17

Portfolio Management

The investment environment has, over a period of time, led to the evolution of distinguishable investment styles of investors. Such investment styles have contributed towards superior performance results for investors.

Portfolio management is often described according to the investment philosophy or “style” of share selection used. Most methods build on one of the two most common approaches, ie, growth or value equity investing. Growth investing involves focusing on companies expected to have above average rates of growth in earnings and dividends. Value investing involves focusing on securities considered to be temporarily undervalued or unpopular for various reasons. In growth investing, share identification is defined in terms of securities selling for prices below the value of future growth opportunities.

GROWTH INVESTING

Growth investment style identifies shares based on the growth potential of companies. These types of investors look into the future potential returns from the company. The strategy of growth investors is to identify the shares whose future returns are expected to grow at a fast rate. Historical returns need not exhibit a close relationship with growth rate or historical earnings per share. The share value in the market is mostly dependent on future growth values and hence growth investors evaluate share value at its future earnings growth. Growth investing style is therefore dependent on the forecast ability of the growth rates.

Growth investors use several factors to identify superior performing securities for purchase. Some of the factors that are looked into are short run and long run high growth rates from sales and EPS, high profit margin and notable increase in projected earnings for both three and five years. Growth companies are also identified through comparison with industry averages. If the company has superior expected growth rates compared with the industry averages, such companies are considered as growth companies.

A few other aspects that are considered by growth investors are the financial soundness of the company and the quantum of the company’s debt obligations. Investors look for companies that are able to fund their growth through equity/internal earnings rather than debt. Internally generated funds rather than external funds should have fueled growth. Internal funds enable the company to meet future expenses out of the excess earnings generated through growth. Hence, growth companies are identified through their capacity to generate sufficient funds for above average growth from retained earnings. Growth companies are also identified through the quantum of debt obligations. When debt is a very small component of the total capital it indicates that debt financing is not the major part of their net worth. In these companies the interest component becomes a cheap source of finance rather than a burden. Mostly companies with burdensome levels of debt financing are not considered for growth investment due to future heavy interest burdens on the profit earning capacity of the firm.

The quality of management is also a key factor in the identification of shares by growth investors. Growth investors also look at whether managers have the experience and know-how to cope with rapid growth. Related issues such as management and employee compensation plans to provide appropriate incentives for high-margin growth are also examined to identify growth shares.

Growth investing focuses on well-managed companies whose earnings and dividends are expected to grow faster than macro economic factors such as inflation and the overall economic growth. Specifically, growth companies should be able to show superior profits in times of economic depression rather than in economic boom. These companies, by withstanding economic slowdowns, are able to provide superior growth forecasts in terms of EPS, revenue, dividend, and net worth.

In brief, a fundamental analysis of such companies supports growth forecasts with historically superior profit margins, good return on assets, consistent earning per share, and low levels of debt financing. Growth shares also have the characteristic of significant research and development investment and have product quality/superiority to suppress competition.

Growth shares also show distinctive cost advantage over other companies and are marked by high pay scales to attract talented employees.

It is not always possible to identify the growth shares in all capital market situations. Many situations might arise, which would make the identification of growth shares very difficult. Also, the identified growth shares might change their characteristics and might often result in unexpected losses for the investor. Some of the problems encountered by growth investors are:

Customer Loyalty Risk

The possibility of losing customers to established competitors or new entrants is always prevalent for the companies at the top. When new markets are undergoing abnormal growth, many competitors are identified, and unless the leadership is reemphasized, there will be a loss of the long established customer loyalty. As a result, customer loyalty risk is high and market share stability is low in rapidly changing market situations.

Rapidly growing markets are filled with risk and opportunity for companies and in such markets investors also participate enthusiastically in large numbers. Sometimes early entrants are able to achieve advantages over subsequent competitors. More often, however, quick and unpredictable changes in the product/service marketplace make both companies and their investors’ expectations go wrong.

Merger Risk

Economic loss arising from failure to achieve merger benefits (large scale operations) is the merger risk faced by growth companies. When the key employees leave following a merger or acquisition, their loss often represents more than just an important loss of the acquired company’s intellectual capital. Lost key employees often form the basis for new competitors. As a result, growth through merger and acquisition could lead to the sowing of new competitions. In many instances companies that have merged are unable to integrate fully due to cultural mismatches and often end up reporting operational losses.

Regulation Risk

Regulation risk is the possibility of investment loss due to burdensome government rules and regulations mostly in the form of taxes. Growth investors seek out new opportunities and sectors that are on the path of economic growth to succeed in investing. Since risk can be reduced but not eliminated, when growth investors buy and hold for long term appreciation and future income, many unforeseeable changes especially through market regulation might hinder the identified growth companies’ performance.

Market Price Risk

Market price risk is the possibility of overpaying for growth companies. One of the most important potential risks tied to growth investing is that the approach may often lead to a bullish expectation run in the market. The lack of a strict buying discipline hence leaves growth investors open to market price risk, the chance of overpaying for companies with growth potential, and the risk of suffering net worth loss to their investment portfolios when temporary declines in the overall market takes place as a market correction.

