Portfolio ConstructionAnd Analysis

8/10/2019 Portfolio ConstructionAnd Analysis

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Portfolio Construction And Analysis

Presented by

Pranav Bhagat(03)Darshit Desai(08)

Ratul Ghosh(12)

Sagar Ghutkude(13)

Aanchal Narula(30)

Madhur Sawant(43)

Khushbu Shah(46)


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Flow of Presentation

Introduction to Portfolio Construction

Portfolio Risk and Returns

Portfolio Optimization

Portfolio Management Strategies

Portfolio Performance Measurement


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Introduction

Traditional Investments

- Security Analysis

- Portfolio Management

Security Analysis involves estimating the merits of individual

investments

Portfolio Management deals with the construction and maintenanceof collection of investments

Aims at reducing risks rather than increasing returns

Portfolio construction is a part of portfolio management

Portfolio Construction is a disciplined personalized process In constructing a portfolio, the individual risk & return characteristic

of underlying investment must be considered along with clients

unique needs, goals and risk considered


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Brief History1952

-Publication ofHarry

Markowitzthesis, Portfolio

Selectiion

1964

- WilliamSharpe came

out withCAPM model

-IntroducedAlpha and Beta

1980

- AG Beckerintroducedconcept ofInvestment

Style

1986

- GaryBrinson

introducedDeterminants

of PortfolioPerformance


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Importance of Portfolio Construction

Planning investment with financial planner helps in

reaching the investment objectives

Individual investor focus more on right fund manager and

securities Portfolio constructions helps in attaining investment

objectives with minimum risk

2 types of investors- Private investors and Professional

investors They build their portfolio in 2 different ways

- Bottom Up Approach

- Top down Approach


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Investment Consulting Process

It formalizes investing just like an architect

Developing a blue print based on your needs and goals, investment

parameters

The Investment Consulting Process is as follows

Establishing of Goals and Objectives

Asset Allocation

Manager Search and Selection

Performance Monitoring


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Cash Flow needs

Risk Tolerance Performance Objectives

Time Horizon

Investments Restriction

Determine Investment Parameters

Formulating Policy Statements

Optimize Risk and Reward tradeoff

Determining Asset Allocation

Define Investment Strategies

Portfolio Construction

Evaluation of Investment Structure

Manager Selection

Implement Investment Strategy


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Determine Performance benchmark

Evaluate Relative and Absolute Returns

Measure Performance

Ongoing review of Objectives and Strategies

Changing Clients circumstances

Changing Financial market conditions

Provide Ongoing Review andAdjustment


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Major Blunders in Portfolio

Construction

One sided approach

Lumpy Risks

Liquidity Problem Home bias problem

Failure to monitor portfolio regularly

Portfolio drift Awkward issue of no loss control


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Important Terms

ValueInvesting

Deep Value

RelativeValue

GrowthInterest

GARP

Important Terms

CumulativeReturns

RollingPeriod Return

StandardDeviation

Beta

Alpha


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Value investingis the art of buying stocks which trade at asignificant discount to their intrinsic value. Value investorsachievethis by looking for companies on cheap valuation metrics, typically

low multiples of their profits or assets, for reasons which are notjustified over the longer term.

Deep value investing-means finding companies that are genuinebargains that can pay back phenomenally over the long term. Theyare firms so cheap that even if they were to close tomorrow theirassets would pay you out at a profit.

Relative Value-A method of determining an asset's value that takesinto account the value of similar assets. In contrast, absolute valuelooks only at an asset's intrinsic value and does not compare it toother assets. Calculations that are used to measure the relative valueof stocks include the enterprise ratio and price-to-earnings ratio.

Beta is a historical measure of volatility. Beta measures how anasset (i.e. a stock, an ETF, or portfolio) moves versus a benchmark(i.e. an index).

Alphais a historical measure of an assets return on investmentcompared to the risk adjusted expected return.


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Growth At A Reasonable Price - GARP

An equity investment strategy that seeks to combine tenets of both growthinvesting and value investing to find individual stocks. GARP investorslook for companies that are showing consistent earnings growth above

broad market levels (a tenet of growth investing ) while excludingcompanies that have very high valuations (value investing

Cumulative Return

The aggregate amount that an investment has gained or lost over time,independent of the period of time involved. Presented as a percentage, thecumulative return is the raw mathematical return of the following

calculation Rolling Returns

The annualized average return for a period ending with the listed year.Rolling returns are useful for examining the behavior of returns for holding

periods similar to those actually experienced by investors.

