Chapter 20 PORTFOLIO MANAGEMENT FRAMEWORK The Grand Design

Chapter 20 PORTFOLIO MANAGEMENT FRAMEWORK The Grand Design

OUTLINE • Phases of Portfolio Management • Specification of Investment Objectives and Constraints • Choice of Asset Mix • Formulation of Portfolio Strategy • Selection of Securities • Portfolio Execution • Portfolio Revision • Portfolio Evaluation

PHASES OF PORTFOLIO MANAGEMENT SPECIFICATION OF INVESTMENT OBJECTIVES AND CONSTRAINTS CHOICE OF ASSET MIX FORMULATION OF PORTFOLIO STRATEGY SELECTION OF SECURITIES PORTFOLIO EXECUTION PORTFOLIO REVISION PORTFOLIO EVALUAYION

SPECIFICATION OF INVESTMENT OBJECTIVES • The commonly stated investment goals are : income, growth, and stability • Since income and growth represent two ways by which return is generated and stability implies containment of risk, investment objectives may be expressed more succinctly in terms of return and risk.

A RISK TOLERANCE QUESTIONNAIRE To assess your risk tolerance, seven questions are given below. Each question is followed by three possible answers. Circle the letter that corresponds to your answer. 1. Just six weeks after you invested in a stock, its price declines by 20 percent. If the fundamentals of the stock have not changed, what would you do? a. Sell b. Do nothing c. Buy more 2. Consider the previous question another way. Your stock dropped 20 percent, but it is part of a portfolio designed to meet investment goals with three different time horizons. (i) What would you do if your goal were five years away? a. Sell b. Do nothing c. Buy more

(ii) What would you do if the goal were 15 years away? a. b. c. Sell Do nothing Buy more (iii) What would you do if the goal were 30 years away? a. b. c. 3. You have bought a stock as part of your retirement portfolio. It price rises by 25 percent after one month. If the fundamentals of the stock have not changed, what would you do? a. b. c. 4. Sell Do nothing Buy more You are investing for retirement which is 15 years away. What would you do? a. Invest in money market mutual fund or a guaranteed investment contract

b. Invest in a balanced mutual fund that has a stock : bond mix of 50 : 50 c. Invest in an aggressive growth mutual fund 5. As a prize winner, you have been given some choice. Which one would you choose? a. Rs 50, 000 in cash b. A 50 percent chance to get Rs 125, 000 c. A 20 percent chance to get Rs 375, 000 6. A good investment opportunity has come your way. To participate in it you have to borrow money. Would you take a loan? a. No b. Perhaps c. Yes 7. Your company, which is planning to go public after three years, is offering 8. stock to its employees. Until it goes public, you can’t sell your shares. Your 9. investment, however, has the potential of multiplying 10 times when the 10. company goes public. How much money would you invest?

a. Nothing b. Three months’ salary c. Six months’ salary Your risk tolerance score is: Number of (a) answers x 1 + Number of (b) answers x 2 + Number of (c) answers x 3 If your score is … You may be a … 9– 14 points Conservative investor 15– 21 points Moderate investor 22– 27 points Aggressive investor Adapted from a risk tolerance questionnaire developed by Dow Jones & Company Inc.

CONSTRAINTS • LIQUIDITY • TAXES • TIME HORIZON • UNIQUE PREFERENCES & CIRCUMSTANCES

SELECTION OF ASSET MIX • Should the long-term stock-bond mix be 50 : 50 or 75 : 25 or 25 : 75 or any other ? • Referred to as the strategic asset-mix decision (or policy asset-mix decision), this is by far the most important decision by the investor. Empirical studies have shown that nearly 90 percent of the variance of the portfolio return is explained by its asset mix.