VALUE INVESTING

Value investors pick up shares at attractive low prices. They are characterised by maintaining a portfolio of market under performers. The value investors’ portfolio will have shares that have been undervalued by the market. Such value investing is suitable in a market economy that is facing depression. This style of investing is also termed as conservative investing.

Value investors look for bargains, whereas growth investors seek companies with the potential for above average rates of growth in earnings and dividends. Value investors seek companies whose share prices have been unfairly beaten down in the market. Thus, value investors seek bargain shares selling at prices below their real economic value. Growth investor look for bargains in terms of future potential. However, the difference in investment philosophy between growth and value investing leads to distinctive investment decisions.

Growth investors sometimes buy shares selling at very high prices relative to earnings and book values when they perceive that even higher price earnings (P/E) and price/book (P/B) ratios fail to fully reflect the superior capabilities of leading companies in dynamic industries. The share selection style of value investors on the other hand is aggressive.

In the case of value investing, bargains are often measured in terms of market prices that are below the estimated current economic value of tangible and intangible assets. Most value investors’ focus on tangible assets such as plant, equipment, or other financial holdings in subsidiaries or other companies, and real estate. A bargain is discovered when market prices are temporarily depressed below a conservative estimate of the current market value of tangible assets. When the gap between the share market prices and the market value of tangible assets is large an attractive investment opportunity is discovered by value investors.

Traditionally value investors seek out of favour shares selling at a discount to the overall market. The discounts are measured in terms of low P/E and P/B ratio, and/or high dividend yield. Markets often undervalue select industry shares such as financial or service companies due to changing investment preferences.

Value investors, who select only cheap shares that are very infrequently traded are called deep-value investors. Some value investors focus on companies at the brink of bankruptcy or in the midst of bankruptcy proceedings. Cyclical shares also become a favourite with value investors when recession hits and economically sensitive shares get undue importance due to short term investors focussing on temporarily adverse sales and earnings information.

The most important tool for a value investor is the margin of safety concept. According to Graham and Dodd (who introduced the value investment style), the margin of safety concept becomes evident when applied to undervalued or bargain securities. Bargains reflect a difference between market price and estimated or appraised value. This difference is the margin of safety. It is needed for absorbing the effect of miscalculation. Bargain buyers hence, place particular emphasis on the ability of a given investment to withstand adverse developments.

The growth investor seeks investment opportunities with expected earnings growth that is greater than historical averages. A growth investment approach entails a dependable margin of safety, only if future calculations are conservatively made. The danger in growth investing lies in the tendency to pay high prices at present for shares with questionable growth prospects. For growth investors, the margin of safety is large when a low price is paid for a company with good growth prospects. The margin of safety will be lower when higher prices are paid and non-existent (or negative) at even higher prices.

From this perspective, the objective of security analysis is to obtain a true picture of the company as a going concern over a representative time period. Investors search for an informed judgment of future profitability and growth. Investors hence tend to look at company valuations that, on an average, prove more reliable than the marketplace valuation. In this process, the investor tends to identify under priced shares to enjoy excess returns following the market’s subsequent upward revaluation to a price consistent with intrinsic value. Assets, earnings, dividends, future prospects, and management vision justify the intrinsic value of a share.

Value investors would be benefitted only when they find bargain shares selling at prices below even the company liquidation value. Such shares sell at a price below the net working capital. Net working capital equals current assets minus all liabilities, including long term debt and preference shares. Net working capital shows what an investor would end up with if the company was liquidated and assets are converted into cash after paying off all short term and long term debt but ignoring non-current assets. Net working capital concentrates on easy to value cash holdings, marketable securities, investments, etc. Obviously the intrinsic economic value of a business is more than just the cash on hand less all short term dues. Valuation using net working capital is considered as a conservative guide to investing by value investors because it only considers what a company has on the books at present. Any future profits and growth are not given importance. To value investors, the ratio of price to net working capital is a very useful valuation measure in which

Besides this conservative tool, value investors also rely on a variety of tangible indicators of a share’s fundamental value. Fundamental value is the worth of a share derived from a company’s assets, its future prospects, and financial/product strength. Other tools used by value investors are:

P/E Ratios

The search for value almost always starts with a review of basic financial information such as (Price Earnings) P/E. Low P/E ratios signal relatively cheap shares and high P/E ratios signal relatively expensive shares.

P/B Ratios

P/B (Price/Book) ratios are also looked at to determine the value of the company. P/B ratio tells investors the extent to which a share’s price closely reflects the historical accounting value of the company’s tangible and financial assets per share. A P/B ratio of 1:1 means a share’s price equals the historical accounting value of the company’s assets. A P/B ratio below 1:1 or below industry or company norms could indicate a cheap share.

