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PORTFOLIO REBALANCING:
Rebalancing a portfolio is the process of periodically adjusting it to maintain the
original conditions. Following strategies can be employed:
1.
Constant mix strategy
Portfolio
Value
Actual
Allocation
Stock
1 Jan
Rs.2,000,000
60%/40%
Rs.1,200,000 Rs.800,000
1 Apr
Rs.2,500,000
56%/44%
Rs.1,400,000 Rs.1,100,000
Bonds
What dollar amount of stock should the portfolio manager buy to rebalance
this portfolio? What dollar amount of bonds should he sell?
Solution: a 60%/40% asset allocation for a Rs.2.5 million portfolio means
the portfolio should contain Rs.1.5 million in stock and Rs.1 million in
bonds. Thus, the manager should buy Rs.100,000 worth of stock and sell
Rs.100,000 worth of bonds.
2.
3.
The other valid reasons for portfolio revision such as short-term price fluctuations
in the market do also exist. There are, thus, numerous factors, which may be
broadly called market related and investor-related, which spell need for portfolio
revision.
An individual at certain point of time might feel the need to invest more. The need
for portfolio revision arises when an individual has some additional money to
invest.
Change in investment goal also gives rise to revision in portfolio. Depending on
the cash flow, an individual can modify his financial goal, eventually giving rise to
changes in the portfolio i.e. portfolio revision.
Financial market is subject to risks and uncertainty. An individual might sell off
some of his assets owing to fluctuations in the financial Market.
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OBJECTIVE
Portfolio evaluating refers to the evaluation of the performance of the portfolio. It
is essentially the process of comparing the return earned on a portfolio with the
return earned on one or more other portfolio or on a benchmark portfolio. Portfolio
evaluation essentially comprises of two function performance measurement and
performance evaluation. Performance measurement in accounting function which
measures the return earned on a portfolio during the holding period or investment
period. Performance evaluations, on the other hand, address such issues as whether
the performance was superior or inferior whether the performance was due to skill
or luck etc.The objective of portfolio management is maximizing return and
minimizing risk. It requires a continuous research, appraisal and evaluation of
capital market as well as that of portfolio. Portfolio evaluation involves the process
of examining whether the objective of portfolio management has been achieved or
not .The portfolio evaluation is the appraisal of performance of the portfolio.
Portfolio evaluation is the process of measuring and comparing the returns earned
on a portfolio with the returns for a benchmark portfolio. In other words the
portfolio evaluation identifies whether the performance of a portfolio has been
superior or inferior to other portfolios. It may be noted that the returned of the
portfolio included both the capital gain and the revenue income.
Evaluation a portfolio performance is not restricted to calculation of average
returns of the portfolio there are several factor that should be incorporated in the
evaluation procedure would give a true ranking of the performance of different
portfolios.
Some of the factors that need attention in the evaluation procedure are:
Transaction cost.
Taxes.
Statutory Stipulation.
No Single Formula.
Transaction cost
Buying and selling of securities involves transaction cost such as
commission and brokerage frequent buying and selling of securities for
portfolio revision may be push up transaction cost there by reducing the gain
from portfolio revision hence the transaction cost involved in portfolio
revision may act as a constraint to timely revision of portfolio.
Taxes
Taxes are payable on the capital gain arising from sale of securities. Usually
long term capitals gained are taxed at a lower rate than short term capital
gain. To qualify a long term capital gain,a security must be held by an
investor for a period 12 months before the sale .Frequent sale of securities in
the course of portfolio revision or a adjustment will result in short term
capital gain which would be taxed at a higher rate compared to the long term
capital gain. The higher tax on short term capital gain may act as constraints
to frequent portfolio revision
Statutory Stipulation
The largest portfolios in every country are managed by investment
companies and mutual fund. This institutional are normally governed by
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1. Systematic risk.
2. Unsystematic risk.
The meaning of systematic and unsystematic risk in finance:
1. Systematic risk is uncontrollable by an organization and macro in nature.
2. Unsystematic risk is controllable by an organization and micro in nature.
A.SYSTEMATIC RISK
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Reinvestment rate risk: Reinvestment rate risk results from fact that the
interest or dividend earned from an investment can't be reinvested with the
same rate of return as it was acquiring earlier
2. Market risk: Market risk is associated with consistent fluctuations seen in
the trading price of any particular shares or securities. That is, it arises due to
rise or fall in the trading price of listed shares or securities in the stock
market.
