INTRODUCTION TO PORTFOLIO

MANAGEMENT

We all dream of beating the market and being super investors and spend an
inordinate amount of time and resources in this endeavor. Consequently, we are easy prey
for the magic bullets and the secret formulae offered by eager salespeople pushing their
stuff. In spite of our best efforts, most of us fail in our attempts to be more than average
investors. Nonetheless, we keep trying, hoping that we can be more like the investing
legends – another Warren Buffett or Peter Lynch. We read the words written by and
about successful investors, hoping to find in them the key to their stock-picking abilities,
so that we can replicate them and become wealthy quickly.
Investing in shares and debentures is profitable as well as exiting. It is indeed
rewarding, but involves a great deal of risk and calls for scientific knowledge and
forecasting skill. In such investments, both rational as well as emotional responses are
involved. Investing in securities is considered as one of the best avenues to invest ones
savings while it is acknowledged to be one of the most risky avenues of investment.
It is unusual to find investors investing their entire money in one single security.
Instead, they tend to invest in a group of securities. Such a group of securities is called a
portfolio. Creation of a portfolio helps to reduce risks without sacrificing returns.
Portfolio management deals with the analysis of individual securities as well as with the
theory and practice of optimally combining securities into portfolios. An investor who
understands the fundamental principals and analytical aspects of portfolio management
has a better chance of success.

WHAT IS PORTFOLIO MANAGEMENT?

An investor considering investment in securities is faced with the problem of
choosing from among a large number of securities. His choice depends on the risk-return
characteristics of individual securities. He would attempt to choose the most desirable
securities and like to allocate his funds over this group of securities. Again he is faced
with the problem of deciding which security to hold and how much to invest in each. The
investor faces an innumerable number of possible portfolios or group of securities. The
risk and return characteristics of portfolios differ from those of individual securities
combining to form a portfolio. The investor tries to choose the optimal portfolio taking
into consideration the risk return characteristics of all possible portfolios. As the
economic and financial environment keeps changing the risk and return characteristics of
individual securities as well as portfolios also change. This calls for periodic review of
and revision of investment portfolios of investors. An investor invests his funds in a
portfolio expecting to get good return consistent with the risks that he has to bear. The
return realized from the portfolio has to be measured and the performance of the portfolio
has to be evaluated.
It is evident that rational investment activity involves creation of an investment
portfolio. Portfolio management comprises all the processes involved in the creation and
maintenance of an investment portfolio. It deals specifically with security analysis,
portfolio analysis, portfolio selection, portfolio revision and portfolio evaluation.
Portfolio management makes use of analytical techniques of analysis and conceptual
theories regarding rational allocation of funds. Portfolio management is a complex
process, which tries to make investment activity more rewarding and less risky.

OBJECTIVES OF PORTFOLIO MANAGEMENT

• Security/Safety of Principal: Security not only involves keeping the principal
sum intact but also keeping intact its purchasing power.
• Stability of Income: Stability of income so as to facilitate planning more
accurately and systematically the reinvestment or consumption of income.
• Capital Growth: Capital growth which can be attained by reinvesting in growth
securities or through purchase of growth securities.
• Marketability: The case with which a security can be bought or sold. This is
essential for providing flexibility to investment portfolio.
• Liquidity: Liquidity i.e. nearness to money. It is desirable for the investor so as to
take advantage of attractive opportunities upcoming in the market.
 • Diversification: The basic objective of building a portfolio is to reduce the risk of
loss of capital and income by investing in various types of securities and over a wide
range of industries.
• Favourable Tax Status: The effective yield an investor gets from his investment
depends on tax to which it is subject. By minimizing the tax burden, yield can be
effectively improved.

BASIC PRINCIPLES OF PORTFOLIO MANAGEMENT

There are two basic principles for effective Portfolio Management:
1) Effective investment planning for the investment in securities by considering the
following factors:
a) Fiscal, financial and monetary policies of the Government of India and
the Reserve Bank of India.
b) Industrial and Economic environment and its impact on industry
prospects in terms of prospective technological changes, competition in the
market, capacity utilization with industry and demand prospects etc.