Price to Cash Flow Ratios

One of the most important indicators of fundamental value is a company’s free cash flow. Free cash flow consists of earnings before interest, taxes, depreciation and amortization, also referred to as EBITD after adjusting for capital expenditures. Companies with low price cash flow ratios may end up as takeover targets and are considered as cheap shares.

Dividends

The goal of conservative investing is to achieve satisfactory long-term growth of capital without the extreme fluctuations that sometimes cause investors to sell their holdings. Conservative portfolios emphasize on established companies with above-average dividend yields and dividend growth rates. Investing in cheap shares with consistent dividends allow investors to earn a return despite market’s inevitable downturns. To value investors, limiting this downside risk is an important component of long-term value maximization.

Private Market Value

Another useful indicator of fundamental value is private market value. Private market value is the price a knowledgeable private buyer such as the competitor or merchant banker would pay for the company. As such, it considers both on-balance sheet and off-balance sheet assets and liabilities. Private market value is also referred to as potential transaction price or acquisition value. It is often a more accurate reflection of fundamental value than stated book value especially if a company is very conservative in its application of accounting principles. Value investors stand to gain if they base their investment decision on such private valuation.

Managerial Holding

Managerial holding of company’s shares is another fundamental value indicator. It is considered imperative to investigate the extent to which stock options and insider ownership give managers strong incentives to maximise the value of the firm. Many value investors may not select investment alternatives in which top managers have little or no ownership interest in the company.

Value Catalyst

The concept of a value catalyst is often important in value investing. A value catalyst is an inside or outside stimulus that will help close any discount between the current market price of a share and the proposed value of the company based on its private market value. Example of a value catalyst is changes in regulation. A value catalysts might involve a change in corporate control that ousts inefficient managers in favor of shareholder-friendly management. Evaluating and monitoring the value catalyst gives the investors the justification for selection of shares.

Value Line

Value Line’s founder Arnold Bernard believed that the intrinsic value of a share was determined by its fundamental business prospects. In turn, the fundamental business prospects of a company’s share were described by per-share growth in revenues, cash flow, earnings, dividend, and so on.

The value line designed by him is a regression line that best describes or “fits” the 60 month or five year share price history of a company. When this regression line is combined with estimated sales, cash flow earnings, and dividend information for some future point in time the projected value of a given share is calculated. If the present share prices were sufficiently low when compared with the projected value, the share would be considered for purchase. If the present share price were relatively high when compared with this projected value, the share would be considered as overvalued.

A combination of the advantages of both growth and value stock investment styles would be most beneficial for an investor.

Growth and value investing can be explained through Figure 17.1, which represents the cycle of rising and falling expectations about a company’s earnings over a period of time.

Value Investors find it very difficult to select stocks for investment when there is optimism in the market. On the other hand growth investors will not be able to invest in a pessimistic scenario. However, a combination of the value and growth stock investing styles to suit market movements will help the investor to select good portfolios.

As presented in Figure 17.2, investors should be able to identify value and growth shares at specific market turning points and reap the benefits when the market offers good value and good growth. Investment style must hence identify and select both good value and growth share rather than stick to one and ignore the other. From this perspective a portfolio revision becomes a relevant activity of the investor.

PERFORMANCE INDEX

Portfolio performance evaluation is a component of the portfolio management process. Specifically, it can be viewed as a feedback and control mechanism that identifies superior performance and makes the investment management process successful. Superior performance of a portfolio may have been the result of good portfolio management decisions/styles or due to chance. Conversely, inferior performance of a portfolio could also be attributed to a chance factor or due to costs associated with unscientific portfolio management.

Portfolio performance is evaluated over a specific time period. The most often used risk adjusted portfolio performance measures are the:

Sharpe’s Portfolio Performance Measure;

Treynor Portfolio Performance Measure; and

Jensen Portfolio Performance Measure

Sharpe’s Portfolio Performance Measure

Sharpe developed a composite measure to evaluate the performance of mutual funds, but it can also be used to evaluate any portfolio. The measure closely follows his work on the capital asset pricing model (CAPM), dealing specifically with the Capital Market Line (CML). In essence, investors seek to maximise the slope of the line connecting the risk-free return to the Markowitz efficient frontier, or, equivalently, they seek the Markowitz efficient portfolio that allows them to maximise their expected excess return-to-risk ratio.

The slope of the Capital Market Line is measured by:

Hence, investors seek to maximise

The Sharpe’s measure for risk adjusted return is based on this relationship. It is the ratio of the portfolio’s actual excess return divided by its standard deviation:

 

Sharpe’s Measure

where

RFR refers to risk free rate

R_port refers to portfolio return

σ_port refers to portfolio standard deviation

 

This composite measure of portfolio performance seeks to measure the total risk of the portfolio by including the standard deviation of returns rather than considering only the systematic risk by using beta. Since the numerator is the portfolio’s risk premium, this measure indicates the risk premium return earned per unit of total risk. In terms of Capital Market Theory, this portfolio performance measure uses total risk to compare portfolios to the CML. Portfolios with Sharpe’s measures higher than the market lie above the CML while portfolios with Sharpe’s measures below those of the market lie below the CML. See Figure 17.3.