Standard Deviation

A measure of the dispersion of a set of data from its mean. The morespread apart the data, the higher the deviation. Standard deviation iscalculated as the square root of variance.


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Sharpe Ratio & Information Ratio

While selecting funds most simple approach would be

performance that is returns

But reliabilty of scheme is also important that is volatility

A scheme giving good returns but extremely volatile may notfavor large number of investors

Sharpe Ratio expresses this measure

The ratio will be high if returns are high and volatility is low

A good fund will have a high ratio This can be explained with the help of drawing an analogy

with cricket


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Analogy

Imagine a cricket series just got over and we areanalyzing the score of Sehwag, Dhoni and Sreesanth

1.Sehwag (0, 0, 120, 160) Average- 70, StandardDeviation- 71.41

2.Dhoni (60, 60, 70, 70) Average- 65, StandardDeviation- 10

3.Sreeasnth (0, 0, 5, 20) Average- 6.25, StandardDeviation- 8.19

Here Sharpe Ratio will be

Sehwag - 70-6.25/71.41= 0.9

Dhoni - 65-6.25/10 = 5.8


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Mathematically, Sharpe Ratio= (Rp-r)/Sp

Where, Rp = Return of the fund or the portfolio, r

= Risf free rate,

Sp = Volatility of the the funds

Higher the Sharpe Ratio better is the fund

While calculating Sharpe Ratio we compared theaverage of batsman with that of bowler

In the world of finance the bowler is the risk free

investment ie government bonds


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Hence we should compare average of batsman with another

batsman who could be treated as benchmark

Similarly in funds we compare the performance with

benchmark funds performance both for return as well as

volatility

This is called Information Ratio

Now lets assume Dravid is the benchmark batsman for India in

this series

In our example Information Ratio would compare performance

of batsman (Sehwag and Dhoni ) with Dravid

Dravid (80, 75, 85, 70) Average-77.5 Standard Deviation-

5.59

Both average and s.d are better and hence he is the benchmark


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Thus, Information Ratio =

Difference in average of players compared to

benchmark/ Difference in standard deviation ofplayer compared with benchmark

Thus IR of Dhoni is 0.34

IR measures the excess return of an investmentmanager divided by the amount of risk the manager

takes relative to a bencmark

Whereas SR compares the performance of an asset

against the return of a risk free instrument


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Qualitative Risk Parameters

Qualitative Risk Analysisis concerned with

discovering the probability of a risk event occurring

& the impact the risk will have if it does occur.

All risks have both probability & impact. Probabilityis the likelihood that a risk event will occur, and

impact is the significance of the consequences of the

risk event.

Impact typically affects the following project

elements: Schedule, Budget, Resources, Deliverables,

Costs, Quality, Scope, Performance.


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Market Sentiments

Market sentimentis the general prevailing attitude

of investors as to anticipated price development in a

market.

This attitude is the accumulation of a varietyof fundamental and technical factors, including price

history, economic reports, seasonal factors, and

national and world events.


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For example, if investors expect upward price

movement in the stock market, the sentiment is said

to bebullish

. On the contrary, if the market sentiment is bearish,

most investors expect downward price movement.

Market sentiment is usually considered as

a contrarian indicator: what most people expect is a

good thing to bet against.

Market sentiment is used because it is believed to be

a good predictor of market moves, especially when itis more extreme.

Very bearish sentiment is usually followed by the

market going up more than normal, and vice versa.


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Accounting scandals

Accounting scandals are political and/or businessscandals which arise with the disclosure of financialmisdeeds by trusted executives of corporations orgovernments.

Such misdeeds typically involve complex methods for

misusing or misdirecting funds, overstating revenues,understating expenses, overstating the value of corporateassets or underreporting the existence of liabilities,sometimes with the cooperation of officials in othercorporations or affiliates.

In public companies, this type of creativeaccounting" canamount to fraud, and investigations are typically launched bygovernment oversight agencies, such as the Securities andExchange Board of India (SEBI).


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Satyam scandal

The Satyam Computer Services scandal was a corporate

scandal that occurred in India in 2009 where chairman Ramalinga

Raju confessed that the company's accounts had been falsified.

The Global corporate community was shocked and scandalized

when the chairman of Satyam, Ramalinga Raju resigned on 7

January 2009 and confessed that he had manipulated the accountsby US$1.47-Billion.

The Indian arm of PwC was fined $6 million by the SEC (US

Securities and Exchange Commission) for not following the code of

conduct and auditing standards in the performance of its dutiesrelated to the auditing of the accounts of Satyam Computer

Services.

