifytheprobabilityoftheactual
returnbeingdifferentfromtheexpectedreturn.
Thevariabilityofthereturnortheriskcanbesegregatedintomany
components,basedonthefactorsthatgiverisetoit.Broadly,riskissaidto
bemadeupofthreecomponents:businessrisk,financialriskandliquidity
risk.
Businessriskisthevariabilityofreturnsintroducedbythenatureof
businessoftheentityinvestedin.
Financialrisk arisesfromthefinancingpatternoftheinvesteecompany.In
otherwords,itisthevariabilityofthereturnsfrominvestmentsmadein
thecompaniesthatarebroughtaboutbythefinancingmixusedbythe
company.
Liquidityrisk referstotheuncertaintyoftheabilityofaninvestortoexit
fromaninvestmentwhenhedesires.

NeedforPortfolioManagement
Aportfolioisacollectionofassets.Butthequestioniswhyshould
weinvestinacollectionorgroupofassets,ratherthaninasingle
asset?
Byinvestinginacombinationofstocksinsteadofasinglestock,we
canalterthetotalreturnweget,aswellasthevariabilityofthe
return.
Thereturnsfromthecombinationofthetwoshares,obviously,are
lessvolatilethanthereturnsfromanyoneoftheshares.
Thereturnsonthestockshavebeenevenedout,reducingthe
variation,butthereductioninthevariationhasalsoreducedthe
returns.
Sowecancreateanewinvestmentopportunity,whoseriskreturn
profileisdifferentfromtheexistinginvestments.

ProcessofPortfolioManagement
AccordingtoMaginn andTuttle,portfoliomanagementcanbedescribedasa
systematic,continuous,dynamicandflexibleprocesswhichinvolves:
Identifyingandspecifyinganinvestorsobjectives,preferencesandconstraintstodevelop
clearinvestmentpolicies.
Developingstrategiesbychoosingoptimalcombinationsoffinancialandrealassets
availableinthemarketandimplementingthestrategies.
Monitoringthemarketconditions,relativeassetvalues,andtheinvestorscircumstances.
Makingadjustmentsintheportfoliotoreflectsignificantchangesinoneormorerelevant
variables.

PortfolioManagementConcepts
Portfoliomanagers,tobesuccessful,havetoworkon
anyoneormoreofthefollowingstrategies:

Timingthemarket
Selectionofsuperiorstocksorgroupsofstocks
Makingchangesintheportfoliostructureand/orstrategy
Havingalongterminvestmentphilosophy.

Allthefourstrategiesmentionedearlierhave
onethingincommon theyalldependonthe
mistakesoftheothersforsuccess.Thatis,the
expectationsoftheinvestoradoptingthe
strategieshavetocometrueandthoseofthe
othersshouldnot.

EfficientPortfoliosandEfficientFrontier
Intheory,wecanplotallconceivablecombinationsofriskyassets
intheriskreturnspace.Itisreasonabletoassumethatinvestors
wouldprefermorereturnstoless;andwouldpreferlessriskto
more.
Ifwecanfindasetofportfolioswhichofferhigherreturnforthe
samelevelofrisk,orthatofferingalowerriskforthesame
return,wewouldhaveidentifiedtheportfolioswhichaninvestor
wouldliketohold.
Sowefindthatsomeportfoliomaydominateotherportfolios
becausetheyoffermorereturnforthesamelevelofrisk.Sothey
arecalledefficientportfolio.
Anefficientordominantportfolioisthatportfoliowhichhasno
alternativewith:
thesameE(Rp)andlower
thesameandhigherE(Rp)
ahigherE(Rp)andalower.