Portfolios that are above the CML are considered superior while portfolios below the line are considered infereior. Portfolio Sp in Figure 17.3 underperforms market expectations while portfolios S_E and S_F have outperformed market expectations.

Sharpe has also suggested a more general performance measure that relates performance to any benchmark for a portfolio. It is as follows:

The historic (ex post) Sharpe’s Ratio (S) is:

where

R_Pt = the return on a portfolio in time t

R_Bt = the return on the benchmark portfolio in time t

D_t = the differential return in time t

D_t = R_Pt – R_Bt

D̄ = the average value of D_t over the period being examined

σ_p = the standard deviation for the portfolio during the period

 

This ratio indicates the historic average differential return (relative to a specified benchmark). Here, the emphasis is on a differential return relative to a specific benchmark that is similar to the objectives of the portfolio.

Treynor’s Portfolio Performance Measure

Treynor distinguished two components of risk, the risk produced by general market fluctuation and risk resulting from unique fluctuations in the shares in the portfolio. He recognised that in a completely diversified portfolio, the unique returns for individual shares should cancel out. His measure of risk adjusted performance focuses on the portfolio’s undiversifiable risk, which is also known as market risk or systematic risk. This risk, which represents the relative volatility of the portfolio’s returns compared to the market’s returns, is measured by beta. The Treynor’s measure, designated as T, is equal to:

Because the numerator of the ratio is the risk premium and the denominator is a systematic measure of risk, the total expression indicates the portfolio’s risk premium return per unit of systematic risk. All risk averse investors would prefer to maximise this value.

The use of beta as a risk measure than standard deviation is based on the assumption of a completely diversified portfolio, which means that systematic risk is the only relevant risk measure.

Comparing a portfolio’s T value to a similar measure for the market portfolio indicates whether the portfolio would plot above or below the Security Market Line (SML). T value for the market portfolio is:

Since the beta of the market portfolio always equals 1.00, the Treynor’s measure for the market portfolio reduces to the market risk premium. This equals the slope of the SML. Therefore, a portfolio with a T value higher than the market risk premium would be above the SML, indicating superior risk adjusted performance (T_x and T_y). A portfolio with a T value lower than the market risk premium would plot below the SML(T_w), showing poor risk adjusted performance. See Figure 17.4.

A portfolio with a negative beta and an average rate of return above the risk free rate of return would have a negative T value. In this case, however, it could indicate exemplary performance when the SML line is extended downwards.

Jensen’s Portfolio Performance Measure

The Jensen measure is similar to the capital asset pricing model (CAPM). CAPM calculates the expected one-period return on any security or portfolio by the following expression.

where

E(R_j) = the expected return on portfolio j

RFR = the risk free interest rate

β_j = the systematic risk (beta) for portfolio j

E(R_m) = the expected return on the market portfolio of risky assets

 

Assuming the asset pricing model is empirically valid, we can express the expectations formula in terms of realised rates of return over time period t as follows:

That is, the realised rate of return on a security or portfolio during a given time period is a linear function of the risk free rate of return during the period, plus a risk premium that depends on the systematic risk of the security or portfolio during the period, plus a random error term.

Subtracting the risk free return from both sides, we have

This indicates that according to the Security Market Line, the risk premium earned on portfolioj is equal to β times a market risk premium, plus a random error term. A superior portfolio manager who can forecast market turns or consistently select undervalued shares will earn higher risk premiums than those implied by this model. Similarly, inferior portfolio managers will earn lower risk premiums. Specifically, superior portfolio managers would have consistently positive random error terms because the actual returns for their portfolios would consistently exceed the expected returns implied by this model, and inferior managers would have negative error terms because returns for their portfolios would fall below the implied expected returns. See Figure 17.5.

To detect and measure for superior or inferior performance, Jensen uses the intercept (a constant) that measures any positive or negative difference from the model. With an intercept constant, the earlier equation becomes

In this equation, the aj value (or alpha) indicates whether the portfolio manager is superior or inferior in market timing and share selection or both. The alpha represents how much of the rate of return on the portfolio is attributable to the manager’s ability to derive above average returns adjusted for risk. A superior manager will have a significant positive aj and inferior manager’s returns will have a significant negative value for aj. A portfolio manager who basically matched the market on a risk adjusted basis will have an alpha value that will not be significantly different form zero.

Portfolio alpha can be computed in two different ways. First, Period-by-period alpha can be computed using the above equation assuming a zero residual (Ujt) term. That is, the equation can be rearranged as follows to solve for alpha.

Second, time series data on a portfolio’s returns, the risk free rate, and the market return can be used together to form a simple linear regression. The constant or intercept term from the regression is the estimate of the portfolio’s alpha.