Satyam's shares fell to 11.50 rupees on 10 January 2009, their

lowest level since March 1998, compared to a high of 544 rupees in

2008


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Minority Shareholder Rights

(Companies Act 2013)

The Companies Act 2013, expected to be fully operational by April2014, goes a long way in protecting shareholders' interests andremoves administrative burden in several areas.

The Act would protect minority shareholders, investor protection

and better framework for insolvency regulation, besides institutionalstructure.

Provisions such as class action suit, approval of auditors byshareholders will bring in more transparency.

Small investors who at present are not able to get compensation incases of fraud due to the absence of any such law will be able to

fight for justice with such suits. This suit is brought by one party on behalf of a group of individuals

to file for claims against erring companies in a court.


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Systematic Risk

The risk inherent to the entire market or an entire market segment.This type of risk is both unpredictable and impossible to completelyavoid.

Putting some assets in bonds and other assets in STOCKS canmitigate systematic risk because an interest rate shift that makes

bonds less valuable will tend to make stocks more valuable, and viceversa, thus limiting the overall change in the portfoliosvalue fromsystematic changes.

Systematic risk underlies all other investment risks.

The Great Recession provides a prime example of systematic risk.Anyone who was invested in the market in 2008 saw the values of

their investments change because of this market-wide economicevent, regardless of what types of securities they held.


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Returns Benchmarking

A benchmark is a feasible alternative to a portfolio againstwhich performance is measured.

Investors look to broad indexes as benchmarks to help

them gauge not only how well the markets are performing, but

also how well they, as investors, are performing. For those who own stocks, they look to indexes like the S&P

500, the Dow Jones Industrial Average (DJIA) and the Nasdaq

100 to tell them "where the market is".

Most investors hope to meet or exceed the returns of theseindexes over time.

The problem with this expectation is that they immediately put

themselves at a disadvantage because they are not comparing

apples to apples.


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How it works

Let's assume you compare the returns of

your stock portfolio, which is a broadly diversified

collection of small-cap stocks and is managed by

Company XYZ, with the Russell 2000 index, whichyou feel is an accurate universe of feasible

alternative investments.

If Company XYZ's portfolio returns 5.5% in a year

but the Russell 2000 (the benchmark) returns 5.0%,then we would say that your portfolio beat its

benchmark.


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Portfolio Optimization

Definition

Portfolio optimizationis the process of choosing the

proportions of various assets to be held in a portfolio,

in such a way as to the portfolio better than any other

according to some criterion.


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Modern Portfolio Theory

Modern portfolio theory has had a marked impact on

how investors perceive risk, return and portfolio

management.

The theory demonstrates that portfolio diversificationcan reduce investment risk.

MTP has Shortcomings in the real world


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The Efficient Frontier

How to identify the best level of diversification?

For every level of return, there is one portfolio that

offers the lowest possible risk, and for every level ofrisk, there is a portfolio that offers the highest return.


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CML (Capital Market Line)

A line used in the capital asset pricing model to

illustrate the rates of return for efficient portfolios

depending on the risk-free rate of return and the level

of risk (standard deviation) for a particular portfolio. CML is considered to be superior to the efficient

frontier


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Risk Free rate

It is the market off which other assets are priced;

companies pay an extra spread over the risk-free rate,

equities offer a "risk premium" in the form of a

higher long-term return to compensate for theirhigher short-term volatility.

Local government bond that constitutes the risk-free

rate


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Methods of portfolio optimization

Traditional measure

standard deviation

Sortino ratio

CVaR (Conditional Value at Risk)


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Optimization constraints

Regulation and taxes

Transaction costs


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Mathematical tools used in portfolio

optimization

Quadratic programming

Nonlinear programming

Mixed integer programming

Meta-Heuristic Methods


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Issues with portfolio optimization

Investment is a forward looking activity

Financial crises are characterized by a significant

increase in correlation of stock price movements

which may seriously degrade the benefits ofdiversification.


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4 Steps To Building A Profitable

Portfolio

Determining the Appropriate Asset Allocation for You

Achieving the Portfolio Designed in Step 1

Reassessing Portfolio Weightings Rebalancing Strategically

B d O i f I t t


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Broad Overview of Investment

Strategies

Active Management Strategies

Fundamental Analysis

TopDown(asset class rotation, sector rotation)

Bottom Up(stock undervaluation/overvaluation)

Technical Analysis

Contrarian (e.g. overreaction)

Continuation (e.g. price momentum)

Passive Management Strategies

Efficient Markets Hypothesis

Buy and Hold

Indexing


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Portfolio Management Strategies refer to the approaches that

are applied for the efficient portfolio management in order to

generate the highest possible returns at lowest possible risks.