2) Constant review of investment: Portfolio managers are required to review their

investment in securities and continue selling and purchasing their investment in more
profitable avenues. For this purpose they will have to carry the following analysis:
a) Assessment of quality of management of the companies in which
investment has already been made or is proposed to be made.
b) Financial and Trend analysis of companies, Balance Sheet/Profit
and Loss accounts to identify sound companies with optimum capital
structure and better performance and to disinvest the holding of those
companies whose performance is found to be slackening.
c) The analysis of securities market and its trend is to be done on a
continuous basis.
The above analysis will help to arrive at a conclusion as to whether the securities already
in possession should be disinvested and new securities be purchased. If so, the timing for
investment or dis-investment is also revealed.
ACTIVITIES IN PORTFOLIO MANAGEMENT
The following three major activities are involved in an efficient portfolio management:
a) Identification of assets or securities, Allocation of investments and
identifying asset classes.
b) Deciding about major weights/proportion of different
assets/securities in the portfolio.
c) Security selection within the asset classes as identified earlier.
The above activities are directed to achieve the sole purpose to maximize return and
minimize risk in the investments. This will however be depending upon the class of
assets chosen for investment.
The class of assets/securities varies according to the degree of risk. It is well interpreted
that higher the risk, higher will be the returns and vice versa. The portfolio manager
foresees the balancing of risk and return in a portfolio investment. The composite risks
involving the different risks are as indicated:

1) Interest Rate Risk: This arises due to variability in the interest rates from time to
time. A change in the interest rates establishes an inverse relationship in the price of
security i.e. price of securities tend to move inversely with change in rate of interest, long
term securities show greater variability in the price with respect to interest rate changes
than short term securities. Interest rate risk vulnerability for different securities is as
under:
2) Purchasing Power Risk: It is also known as inflation risk also emanates from the
very fact that inflation affects the purchasing power adversely. Nominal return contains
both the real return component and an inflation premium in a transaction involving risk to
compensate for inflation over an investment holding period. Inflation rates vary over time
and investors are caught unaware when rate of inflation changes unexpectedly causing
erosion in the value of realized rate of return and expected return. Purchasing power risk
is more in inflationary conditions especially in respect of bonds and fixed income
securities. It is not desirable to invest in such securities during inflationary periods.
Purchasing power risk is however, less in flexible income securities like equity share or
common stock where rise in dividend income off-sets increase in the rate of inflation and
provides advantage of capital gains.

3) Business Risk: Business risk emanates from sale and purchase of securities affected
by business cycles, technological changes, etc. Business cycle affect all types of
securities viz. there is cheerful movement in boom due to bullish trend in stock prices
whereas bearish trend in depression brings down fall in the prices of all types of
securities. Flexible income securities are more affected than fixed rate securities during
depression due to decline in their market price.

3) 4) Financial Risk: It arises due to changes in the capital structure of the

company. It is also known as leveraged risk and expressed in terms of debt-
equity ratio. Excess of debt
equity in the capital structure indicates that the company is highly geared. Although a
leveraged company’s earnings per share are more but dependence on borrowings exposes
it to the risk of winding-up for its inability to honor its commitments towards
lenders/creditors. This risk is known as leveraged or financial risk of which investors
should be aware and portfolio managers should be vary careful

INTRODUCTION TO PORTFOLIO MANAGER

In view of peculiar nature of stock exchange operations most of the investors feel
insecure in managing their investment on the stock market because it is difficult for an
individual to identify companies which have growth prospects conducive for investment.
This is further complicated by the volatile nature of the markets, which demands constant
reshuffling of portfolios to capitalize on the growth opportunities.
Even if the investor is able to identify growth oriented companies and their securities, the
trading practices are complicated, making it a difficult task for investors to trade in all the
exchanges and follow-up on post trading formalities. That is why professional investment
advice through Portfolio Management Services (PMS) can help the investor to make an
intelligent and informed choice between alternative investment opportunities without the
worry of post trading hassles.