Sharpe’s Versus Treynor ’s and Jensen’s Measures

When we use the Sharpe, Treynor, and Jensen measures to evaluate the performance of diversified portfolios, such as mutual funds, these performance measures will tend to be highly correlated.

Market portfolios are most often considered as a benchmark against which evaluation is carried out for the portfolios. Portfolio evaluation itself is meaningful only when portfolio performance is compared to an appropriate benchmark. Benchmark portfolios and their characteristics are discussed hereunder.

Benchmark Portfolios

A benchmark portfolio represents the performance evaluation standard. The benchmark portfolio is usually a passive index. Portfolios, represented by indices ie, BSE Sensex, BSE 100, S & P Nifty are used as benchmarks for portfolio evaluation.

Sometimes specialised or customised benchmarks are specially constructed to evaluate a portfolio with unique investment style or philosophy (for example investing in small market capitalisation shares with high earnings momentum).

Required Characteristics of Benchmarks

Any useful benchmark should be:

Unambiguous: The names and weights of shares constituting the benchmark should be clearly defined.

Investable: The investor at anytime should be able to forego active management and simply hold the benchmark.

Measurable: It should be possible to calculate the return on the benchmark on a reasonably frequent basis.

Appropriate: The benchmark should be consistent with the manager’s investment style. The implication is that the returns of the actively managed portfolio should be highly correlated with those of the benchmark, reflective of similar investment objectives.

Specified in advance: The benchmark should have been constructed before an evaluation period begins.

The actual portfolio should reflect the size, distribution, and P/E characteristics of the benchmark. The portfolio’s beta and return hence should be limited to prescribed ranges from the benchmark. Deviations from these constraints should be taken as signals for the revision of the portfolio. Some of the benchmark portfolios that are used in the capital markets are the S & P Nifty, BSE sensex and so on. These indices are unambiguous, are traded in basketable lots. These are measured in frequent time intervals and are displayed instantaneously to investors. However, the appropriateness of such passive indices as benchmark portfolios would depend on the specific portfolio investment style. As an all equity growth portfolio, S & P Nifty and Sensex could serve as benchmark portfolios. But for a technology portfolio these might not be the right benchmarks.

All equity portfolio performance measures are derived from the CAPM, which assumes the existence of a market portfolio at the point of tangency on the Markowitz efficient frontier. Theoretically, the market portfolio is an efficient, diversified portfolio that contains all risky assets in the economy, weighted by their market values.

The problem arises in finding a real world proxy for this theoretical market portfolio. The lack of appropriateness of a market index has always been recognised, but more rigorously evaluated by researchers. The problem with market proxy is that if not appropriate it could result in a misrepresentation of the portfolio that is being evaluated.

A second problem is that the beta derived using this market proxy could differ from that computed using the true market portfolio. For example, if the “ true” beta were larger than the beta computed using the proxy, the true position of the portfolio would shift and could accept a portfolio as a good performer rather that representing the reality. See Figure 17.6.

Benchmarking and Portfolio Style

Benchmark portfolios are important since, shares an investor who desires to put money into value shares would like to confirm that the portfolio that has been built for him has a value style investment pattern rather than a growth strategy. An investment policy statement may place some constraints on investment choices; in such instances, the investor needs to identify appropriate benchmarks or indexes with which to judge a portfolio’s risk and return performance.

One way of determining style is to use the returns based analysis or effective mix analysis developed by William E Sharpe. A return based analysis uses the historical return pattern of the portfolio and compares this to the historical returns of various well specified indexes. The analysis uses sophisticated quadratic programming techniques to indicate what style or style combinations were most similar to the portfolio’s actual historical returns.

A second method for determining style is to analyse the characteristics of the securities that currently compose a portfolio. Rather than using historical returns, such characteristics analysis is based on the belief that the portfolio’s current make up will be a good predictor for the next period’s returns.

The method classifies a portfolio into one of four basic equity styles; value, growth, market oriented, and small capitalisation. The methodology uses a complex decision tree approach to classify a portfolio’s shares relative to fundamental characteristics of indexes. The portfolio is then examined on the basis of its small-capitalisation share exposure, price/book ratio, dividend yield, price/earnings ratio, and return on the equity, and sector weightage of its constituent shares. The results of these analyses are combined to determine the portfolio’s style.

The detailed characteristic analysis method is likely to be most useful for forecasting a portfolio’s near term future returns, given its current style composition and a set of forecasts for style index returns. It is also useful for determining whether a portfolio’s current style is in line with the past investing patterns.

Sharpe’s method is also more useful for performance attribution. A benchmark portfolio can be constructed using the outcomes of the effective mix analysis. A regression analysis can be done using the following equation:

By using regression analysis, we can determine variation in the portfolio’s actual returns, which can be explained by the passively managed benchmark. This allows us to see what percentage of the managed portfolio’s returns were because of style (coefficient of determination of the regression) and how much occurred because of share selection skill (1-coefficient of determination). The alpha of the regression is Jensen’s alpha, which gives us a measure of the portfolio’s ability to earn above average risk adjusted returns.