There are two basic approaches for portfolio management

including Active Portfolio Management Strategy and Passive

Portfolio Management Strategy.


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The Active portfolio management relies on the fact that particular

style of analysis or management can generate returns that can beat

the market. It involves higher than average costs and it stresses on

taking advantage of market inefficiencies. It is implemented by the

advices of analysts and managers who analyze and evaluate market

for the presence of inefficiencies.

The active management approach of the portfolio management

involves the following styles of the stock selection.

Active Portfolio Management Strategy


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Fundamental Strategies

Tactical Asset Allocation

- Asset Class Rotation: Shifts funds between stocks, bonds andother securities depending on market forecasts and estimatedreturns.

Sector, Industry or Style Rotation Strategy- Shifts funds between different equity sectors and industries(financial stocks, technology stocks, consumer cyclicals,durable goods) or among investment styles (e.g., largecapitalization, small capitalization, value growth)

Individual Stock Selection

- Buy low, Sell High

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Technical Strategies

Contrarian investment strategy

- Best time to buy a stock is when the majority of other

investors are selling.

- Buy low, sell high. Hope asset prices are meanreverting.

- Overreaction hypothesis.

Price momentum strategy Earnings momentum strategy

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A financial strategy in which an investor invests in accordance with a pre-determined

strategy that doesn't entail any forecasting.

The idea is to minimize investing fees and to avoid the adverse consequences of failing

to correctly anticipate the future.

Passive management is most common on the equity market, where index funds track

a stock market index

One of the largest equity mutual funds, the Vanguard 500, is a passive management

fund.

The two firms with the largest amounts of money under management, Barclays Global

Investors and State Street Corp., primarily engage in passive management strategies.

Passive Portfolio Management Strategy


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Passive asset management is based on the belief that: Markets are efficient.

Market returns cannot be surpassed regularly over

time. Low-cost investments held for the long-term will

provide the best returns


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Efficient market theory: This theory relies on the fact that theinformation that affects the markets is immediately available and

processed by all investors. Thus, such information is always considered

in evaluation of the market prices. The portfolio managers who follows

this theory, firmly believes that market averages cannot be beaten

consistently.

Indexing: It is done by retail investors by buying one or more index

funds. An investment portfolio tracks an index and achieves low

turnover, very low management fees and good diversification.The low management fees enable the investor to receive higher returns in

comparison to similar fund investments with higher management fees or

transaction costs. Passive management is widely used in the equity

market and involves tracking of stock market index by index funds.

METHODS


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Patient Portfolio:This type of portfolio involves making investments in well-

known stocks. The investors buy and hold stocks for longer periods. In this

portfolio, the majority of the stocks represent companies that have classic growth

and those expected to generate higher earnings on a regular basis irrespective of

financial conditions.

Aggressive Portfolio: This type of portfolio involves making investments in

expensivestocksthat provide good returns and big rewards along with carrying

big risks. This portfolio is a collection of stocks of companies of different sizes

that are rapidly growing and expected to generate rapid annual earnings growth

over the next few years.

Conservative Portfolio:This type of portfolio involves the collection of stocks

after carefully observing the market returns, earnings growth and consistent

dividend history.

I l t ti f P i tf li


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Implementation of Passive portfolio

management strategy

Index funds refer to the collective investment

schemes that utilize passive investment strategies for

tracking the performance of a stock market index.

An index fund can be implemented by buyingsecurities in the similar proportion as present in the

stock market index.

The sampling involves purchasing each type of stocksfrom various sectors in the index but do not include

some quantity of stocks of every individual stock.


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Advantages

Low cost: Provides meaningful and specificincremental advantage.

Reduced uncertainty of decision errors: By makinginvestments, investors are exposed to market risks and

passive investment strategy reduces the uncertainty ofdecision errors.

Style consistency: Indexing enables the investors tocontrol their overall allocation by selecting theappropriate indexes.

Tax efficiency: Indexing is considered as more taxefficient especially in cases of larger-cap indexes thatinvolve less trading and which are fairly stable.