SELECTION OF ASSET MIX CONVENTIONAL WISDOM 1. GREATER RISK TOLERANCE STOCKS 2. LONGER INVESTMENT HORIZON STOCKS RISK-RETURN RELATIONSHIP FOR VARIOUS TYPES OF BONDS AND STOCKS SPECULATIVE SHARES RETURN BLUE CHIP SHARES PUBLIC SECTOR BONDS NCDs OF PRIVATE SECTOR GROWTH SHARES DEFENSIVE SHARES BANK DEPOSITS INCOME/GROWTH ORIENTED UNITS RISK

RANGE OF RETURN ON COMMON STOCKS Source : Vanguard Group

ENDURING RELATION J. H. LORIE : “THE MOST ENDURING RELATION IN ALL FINANCE PERHAPS IS THE RELATIONSHIP BETWEEN RETURNS ON EQUITIES (OR STOCKS) AND RETURNS ON BONDS. IN ALL PERIODS OF AMERICAN HISTORY, BRITISH HISTORY, AND GERMAN HISTORY, EQUITIES (STOCKS) HAVE PROVIDED HIGHER RETURNS THAN BONDS” A SIMILAR OBSERV’N CAN BE MADE WHEN WE LOOK AT THE RETURNS ON STOCKS AND BONDS IN INDIA FOR THE LAST TWO DECADES

APPROPRIATE PERCENTAGE ALLOCATION

FALLACY OF TIME DIVERSIFICATION EVEN THOUGH. . UNCERTAINTY ABOUT THE AVERAGE RATE OF RETURN DIMINISHES OVER A LONG PERIOD OF TIME, IT COMPOUNDS OVER A LONGER TIME PERIOD EXPECTED RETURN STANDARD DEVIATION 1 YR 15% 30% 5 YRS 15% 30% / 5 = 13. 42% A DISAPPOINTMENT OF ONE STANDARD DEVIATION WILL AFFECT THE TERMINAL WEALTH BY A FACTOR OF (1 - 0. 1342)5 = 0. 487 THIS CERTAINLY … LARGER. . IMPACT … 30% BODIE : “ WHILE THE CONFIDENCE BAND AROUND THE EXPECTED RATE OF RETURN NARROWS WITH INVESTMENT LIFE, THE DOLLAR CONFIDENCE BAND WIDENS”

RESURRECTION OF TIME DIVERSIFICATION 1. THERE IS SOME EVIDENCE THAT STOCK RETURNS ARE NOT SERIALLY INDEPENDENT BUT TEND TO MEAN - REVERT OVER LONG INTERVALS. . THE DISPERSION OF TERMINAL WEALTH INCREASES AT A SLOWER RATE THAN WHAT IS IMPLIED BY SERIALLY INDEPENDENT RETURNS 2. RISK OVER A LONGER HORIZON AS YOU HAVE GREATER SCOPE TO ADJUST YOUR CONSUMPTION AND WORK HABITS

PORTFOLIO STRATEGY • ACTIVE • PASSIVE

MARKET TIMING • REVIEW. . MARKET FLUCT’NS. . TEMPTED. . PLAY. . GAME • A CAREFUL STUDY. . MARKET TIMING … SUGGESTS … CORRECTLY FORECAST … 75% … BREAK-EVEN • FISHER BLACK SAYS : “THE MARKET DOES JUST AS WELL, ON AVERAGE, WHEN THE INVESTOR IS OUT OF THE MARKET AS IT DOES WHEN HE IS IN. SO HE LOSES MONEY, RELATIVE TO A SIMPLE BUY-AND-HOLD STRATEGY, BY BEING OUT OF THE MARKET PART OF THE TIME”

USE OF A SPECIALISED CONCEPT CHARLES. D. ELLIS … A POSSIBLE WAY TO ENHANCE RETURNS • GROWTH STOCKS • NEGLECTED OR ‘OUT OF FAVOUR’ STOCKS • ASSET-RICH STOCKS • TECHNOLOGY STOCKS • CYCLICAL STOCKS PROS CONS FOCUS OBSOLETE MASTERY INERTIA