Determining the Reasons for Superior (or Inferior) Performance

In addition to examining historical returns, determining style, and adjusting them for risk, portfolio evaluation also involves identifying why a specific portfolio did better or worse than the benchmark. For example, a portfolio’s superior returns could have been the result of:

• an insightful asset allocation strategy, which over weighted an asset class that earned high returns;
• investing in undervalued sectors;
• selecting individual shares that earned above average returns;

or some combination of these reasons. Similarly, poor returns can likewise arise from a combination of inappropriate strategies.

Performance attribution seeks to discover what went right or wrong and why. A postmortem, along with a review of economic and industry conditions existing at the time the portfolio decisions were made, can be useful in determining what key variables contributed to portfolio returns.

Performance attribution, another measure of portfolio evaluation, begins with policy statement, the portfolio’s normal weights (or asset allocation), and benchmark returns. These determine what the portfolio returns would have been had the portfolio invested funds according to the normal weights in the benchmark indexes. By comparing this with the portfolio’s actual asset weights and actual returns, the sources of superior or inferior return can be pinpointed.

Performance attribution analysis begins with an overall view, focusing on major portfolio decisions that contributed to return, and then examines, in detail, aspects of how the portfolio was constructed. Because of this, the first step of performance attribution examines the impact of the asset allocation decision on portfolio returns.

The impact of asset allocation are examined by comparing the effect of policy weights and actual portfolio weights on portfolio returns. When policy portfolio returns are compared with the actual portfolio returns, the asset allocation performance is evaluated.

The next phase of the analysis involves determining the impact of sector and share selection. This analysis compares the return components of the actual portfolio with that of a presumed portfolio investing in the asset indexes in the same proportion as the actual portfolio weights. This comparison determines the effect of sector selection and share selection on portfolio returns as it focuses on the difference between portfolio returns versus index returns. See Table 17.1

 

PORTFOLIO REVISION

Portfolio revision considers the change in the structure and composition of shares in the portfolio. It might involve a simple revision of weights of the shares or the inclusion or dropping of a share to/from the portfolio. Portfolio revision can be studied under the following formula plans:

Rupee Cost Averaging

Constant Rupee Plan

Constant Ratio Plan

Variable Ratio Plan

The Formula Plans

Formula plans presume that portfolios differ in their characteristics and, to a large extent, are capable of reducing unique security risks through a combination of negatively related securities in a portfolio. Portfolios usually have a composition of “less risk-less return” securities as well as “high risk-high return” securities. The less risk-less return combination can be termed as the conservative component of a portfolio while the high risk-high return securities can be categorised as an aggressive component of a portfolio. The latter component of portfolios is usually constructed with shares of companies while the conservative component holds mostly fixed return securities such as debt and treasury bonds.

Portfolio revision, besides changing the individual security selection, also considers the total quantum of investment in a conservative or aggressive component. This subdivision is also often made depending on the objectives of the portfolio. A portfolio with growth objective would have a major aggressive component. On the other hand, a portfolio with regular assured income would have a major subdivision of conservative investment. The formula plan helps in distributing funds between these types of portfolio components since the aggressive and conservative components are expected to behave in an inverse fashion at any specific point of time.

Rupee Cost Averaging

Rupee cost averaging relies on the mathematical advantage of “averaging out”. Here investors are buyers in the market. Irrespective of a fall or rise in prices, the investors intend to purchase the shares. This plan is used most often for portfolio building. The method of buying the shares depends on the rise or fall in prices. When there is a fall in the price of a share, it is purchased in larger quantities. On the other hand when the share price keeps rising, the investors purchase the share in smaller quantities. The intention is to increase the wealth of the investors rather than secure returns for the investors.

For enlarging this portfolio, investors may identify a certain percentage of increment or decrement. For example, a 10 per cent increase or decrease in share price from the current price can be made as a target for enlargement. While a 10 per cent increase might increase the holdings by 80 per cent, a 10 per cent decline could imply a purchase of 120 per cent of the original holdings. Assume that an investor has bought 100 shares at Rs. 100 per share. The enlargement of the portfolio for the investor could be stated as in Table 17.2.

 

When the share price falls to Rs.90 (a 10 per cent decline) in the second quarter, the additional number of shares that are purchased would be 120. The cumulative investment gives the total amount of investment made in the share. The market value indicates the current value of the 220 shares held by the investor till the second quarter. In the third quarter, the share price reaches Rs.100, the price at which initial investments had been made. Here, the additional purchase of 100 shares raises the cumulative investment to Rs.30,800. The fourth quarter further sees a rise in price by 10 per cent. However, the investor purchases an additional 80 shares since the price rise is high. With the additional incremental price, the investor would wish to buy fewer shares to derive the advantage of rupee cost averaging. The unrealised profit on shares will also be incremental to the investor, as can be seen from the table. The investor was able to buy more shares in the second quarter than in the third or fourth quarters. The rupee cost averaging enables an investor to achieve a lesser cost price to average market price irrespective of a price rise or decline, as can be seen from the last two columns.