B. UNSYSTEMATIC RISK
Unsystematic risk is due to the influence of internal factors prevailing within an
organization. Such factors are normally controllable from an organization's point of
view.It is a micro in nature as it affects only a particular organization. It can be
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People risk: People risk arises when people do not follow the organizations
procedures, practices and/or rules. That is, they deviate from their expected
behavior
Legal risk : Legal risk arises when parties are not lawfully competent to
enter an agreement among themselves. Furthermore, this relates to the
regulatory-risk, where a transaction could conflict with a government policy
or particular legislation (law) might be amended in the future with
retrospective effect
Political risk: Political risk occurs due to changes in government policies.
Such changes may have an unfavorable impact on an investor. It is
especially prevalent in the third-world countries
TREYNOR MEASURE
Jack L. Treynor was the first to provide investors with a composite measure of
portfolio performance that also included risk. Treynor's objective was to find a
performance measure that could apply to all investors, regardless of their personal
risk preferences. He suggested that there were really two components of risk: the
risk produced by fluctuations in the market and the risk arising from the
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The basic idea is that to analyze the performance of an investment manager you
must look not only at the overall return of a portfolio, but also at the risk of that
portfolio. For example, if there are two mutual funds that both have a 12% return, a
rational investor will want the fund that is less risky. Jensen's measure is one of the
ways to help determine if a portfolio is earning the proper return for its level of
risk. If the value is positive, then the portfolio is earning excess returns. In other
words, a positive value for Jensen's alpha means a fund manager has "beat the
market" with his or her stock picking skills.
In finance, Jensen alpha is used to determine the abnormal return of security or
portfolio of security or portfolio of securities over the theoretical expected return.
The security could be any asset such as stock, bond or derivatives. The theoretical
return is predicated by a market model; most commonly the Capital Asset Pricing
Model (CAPM) model .The market model uses statistical methods to predict the
appropriate risk-adjusted return of an asset. The CAPM for instance uses beta as a
multiplier.
Jensens alpha was first used as a measures in the evaluation of mutual fund
managers by Michael Jensen in 1968.The CAPM return is supposed to be risk
adjusted, which means it takes account of the relatives riskiness of the asset. After
all riskier assets will have higher expected returns than less risky asset. If an assets
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return is even higher than the risk adjusted return, that asset is said to have
positive alpha or abnormal returns. Investors are constantly seeking investment
that have higher alpha.
Jensens alpha is alpha is significant band positive, then the strategy being
considered has a history of generating returns on top of what would be expected
based on other factor alone .
For example in the 3 factor case we may regress momentum factor returns on 3
factor return to find that momentum generates a significant premium on top of size,
value and market returns.
PORTFOLIO ASSESSMENT
Portfolio assessment is the systematic, longitudinal collection of student work
created in response to specific know instructional objective and evaluated in
relation to t he same criteria .Assessment is done by measuring the individual
works as well as the portfolio as a whole against specified criteria which match the
objective toward a specific purpose .
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Portfolio creation is the responsibility of the learner with teacher guidance and
support and often with the involvement of peers and parents. The audience assesses
the portfolio.
Portfolios have generated a good deal of interest in recent years, with teachers
taking the lead in exploring ways to use them. Teachers have integrated portfolio
into instruction an assessment, gained administrative support and answer their own
as well as student administrator and parent question about portfolio assessment .
Concerns are often focused on reliability, validity, process, evaluation, and time
.These concerns apply equally to other assessment instruments. There is no
assessment instrument that meet every teachers purpose perfectly is entirely valid
and reliable takes no time to prepare administer or grade and meet each student
learning style.
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goal.
Enabling teachers and students to share the responsibility for setting learning
process
Facilitating cooperative learning activities including peer evaluation and
conferences.
Enabling measurement of multiple dimensions of student progress by
including different type of data and materials.
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An obvious way to look at the performance of the portfolio is to find out the
reward per unit of risk undertaken .A risk- free security earn only risk- free
return .However the return earned over and above the risk- free return is the risk
premium and is earned for bearing risk .The risk premium may be divided by the
risk factor to find out the reward per unit of risk undertaken. This is also known as
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reward to risk ratio. There are two methods of measuring reward to risk ratio as
follows:
A. Sharpe Ratio
This ration is also called Reward to variability Ration.IN this ratio, the
risk is measured in terms of standard deviation.
The Sharpe Index measures the risk premium of portfolio relative to
the total amount of risk in the portfolio. This index measures the slope
of the risk return line. The Sharpe Index helps summarizing the risk
and return of a portfolio in a single measure that categories the
performance on risk and return of a portfolio in a single measures that
categories the performance on risk-adjusted basis. The larger the
index value, the better the portfolio has performed.
B. Treynor Ratio
This ratio is also called Reward to Volatility Ratio. The Treynor Index
measures the risk premium of the portfolio where the risk premium is the
difference between the return and the risk-free rate. The risk premium is
related to the amount of systematic risk present in the portfolio.