DEFINITION OF PORTFOLIO / PORTFOLIO MANAGER:

Portfolio means the total holdings of securities belonging to any person. Portfolio
manager means any person who enters into a contract or agreement with a client.
Pursuant to such agreements he advices the clients or undertakes on behalf of such clien
management or administration of a portfolio of securities or invests and manages the
client’s funds

Two Types of Portfolio Managers

Discretionary Non- Discretionary

Portfolio Manager Portfolio Manager

Discretionary Portfolio Manager:

A discretionary portfolio manager means a portfolio manager who exercises or may,
under a contract relating to portfolio management, exercises any degree of discretion in
respect of the investments or management of the portfolio of securities or the funds of the
clients, as the case may be. He shall individually and independently manage the funds of
each client in accordance with the needs of the client in a manner which does not
resemble a mutual fund.
FUNCTIONS OF PORTFOLIO MANGERS:
Portfolio mangers rendering the services of portfolio management to their clients in
different categories, viz. individuals, resident Indians and non-resident Indians, firms,
association of persons like Joint Hindu Family, Trust, Society, Corporate Enterprises
Provident Fund Trustees etc. have to enquire of their individual objectives, need pattern
for funds, perspective towards growth and attitude towards risk before counseling them
on the subject and acceptance of the assignment. Nevertheless, portfolio managers in the
wake of rendering their services perform following set of functions:

• They study economic environment affecting the capital market and clients
investment.
• They study securities market and evaluate price trend of shares and securities in
which investment is to be made.
• They maintain complete and updated financial performance data of Blue-Chip
and other companies.
• They keep a track on latest policies and guidelines of Government of India, RBI
and Stock Exchanges.
• They study problems of industry affecting securities market and the attitude of
investors.
• They study the financial behaviour of development financial institutions and
other players in the capital market to find out sentiments in the capital market.
• They counsel the prospective investors on share market and suggest investments
in certain assured securities.
• They carry out investments in securities or sale or purchase of securities on
behalf of the clients to attain maximum return at lesser risk.

1. Non-Discretionary Portfolio Manager:

A Non-Discretionary Portfolio Manager shall manage the funds of each client in
accordance with the directions of the client.
 A portfolio manager, by the virtue of his knowledge, background and
experience is expected to study the various avenues available for profitable
investment and advise his client to enable the latter to maximize the return on his
investment and at the same time safeguard the funds invested.

CODE OF CONDUCT - PORTFOLIO MANAGERS:

• A portfolio manager shall, in the conduct of his business, observe high standards
of integrity and fairness in all his dealings with his clients and other portfolio
managers.

• The money received by a portfolio manager from a client for an investment

purpose should be deployed by the portfolio manager as soon as possible for that
purpose and money due and payable to a client should be paid forthwith.

• A portfolio manager shall render at all time high standards of services exercise
due diligence, ensure proper care and exercise independent professional
judgment. The portfolio manager shall either avoid any conflict of interest in his
investment or disinvestments decision, or where any conflict of interest arises;
ensure fair treatment to all his customers. He shall disclose to the clients, possible
sources of conflict of duties and interest, while providing unbiased services. A
portfolio manager shall not place his interest above those of his clients.

• A portfolio manager shall not make any statement or become privy to any act,
practice or unfair competition, which is likely to be harmful to the interests of
other portfolio managers or it likely to place such other portfolio managers in a
disadvantageous position in relation to the portfolio manager himself, while
competing for or executing any assignment.

• A portfolio manager shall not make any exaggerated statement, whether oral or
written, to the client either about the qualification or the capability to render
 certain services or his achievements in regard to services rendered to other
clients.

NEED FOR AND ROLE OF PORTFOLIO MANAGER:

With the development of the Indian securities market and with the appreciation in the
market price of equity shares of profit-making companies, investment in securities of
such companies has become quite attractive. At same time, the stock market becoming
volatile n account of various factors, a layman is puzzled as to how to make his
investments without losing the same. He has felt the need of expert’s guidance n this
respect. Similarly Non-resident are eager to make their investments in Indian companies.
They have also to comply with the conditions specified by the Reserve Bank of India
under various schemes for investment by the non-resident. The Portfolio Manager, with
his background and expertise, meets the needs of such investors by rendering service in
helping them to invest their funds profitably.
• At the time of entering into a contract, the portfolio manager shall obtain in
writing from the client, his interest in various corporate bodies, which enables
him to obtain unpublished price-sensitive information of the body corporate.