Constant Rupee Plan

The objective of the constant rupee plan is to balance the division between the conservative and aggressive components of a portfolio in terms of the target value. The target value could be fixed initially by the investor in a desirable proportion. For instance, a constant rupee plan could consider the initial value of Rs.10,000 each between conservative and aggressive portfolios. There can also be a initial value of Rs. 15,000 and Rs.5,000 in the aggressive and conservative portfolio components respectively. Subsequently, changes in the portfolio components would cause a revision or shift of funds from one component to the other.

The target portfolio value in the aggressive component could be fixed to the initial value and the excess shifted to the conservative portfolio. Similarly, a shortfall in the aggressive component is set right using the funds in the conservative portfolio. The purpose of the constant rupee plan is to maintain the total value of the aggressive portfolio at a consistent level. To achieve this, the investor can monitor the changes in the portfolio components and fix the percentage change in price that would require a portfolio revision. For instance, the investor can specify either a 5 per cent or 10 per cent or 20 per cent change in price levels to shift portfolio components. Frequent changes in portfolios might become costly for investors, while too large a price level might ignore significant market turning points.

The constant rupee plan is illustrated in Table 17.3. Assume that the investor initially holds Rs.10,000 each in the conservative and aggressive components of a portfolio and wishes to revise the portfolio for a 20 per cent change in market price. The second quarter reduced the market value of the aggressive component by 15 per cent. However, the investor does not initiate a portfolio shift since the target change is 20 per cent. In the third quarter, the share price falls by 20 per cent to Rs. 80. Hence the investor shifts Rs.2,000 from the conservative component to the aggressive component by buying additional 25 shares at Rs. 80.

In the fourth quarter, the share price increases. However the increase is recognised only in the second quarter of Year 2 when the share price increases to Rs. 97. At this point, the investor sells the requisite shares to realise the amount and shifts it to the conservative component of the portfolio. The investor hence sells 21 shares at Rs. 97 and brings back the value of the aggressive component to Rs. 10,000. The value of the total portfolio increases by Rs.125 due to the profits made from shifting investment from aggressive to conservative component and vice versa. In such plans, shares are bought when price declines by a desired percentage and shares are sold when the price increases by a desired percentage.

 

Constant Ratio Plan

Constant ratio plan maintains a constant ratio between the aggressive and conservative components of a portfolio. The initial ratio is fixed by the investor and could be 1:1 or any other desirable ratio. The investor, as in the constant rupee plan, also sets the quantum of price increase or decline that initiates a portfolio revision. The initial ratio set by the investor is maintained whenever the price level in the aggressive component of the portfolio reaches the target level. The constant ratio plan is illustrated in Table 17.4. Assume that the investor has an equal distribution of funds between conservative and aggressive portfolios. Additionally, the investor fixes a target of 20 per cent rise or fall in share price to initiate a portfolio revision.

 

The investor initiates a portfolio revision when the price comes down to Rs. 80 from Rs. 100 (a 20 per cent decline). The objective of the investor is to maintain a ratio of 1:1 rather than a specific value of aggressive portfolio. Hence, the investor shifts Rs. 1,040 from the conservative component to the aggressive component. Computing the present portfolio worth when the share price is Rs. 80 and then dividing it by the desired ratio gives the amount that is to be invested in the aggressive component. In this instance, when the share price is Rs. 80, the portfolio worth is Rs. 18,000. The desired ratio of 1:1 requires an aggressive portfolio value of Rs. 9,000. The number of shares that can be bought at Rs. 80 will hence be 13 (9000/80 = 112.50).

Similarly, at Rs. 97, the investor wishes to stabilise the portfolio by shifting funds from the aggressive component to the conservative component to reach the desired ratio of 1:1. Here the aggressive component value is computed as total portfolio value divided by the desired ratio ((113*97) + 8,960 = Rs. 9,960). The number of shares to be held in the aggressive portfolio hence should be (9960/97) 102.6. Hence, 10 shares are sold and the funds are shifted to the conservative component of the portfolio. Note that the actual portfolio value has declined from the initial value of Rs. 20,000.

Variable Ratio Plan

The variable ratio plan gives more flexibility to the investor to revise the portfolio components. When share price falls, the investor may shift a major component of the conservative portfolio to the aggressive component. The desired ratio of investment holding between conservative and aggressive components of a portfolio hence may vary according to the flexibility that the investor wishes to incorporate in the portfolio revision decisions. When the share price rises back, then the investor may shift funds back to maintain a stabilised portfolio. Consider the following example in Table 17.5. Assume the investor begins with an investment of Rs. 10,000 each in the conservative and aggressive components of his portfolio. Let us also assume that the investor revises the portfolio when the share price falls or rises by 20 per cent.