It may be noted that the numerator in both the Sharpe Ratio ans Traynor
Ratio is same i.e. the risk premium .However the two differ with respect
to the denominator. In Sharpe Ratio , the risk is measured by while in
case of Treynor ratio the risk is measured by .The measure assumes
that the portfolio is well diversified and there is no remaining
diversifiable risk also. So the sharp Ratio adjust the portfolio return for
systematic as well as unsystematic risk .
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The differential return earned by the fund manager may be due to difference in the
exposure to risk. Hence it is imperative to adjust the return for the risk. For this
purpose there are essentially two major methods of assessing risk-adjusted
performance:
a. Return per unit of risk
b. Differential return per unit of risk
a. Return per unit of risk:
The first of the risk adjusted performance measure is the type that assesses the
performance of a fund in terms of return per unit of risk. We can adjust returns for
risk in several ways to develop a relative risk-adjusted measure for ranking fund
performance.
Sharpe Ratio:
One approach is to calculate portfolios return in excess of the risk free return and
divide the excess return by the portfolios standard deviation. This risk adjusted
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return is called Sharpe ratio. This ratio named after William Sharpe, thus measures
Reward to Variability.
This equation calls for three terms:
a. Annualized return of the fund
b. Annualized risk free return
c. Annualized standard deviation.
In our previous example, we have got 11.33% as annualized standard deviation.
Suppose that the annualized return for the same fund is 15.50%. Also suppose that
the average yield on one year treasury paper is 5.75% (this can be taken as riskfree rate).
This suggests that the fund has generated 0.86-percentage point of return above the
risk-free return for each percentage point of standard deviation. The Sharpe ratio is
a measure of relative performance, in the sense that it enables the investor to
compare two or more investment opportunities.
A fund with a higher Sharpe ratio in relation to another is preferable as it indicates
that the fund has higher risk premium for every unit of standard deviation risk.
Because Sharpe ratio adjusts return to the total portfolio risk, the implicit
assumption of the Sharpe measure is that the portfolio will not be combined with
any other risky portfolios. Thus the Sharpe measure is relevant for performance
evaluation when we wish to evaluate several mutually exclusive portfolios.
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This indicates that the fund has generated 0.09-percentage point above the risk-free
return for every unit of systematic risk.
As Treynor ratio indicates return per unit of systematic risk, it is a valid
performance criterion when we wish to evaluate a portfolio in combination with
the benchmark portfolio and other actively managed portfolios. Like Sharpe ratio it
is a measure of relative performance.
Sharpe versus Treynor Measure:
The Sharpe ratio uses standard deviation of return as the measure of risk, where as
Treynor performance measure uses Beta (systematic risk). For a completely
diversified portfolio one without any unsystematic risk, the two measures give
identical ranking, because the total variance of a completely diversified portfolio is
its systematic variance. Alternatively a poorly diversified portfolio could have a
high ranking on the basis of Treynor ratio and a low ranking on the basis of Sharpe
ratio. The difference in rank is because of the difference in diversification.
Therefore, both ratios provide complementary yet different information, and both
should be used.
b. Differential Return:
The second category of risk-adjusted performance measure is referred to as
differential return measure. The underlying objective of this category is to calculate
the return that should be expected of the fund scheme given its realized risk and to
compare that with the return actually realized over the period.
Calculation of alpha is a fairly simple exercise. The intercept term in the regression
equation is the Alpha. This number is usually very close to zero. A positive alpha
means that return tends to be higher than expected given the beta statistic.
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identical with that of the market. The return that this adjusted portfolio earns is
called M2.
Since the standard deviations have been equalized, M2 can be directly compared
with the return in the market. A high (low) M2 indicates that the portfolio has
outperformed (under-performed) the market portfolio.
The measures discussed above are extensively used in the mutual fund industry to
comment on the performance of equity schemes. The same measures can be used
to evaluate the performance of debt securities. However, measures involving use of
Beta are considered theoretically unsound for debt schemes as beta is based on the
capital assets pricing model, which is empirically tested for equities.
CONCLUSION
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An individual at certain point of time might feel the need to invest more. The need
for portfolio revision arises when an individual has some additional money to
invest .Portfolio revision involves changing the existing mix of securities .The
objective of portfolio revision is similar to the objective of portfolio selection i.e
maximizing the return for a given level of risk or minimizing the risk for a given a
level of return .The process of portfolio revision is also similar to the process of
portfolio selction.This is particularly true where active portfolio revision strategy is
followed.It calls for reallocation of fund among different industries through
industry analysis and finally selling and buying of stock within the industries
through company analysis .Where passive portfolio revision strategy is followed ,
use of mechanical formula pan may be made.
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BIBLIOGRAPHY
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