• A portfolio manager shall not disclose to any clients or press any confidential
information about his clients, which has come to his knowledge.

• The portfolio manager shall where necessary and in the interest of the client take
adequate steps for registration of the transfer of the client’s securities and for
claiming and receiving dividend, interest payment and other rights accruing to
the client. He shall also take necessary action for conversion of securities and
subscription of/or rights in accordance with the client’s instruction.

• Portfolio manager shall ensure that the investors are provided with true and
adequate information without making any misguiding or exaggerated claims and
are made aware of attendant risks before they take any investment decision.
• He should render the best possible advice to the client having regard to the
client’s needs and the environment, and his own professional skills.

• Ensure that all professional dealings are affected in a prompt, efficient and cost
effective manner.

PORTFOLIO SELECTION
 The objective of every investor is to maximize his returns and minimize his risk.
Diversification is the method adopted to reduce the risk. It essentially results in the
construction of portfolios. The proper goal of construction of portfolios would be to
generate a portfolio that provides the highest return and lowest risk. Such a portfolio
would be an optimal portfolio. The process of finding the optimal portfolio is described
as portfolio selection.
The conceptual framework and analytical tools for determining the optimal
portfolio in disciplined and objective manner have been provided by Harry Markowitz in
his pioneering work on portfolio analysis described in his 1952 “JOURNAL OF
FINANCE” article and subsequent book in 1959. His method of portfolio selection is
come to be known as Markowitz model. In fact, Markowitz work marked the beginning
of what is today the Modern Portfolio Theory.

FEASIBLE SET OF PORTFOLIOS

With limited number of securities an investor can create a very large number of
portfolios by combining these securities in different proportions. These constitute the
feasible set of portfolios in which the investor can possibly invest. This is also known as
the portfolio opportunity set.
Each portfolio in the opportunity set is characterized by an expected return and a
measure of risk, viz., and variance of the returns. Not every portfolio in the portfolio
opportunity set is of interest to an investor. In an opportunity set some portfolios will be
dominant over the others. A portfolio will dominate the other if it has either a lower
variance and the same expected return as the other, or a higher return and the same
variance as the other. Portfolios that are dominated by the others are called as
insufficient portfolios. An investor would not be interested in all the portfolios in the
opportunity set. He would be interested only in the efficient portfolios.

EFFICIENT SET OF PORTFOLIOS

To understand the concept of efficient portfolios, let us consider various
combinations of securities and designate them as portfolios 1 to n. the expected returns of
these portfolios may be worked out. The risk of these portfolios may be estimated by
measuring the variance of the portfolio returns. The table below shows illustrative returns
and variance of some portfolios:

Portfolio No. Expected Return Variance

(per cent) (risk)
1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9

If we compare portfolios 4 and 5, for the same variance of 8.1 portfolio no. 5
gives a higher expected return of 11.7, making it more efficient than portfolio no. 4.
Again, if we compare portfolios 7 and 8 for the same expected return of 13.5%, the
variance is lower for portfolio no.7, making it more efficient than portfolio no. 8. Thus
the selection of the portfolios by the investor will be guided by two criteria:
• Given two portfolios with the same expected return, the investor will prefer the
one with the lower risk.
• Given two portfolios with the same risk, the investor will prefer the one with the
higher expected returns.
These criteria are based on the assumption that investors are rational and also risk averse.
As they are rational they would prefer more returns to less returns. As they are risk
averse, they would prefer less risk to more risk.
The concept of efficient sets can be illustrated with the help of a graph. The
expected returns and the variance can be depicted on a XY graph, measuring the expected
returns on the Y-axis and the variance on the X-axis. The figure below depicts such a
graph.
As a single point in the risk-return space would represent each possible portfolio in the
opportunity set or the feasible set of portfolio enclosed within the two axes of the graph.
The shaded area in the graph represents the set of all possible portfolios that can be
constructed from a given set of securities. This opportunity set of portfolios takes a
concave shape because it consists of portfolios containing securities that are less than
perfectly correlated with each other.