 

When the share price falls to Rs. 80 per share, the investor shifts funds from the conservative component to the aggressive component. Here, since the variable ratio plan is followed, the investor allows 70 per cent of the total portfolio value to be invested in the aggressive component. Computing the total portfolio value and dividing it by the desired flexible percentage gives the desired value of the aggressive component in a portfolio. At Rs. 80 per share, the total portfolio value is ((100*80) + 10,000) Rs. 18,000. The desired aggressive portfolio value is (18000*0.70) Rs. 12,600. To achieve this, 58 shares are bought at Rs. 80 and hence an amount of Rs. 4,640 is shifted from the conservative component to the aggressive component of the portfolio. This reduces the value of the conservative component to Rs. 5,360.

When the share price rises beyond the 20 per cent level to Rs. 97 per share, the investor shifts funds from the aggressive component to the conservative component. The desired value of the aggressive portfolio is computed as [((158*97) + 5360)*0.5] Rs. 10,343. The desired holdings in terms of numbers are (10,343/97) 107. Hence, 51 shares are sold at Rs. 97 per share. Through this revision the investor brings down the ratio of investment in shares to 50 per cent. The total portfolio value increases by Rs. 686 through this flexible revision process.

The formula plans help investors to determine the value of investment between the aggressive and conservative components of a portfolio. The formula plans do not consider the return from the conservative component of a portfolio. The assumption that is made here is that the conservative portfolio may not decline in value, which need not hold true at all times. Even conservative components can reduce in value due to interest rate changes in the market. Portfolio revisions are necessary for actively managed portfolios. This can help the investor to reap the benefits from the capital market fully.

SUMMARY

Growth investing and value investing are two distinguishable types of investment styles that have been recognised among investors. Growth investors look for forecasted figures and pick up shares that promise very good growth in returns and sales in future. Value investors, on the other hand, look for bargains in the market. They are good at locating shares that are undervalued. They show more interest in such undervalued shares since these confirm the informational inefficiencies present in the market and the market tends to adjust or correct itself in the future. Hence, value investors buy shares that are quoted below their worth and once the market corrects it these investors dispose the shares and gain returns from the portfolio. Both these styles are in contrast with each other, and neither may work always in the market. Hence, investors also look for a combination of investment style by suitably changing the investment style in tune with changes in the market.

Portfolio performance evaluation is a must for investors since feedback and control of portfolio return movement is essential to outperform the market consistently. The composite risk adjusted portfolio performance measures available to the investor are the Sharpe’s, Treynor’s, and Jensen’s methods.

After identifying the good and better portfolio performers, an investor can use any of the portfolio formula plans to revise the portfolios. The formula plans are rupee cost averaging, constant rupee plan, constant ratio plan, and variable ratio plan.

CONCEPTS

• Growth investing style	• Value investing style
• Portfolio revision	• Benchmark portfolios
• Constant ratio plan	• Variable ratio plan
• Rupee cost averaging	• Constant rupee plan
• Regulation risk	• Market risk
• Customer loyalty risk	• Value line

SHORT QUESTIONS

1. What is portfolio performance evaluation?
2. What is benchmarking?
3. What is a diversified portfolio?
4. What is portfolio management?
5. What is portfolio revision?
6. When would value investment become more beneficial to investors?.
7. What is value line?
8. What are the measures considered for a growth investment style?
9. What are the measures considered for a value investment style? 10. What is a value catalyst?

ESSAY QUESTIONS

1. Explain the various measures of portfolio performance evaluation.
2. Discuss the features of a good benchmark. What benchmarking practices should investors have? Can you say that the NSE index is a good benchmark for portfolios in India?
3. What are the different styles of investing? Differentiate them.
4. Contrast the various formula plans that are available to an investor for portfolio revision.

PROBLEMS

1. The following information regarding growth funds is available to an investor. Rank the mutual funds in the order of superior performance. Assume risk free rate to be 4 per cent.
   
2. The following was the initial portfolio structure for an investor. Use the constant ratio plan to revise the investor’s portfolio for the given price changes.

   Initial position—1000 shares at Rs 32 and bonds worth Rs 5000. The share price movements were Rs 30, Rs 25, Rs 20, Rs 28, Rs 35, Rs 42, Rs 36, Rs 35, Rs 32, and Rs 30. Assume the investor reacts to a 10 per cent change in the portfolio structure.

3. Show the effect of the rupee cost averaging on a portfolio of 1000 shares bought at Rs 50, when the following price changes happen: Rs 54, Rs 56, Rs 43, Rs 48, and Rs 52.
4. Assume a constant rupee plan of an investor and revise the following portfolio with a constant level of Rs 50,000 each in the equity and debt market.

   Initial portfolio: 1000 equity shares at Rs 50, Debt of Rs 50,000.

   Equity price changes: Rs 48, Rs 47, Rs 52, Rs 51, and Rs 50.