PASSIVE STRATEGY ACTIVE STRATEGY … PREMISE. . INEFFICIENCIES … EXPLOITED PASSIVE STRATEGY … TENET MARKET. . EFFICIENT. . AVAILABLE INFOR’N 1. CREATE A WELL-DIVERSIFIED PORTFOLIO AT A PRE-DETERMINED LEVEL OF RISK 2. HOLD THE PORTFOLIO RELATIVELY UNCHANGED OVER TIME, UNLESS IT BECOMES INADEQUATELY DIVERSIFIED OR INCONSISTENT WITH THE INVESTOR’S RISK-RETURN PREFERENCES

PORTFOLIO STRATEGY MIX ABILITY TO SELECT UNDERVALUED ABILITY TO FORECAST OVERALL MARKET GOOD BAD SECURITIES GOOD BAD 1. CONCENTRATE 2. SHIFT BETA 2. KEEP BETA STABLE 1. DIVERSIFY 2. SHIFT BETA 2. KEEP BETA STABLE

SELECTION OF SECURITIES SELECTION OF BONDS • YTM • DEFAULT RISK • TAX SHIELD • LIQUIDITY • DURATION SELECTION OF STOCKS • TECHNICAL ANALYSIS • FUNDAMENTAL ANALYSIS • RANDOM ANALYSIS

MARKET EFFICIENCY AND SECURITY SELECTION LEVEL OF APPROACH EFFICIENCY TECHNICAL ANALYSIS FUNDAMENTAL ANALYSIS RANDOM SELECTION INEFFICIENCY BEST POOR WEAK-FORM EFFICIENCY POOR BEST POOR SEMI-STRONG-FORM EFFICIENCY POOR GOOD FAIR STRONG-FORM EFFICIENCY POOR FAIR BEST

PORTFOLIO EXECUTION TRADING GAME BUSINESS TRANSACTION SECURITY TRANSACTION • MOTIVE AND IDENTITY OF THE COUNTERPARTY KNOWN • MOTIVE AND IDENTITY OF THE COUNTERPARTY NOT KNOWN • CONSTRUCTIVE MOTIVES + SUM GAME • ZERO SUM GAME MOTIVES FOR TRADE • COGNITIVE • EMOTIONAL

TRADING MOTIVATIONS, TIME HORIZONS, AND TIME VS PRICE PREFERENCES TRANSACTOR MOTIVATION TIME HORIZON TIME VS PRICE PREFERENCE VBT DISCREPANCY BETWEEN VALUE AND PRICE WEEKS TO MONTHS PRICE IBT NEW INFORMATION HOURS TO DAYS TIME LBT RELEASE OR ABSORB CASH HOURS TO DAYS TIME PIBT APPARENTLY NEW INFORMATION HOURS TO DAYS TIME DEALER ACCOMODATION MINUTES TO HOURS INDIFFERENT

PORTFOLIO REVISION • NEED • PORTFOLIO REBALANCING • BUY AND HOLD POLICY • CONSTANT MIX POLICY • PORFOLIO INSRANCE POLICY • PORTFOLIO UPGRADING

PERFORMANCE EVALUATION RATE OF RETURN 1. ARITHMETIC MEAN 2. IRR 3. GEOMETRIC MEAN RATE OF RETURN DATA

A. M : (15. 0 + 0. 0 + 36. 8 + 26. 7 + 15. 7) / 5 = 18. 8% 10, 000 IRR : 100000 = 10, 000 + (1+r)2 12, 000 + (1+r)3 12, 000 + 150, 000 + (1+r)4 r ≃ 17. 65% GM : [ (1. 15) (1. 00) (1. 368) (1. 267) (1. 157)] 1/5 - 1 ≃ 18. 2% (1+r)5