Let us closely examine the diagram above. Consider portfolios F and E. Both the
portfolios have the same expected return but portfolio E has less risk. Hence portfolio E
would be preferred to portfolio F. Now consider portfolios C and E. Both have the same
risk, but portfolio E offers more return for the same risk. Hence portfolio E would be
preferred to portfolio C. Thus for any point in the risk-return space, an investor would
like to move as far as possible in the direction of increasing returns and also as far as
possible in the direction of decreasing risk. Effectively, he would be moving towards the
left in search of decreasing risk and upwards in search of increasing returns.
Let us consider portfolios C and A. Portfolio C would be preferred to portfolio A because
it offers less risk for the same level of return. In the opportunity set of portfolios
represented in the diagram, portfolio C has the lowest risk compared to all other
portfolios. Here portfolio C in this diagram represents the Global Minimum Variance
Portfolio.

Comparing portfolios A and B, we find that portfolio B is preferable to portfolio A

because it offers higher return for the same level of risk. In this diagram, point B
represents the portfolio with the highest expected return among all the portfolios in the
feasible set.
Thus we find that portfolios lying in
the North West boundary of the shaded
area are more efficient than all the
portfolios in the interior of the shaded
area. This boundary of the shaded area
is called the Efficient Frontier because
it contains all the efficient portfolios in
the opportunity set. The set of
portfolios lying between the global
minimum variance portfolio and the
maximum return portfolio on the
efficient frontier represents the efficient set of portfolios. The efficient frontier is shown
separately in Fig.

The efficient frontier is a concave curve in the risk-return space that extends from the
minimum variance portfolio to the maximum return portfolio.

SELECTION OF OPTIMAL PORTFOLIO

The portfolio selection problem is really the process of delineating the efficient portfolios
and then selecting the best portfolio from the set.
Rational investors will obviously prefer to invest in the efficient portfolios. The particular
portfolio that an individual investor will select from the efficient frontier will depend on
that investor's degree of aversion to risk. A highly risk averse investor will hold a
portfolio on the lower left hand segment of the efficient frontier, while an investor who is
not too risk averse will hold one on the upper portion of the efficient frontier.

The selection of the optimal portfolio thus depends on the investor's risk aversion, or
conversely on his risk tolerance. This can be graphically represented through a series of
risk return utility curves or indifference curves. The indifference curves of an investor are
shown in Fig. Each curve represents different combinations of risk and return all of
which are equally satisfactory to the concerned investor. The investor is indifferent
between the successive points in the curve. Each successive curve moving upwards to the
left represents a higher level of satisfaction or utility. The investor's goal would be to
maximize his utility by moving up to the higher utility curve. The optimal portfolio for an
investor would be the one at the point of tangency between the efficient frontier and his
risk-return utility or indifference curve.

This is shown in Fig. The point O' represents the optimal portfolio. Markowitz used the
technique of quadratic programming to identify the efficient portfolios. Using the
expected return and risk of each security under consideration and the covariance
estimates for each pair of securities, he calculated risk and return for all possible
portfolios. Then, for any specific value of expected portfolio return, he determined the
least risk portfolio using quadratic programming. With another value of expected
portfolio return, a similar procedure again gives the minimum risk portfolio. The process
is repeated with different values of expected return, the resulting minimum risk portfolios
constitute the set of efficient portfolio
 PORTFOLIO EVALUATION

Portfolio evaluation is the last step in the process of portfolio management.

Portfolio analysis, selection and revision are undertaken with the objective of
maximising returns and minimising risk. Portfolio evaluation is the stage where we
examine to what extent the objective has been achieved. Through portfolio evaluation
the investor tries to find out how well the portfolio has performed. The portfolio of
securities held by an investor is the result of his investment decisions. Portfolio
evaluation is really a study of the impact of such decisions. Without portfolio
evaluation, portfolio management would be incomplete.

Two decades ago portfolio evaluation was not considered as an integral part of portfolio
management. Portfolio evaluation has evolved as an important aspect of portfolio
management over the last two decades. Moreover, the evaluation process itself has
changed from crude return calculations to rather detailed explorations of risk and return
and the sources of each.

MEANING OF PORTFOLIO EVALUATION

Portfolio evaluation 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 portfolios or on a benchmark portfolio. Portfolio
evaluation essentially comprises of two functions, performance measurement and
performance evaluation. Performance measurement is an accounting function which
measures the return earned on a portfolio during the holding period or investment
period. Performance evaluation, on the other hand, addresses such issues as whether the
performance was superior or inferior, whether the performance was due to expertise or
fortune etc.