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Portfolio Performance Measurement

Performance evaluation is a critical aspect of

portfolio management

Proper performance evaluation should involve a

recognition of both the return and the riskiness of the

investment


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Risk : It is the amount of volatility of returns in aportfolio measured by standard deviation. Volatility isused as a proxy for risk. Volatility is a measure ofhow much a given number can vary over time and the

wider the range of possibilities

Return : It is ultimately the rate of growth of yourportfolio. Given enough time a high-risk portfoliowill earn higher returns than a low-risk portfolio.


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High Risk :High risk means there is a strong chance

that you could lose a substantial amount (or all) of

your investment.

Low risk : Low risk means when it is thought to bejust a small chance of losing some or all of your

money.

F t t id i M i


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Factors to consider in Measuring

Portfolio Performance

Differential Risk Levels: In order to Evaluate portfolio

performance properly, we must determine whether the returns

are large enough given the risk involved.

Differential Time Periods : In order to evaluate performance oftwo funds of same type with different time periods, time element

must be adjusted.

Appropriate Benchmarks: In evaluating portfolio performance

to compare the returns, the portfolio must be evaluated with thereturns that could have been obtained from a comparable

alternative.

T diti l


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Traditional

Performance Measures

Sharpe Measure

Treynor Measures

Jensen Measure


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Sharpe and Treynor Measures

The Sharpe measureevaluates return relative

to total risk

Appropriate for a well-diversified portfolio,

but not for individual securities

The Treynor measureevaluates the return

relative to beta, a measure of systematic risk

It ignores any unsystematic risk


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Sharpe and Treynor Measures

The Sharpe and Treynor measures:

Sharpe measure

Treynor measure

where average return

risk-free ratestandard deviation of returns

beta

f

f

f

R R

R R

R

R


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Jensen Measure

The Jensen measure is also based on CAPM.

Named after its creator, Michael C. Jensen.

The Jensen measure is a risk-adjusted performance

measure that represents the average return on aportfolio over and above that predicted by the capital

asset pricing model (CAPM), given the portfolio's

beta and the average market return.

This measure of return is also known as alpha.


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Jensen Measure


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Measuring Returns

How to measure returns generated by an investmentmanager?

Two ways to measure returns:

1. Dollar Weighted Rate of Return

2. Time Weighted Rate of Return


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Measuring Returns

Dollar weighted rate of return is the internal rate ofreturn (IRR) of an investment

In investment management industry, time weightedrate of return is preferred

Rate does not depend on when investment ismade (timing of cashflows)

Since different clients will invest at differenttimes, need a measure that is independent oftiming


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PROBLEM

Four years ago, this investor put $200,000 in a

portfolio aligned with her long-term goals. This

portfolio then grew by 10% a year for 4 years. At thestart of the 5th year the investor received a large

inheritance, worth $1,000,000, and added it to the

account. During this same year the market happened

to decline, and the portfolio lost 10%. The portfoliovalue historically would look like this:

Solution dollar Weighted Rate Of


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Solution-dollar Weighted Rate Of

Return


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SOLUTION

Because her account was so much larger during the

market decline of the 5th year, the investor has

actually lost money ($1,163,538 - $1,200,000 = -$36,462) when compared to her total contributions.

However, the statement shows a positive time-

weighted annualized rate of return. How can this be

correct?

Solution time Weighted Rate Of


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Solution-time Weighted Rate Of

Return


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FORMULA

TWRR = (1+10%) x (1+10%) x (1+10%) x (1+10%)

x (1+(-10%)) -1 = 32% cumulative return. Total

returns greater than 1 year are then annualized.

The annualized return is calculated as (1 + totalreturn)^(1/(Time/365))

= (1+ 32%) ^ ((1/1825/365)) -1 = 5.67%.


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SOLUTION

If you were to use dollar-weighted calculations, the 5th yearsperformance would overwhelm the return number, because the

value was so much higher during that one year. In this scenario

theportfoliosprevious 4 years of positive performance would

have less weight, and the focus would almost entirely be onthe 5th year, during which the market happened to decline. In

this scenario the DWRR would be (1.86%), since the

portfoliosmoney managersperformance is dominated by the

timing of the cash flow received.


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FORMULA

DWRR = Initial cash flow + (CashFlow1) / (1 +

Return)^1 + (CashFlow2) / (1+Return)^2 +

(CashFlowN) / (1+Return)^N

In this scenario the DWRR would =$-200,000 + ($-1,000,000) / (1+R)^4 + ($1,163,538) /

(1+R)^5, solving for return = (1.86%).


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Pros And Cons


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THANK YOU

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Portfolio ConstructionAnd Analysis