IRR PERIOD 1 10% RATE OF RETURN EARNED PORTFOLIO A 1. BEGINNING VALUE BEFORE INFLOW OR OUTFLOW 2. INFLOW (OUTFLOW) 3. AMOUNT INVESTED 4. ENDING VALUE PORTFOLIO B 1. BEGINNING VALUE BEFORE INFLOW OR OUTFLOW 2. INFLOW (OUTFLOW) 3. AMOUNT INVESTED 4. ENDING VALUE A : 10, 000 = 17, 160 10, 000 = 4 - 10, 000 11, 000 14, 300 17, 160 (17, 160) - 10, 000 11, 000 (8, 000) 3, 000 3, 900 4, 680 (4, 680) - 0 + (1+r) 3 20% r = 19. 72% (1+r)3 8, 000 B : 2 30% 4680 + (1+r)2 r = 15. 27% (1+r)3 IRR REFLECTS INVESTMENT PERFORMANCE AS WELL AS THE EFFECT OF CONTRIBUTIONS AND WITHDRAWALS. . TOTAL EXPERIENCE OF A FUND (a) INVESTMENET PERFORMANCE & (b) CASH FLOWS. G. M : [(1. 10) (1. 30) (1. 20)] 1/3 - 1 = 0. 1972 OR 19. 72%

RISK • Mean Absolute Deviation d n • Standard Deviation • Beta

PERFORMANCE MEASURE TREYNOR MEASURE : SHARPE MEASURE : JENSEN MEASURE : Rp - Rf p Rp - [Rf + p (RM - Rf)]

ANNUAL RETURNS FOR THREE MUTUAL FUNDS AND A MARKET INDEX

PERFORMANCE EVALUATION OF THE THREE FUNDS Rp - Rf TREYNOR MEASURE : p 17. 1 - 8. 6 FUND A : = 7. 1 1. 20 14. 5 - 8. 6 FUND B : = 4. 9 0. 92 13. 0 - 8. 6 FUND C : = 4. 8 1. 04 11. 0 - 8. 6 MARKET INDEX : = 2. 4 1. 0

SHARPE MEASURE : Rp - Rf p 17. 1 - 8. 6 FUND A : = 0. 302 28. 1 14. 5 - 8. 6 FUND B : = 0. 299 19. 7 13. 0 - 8. 6 FUND C : = 0. 193 22. 8 11. 0 - 8. 6 MARKET INDEX : = 0. 117 20. 5 JENSEN MEASURE FUND A FUND B FUND C MARKET INDEX : : : Rp - [Rf + p (RM - Rf )] 17. 1 - [8. 6 + 1. 20 (2. 4)] = 5. 62 14. 5 - [8. 6 + 0. 92 (2. 4)] = 3. 69 13. 0 - [8. 6 + 1. 04 (2. 4)] = 1. 90 O (BY DEFINITION)

PROBLEMS WITH PERFORMANCE MEASUREMENT • QUANTIFICATION. . FUNCTION ONLY PARTLY AMENABLE • SHORT-TERMISM • CULT OF MARKET-TIMING DIETZ & KIRSCHMAN: “FOR ACCURACY OF COMPUTATIONS, PERFORMANCE SHOULD BE COMPUTED AS OFTEN AS PRACTICED, BUT RESULTS SHOULD NOT BE TAKEN AS SIFNIFICANT BY THE INVESTOR OR THE INVESTMENT MANAGER UNTIL A REASONABLE PERIOD OF TIME, SUCH AS A MARKET CYCLE FOR EQUITIES OR AN INTEREST RATE CYCLE FOR FIXED INCOME SECURITIES, HAS ELAPSED”

SUMMING UP • Portfolio management is a complex process or activity that may be divided into seven broad phases. • Investment objectives are expressed in terms of return and risk. • The strategic asset-mix decision (or policy asset-mix decision) is the most important decision made by the investor. • Investors with greater tolerance for risk and longer investment horizon should tilt the asset mix in favour of stocks • The four principal vectors of an active portfolio strategy are : market timing, sector rotation, security selection, and the use of a specialised concept. • A passive portfolio strategy calls for creating a well-diversified portfolio at a pre-determined level of risk and holding it relatively unchanged over time.

• The factors commonly considered in selecting bonds are : yield to maturity, risk of default, tax shield, liquidity, and duration. • Three broad approaches are employed for stock selection : technical analysis, fundamental analysis, and random selection. • Motives of trading are cognitive and emotional. • Portfolio revision involves portfolio rebalancing and portfolio upgrading • The key dimensions of performance evaluation are rate of return and risk. • Treynor measure, Sharpe measure, and Jensen measure are three popularly employed performance measures.