While evaluating the performance of a portfolio, the return earned on the portfolio has
to be evaluated in the context of the risk associated with that portfolio. One approach
would be to group portfolios into equivalent risk classes and then compare returns of
portfolios within each risk category. An alternative approach would be to specifically
adjust the return for the riskiness of the portfolio by developing risk adjusted return
measures and use these for evaluating portfolios across differing risk levels.

NEED FOR EVALUATION

The individuals may carry out their investment on their own. The funds
available with individual investors may not be large enough to create a well
diversified portfolio of securities. Moreover, the time, skill and other resources
at the disposal of individual investors may not be sufficient to manage the
portfolio professionally. Institutional investors such as mutual funds and
investment companies are better equipped to create and manage well diversified
portfolios in a professional manner. Hence, small investors may prefer to entrust
their funds with mutual funds or investment companies to avail the benefits of
their professional services and thereby achieve maximum return with minimum
risk and effort.

Evaluation is an appraisal of performance. Whether the investment activity is

carried out by individual investors themselves or through mutual funds and
investment companies, different situations arise where evaluation of performance
becomes imperative. These situations are discussed below.

Self Evaluation:
While individual investors undertake the investment activity on their own, the
investment decisions are taken by them. They construct and manage their own portfolio
of securities. In such a situation, the investor would like to evaluate the performance of
his portfolio in order to identify the mistakes committed by him. This self evaluation
will enable the investor to improve his skills and achieve better performance in future.
Evaluation of Portfolio Managers:
A mutual fund or investment company usually creates different portfolios with
different objectives aimed at different sets of investors. Each such portfolio may be
entrusted to different Professional Portfolio Managers who are responsible for the
investment decisions regarding the portfolio entrusted to each of them. In such a
situation, the organisation would like to evaluate the performance of each portfolio so
as to compare the performance of the different portfolio managers.

Evaluation of Mutual Funds:

In India, at present, there are many mutual funds as also investment companies
operating both in the public sector as well as in the private sector. These compete with
each other for mobilising the investment funds with individual investors and other
organisations by offering attractive returns, minimum risk, high safety and prompt
liquidity. Investors and organisations desirous of placing their funds with these mutual
funds would like to know the comparative performance of each so as to select the best
mutual fund or investment company. For this, evaluation of the performance of mutual
funds and their portfolios becomes necessary.

Evaluation of Groups:
As academics or researchers, we may want to evaluate the performance of a whole
group of investors and compare it with another group of investors who use different
techniques or who have different skills or access to different information.

Evaluation of Portfolio Managers:

A mutual fund or investment company usually creates different portfolios with
different objectives aimed at different sets of investors. Each such portfolio may be
entrusted to different Professional Portfolio Managers who are responsible for the
investment decisions regarding the portfolio entrusted to each of them. In such a
situation, the organisation would like to evaluate the performance of each portfolio so
as to compare the performance of the different portfolio managers.

Evaluation of Mutual Funds:

 In India, at present, there are many mutual funds as also investment companies
operating both in the public sector as well as in the private sector. These compete with
each other for mobilising the investment funds with individual investors and other
organisations by offering attractive returns, minimum risk, high safety and prompt
liquidity. Investors and organisations desirous of placing their funds with these mutual
funds would like to know the comparative performance of each so as to select the best
mutual fund or investment company. For this, evaluation of the performance of mutual
funds and their portfolios becomes necessary.

Evaluation of Groups:
As academics or researchers, we may want to evaluate the performance of a whole
group of investors and compare it with another group of investors who use different
techniques or who have different skills or access to different information.

EVALUATION PERSPECTIVE
A portfolio comprises several individual securities. In the building up of the
portfolio several transactions of purchase and sale of securities take place. Thus several
transactions in several securities are needed to create and revise a portfolio of
securities. Hence the evaluation may be carried out from different perspectives or
viewpoints such as a transactions view, security view or portfolio view.

Transaction View:
An investor may attempt to evaluate every transaction of purchase and sale of
securities. Whenever a security is bought or sold, the transaction is evaluated as regards
its correctness and profitability.

Security View:
Each security included in the portfolio has been purchased at a particular price. At the
end of the holding period, the market price of the security may be higher or lower than
its cost price or purchase price. Further, during the holding period, interest or dividend
might have been received in respect of the security. Thus it may be possible to evaluate
the profitability of holding each security separately. This is evaluation from the security
view point.

Portfolio View:
A portfolio is not a simple aggregation of a random group of securities. It is a
combination of carefully selected securities, combined in a specific way so as to reduce
the risk of investment to the minimum. An investor may attempt to evaluate the
performance of the portfolio as a whole without examining the performance of
individual securities within the portfolio. This is evaluation from the portfolio view.

Though evaluation may be attempted at the transaction level, or the security level, such
evaluations would be incomplete, inadequate and often misleading. Investment is an
activity involving risk. Proper Evaluation of the investment activity must therefore
consider return along with risk involved. But risk is best defined at the portfolio level
and not at the security level or transaction level. Hence the best perspective for
evaluation is the portfolio view.

RISK ADJUSTED RETURNS

The obvious method of adjusting risk is to look at the reward per unit of the risk.
It is a known fact that investment in shares is risky. Risk free rate of interest is the
return that an investor can earn on a riskless security, i.e., without bearing any risk. The
return earned over and above the risk free rate is the risk premium that is the reward for
bearing risk. If this risk premium is divided by a measure of risk, we get the risk
premium per unit of risk. Thus the reward per unit of risk for different portfolios may
be calculated and the funds may be ranked in the descending order of the ratio. A
higher ratio indicates a better performance. The two methods to measure risk are: -

Sharpe Ratio:
It is the ratio of the reward or risk premium to the variability of return or risk as
measured by the variance of the return.

Treynor Ratio:
It is the ratio of reward to the volatility of return as measured by the portfolio beta.

Portfolio Evaluation completes the cycle of activities comprising portfolio

management. It provides a mechanism for identifying weakness in the investment
process and for improving the deficient areas. Thus portfolio evaluation would serve as
a feedback mechanism for improving the portfolio management process.

PORTFOLIO REVISION

In portfolio management, the maximum emphasis is placed on portfolio analysis

and selection which lads to the construction of the optimal portfolio. Very little
discussion is seen on portfolio revision which is as important as portfolio analysis or
selection.
The financial markets are continually changing. In this dynamic environment, a portfolio
that was optimal when constructed may not be so with the passage of time. It may have to
be revised periodically so as to ensure that it remains optimal.

NEED FOR REVISION

The primary factor necessitating portfolio revision is changes in the financial
markets since the creation of the portfolio. The need for portfolio revision may arise
because of some investor related factors also. These factors may be listed as:
• Availability of additional funds for investment.
• Change in risk tolerance
• Change in investment goals
• Need to liquidate a part of the portfolio to provide funds for some alternative use.
The portfolio needs to be revised to accommodate the changes in the investor’s position.
Thus the need for portfolio revision may arise from changes in the financial market or
changes in the investor’s position, namely, his financial status and preferences.
.

MEANING OF PORTFOLIO REVISION

A portfolio is a mix of securities selected from a vast universe of securities. Two
variables determine the composition of a portfolio; the first is the securities included in
the portfolio and the second is the proportion of total funds invested in each security
Portfolio revision involves changing the existing mix of securities. This may be effected
either by changing the securities currently included in the portfolio or by altering the
proportion of funds invested in the securities. New securities may be added to the
portfolio or some of the existing securities may be removed from the portfolio. Portfolio
revision thus leads to the purchases and sales of the securities. The objective of portfolio
revision is the same as selection i.e. maximization of returns for a given level of risk or
minimizing the risk for a given level of return. The ultimate aim of portfolio revision is
maximization of returns and minimization of risk.

CONSTRAINTS IN PORTFOLIO REVISION

Portfolio revision is the process of adjusting the existing portfolio in accordance
with the changes in the financial markets and the investor’s position so as to ensure
maximum return from the portfolio with the minimum of risk. Portfolio revision
necessitates purchase and sale of securities. The practice of portfolio adjustment
involving purchase and sale of securities gives rise to certain problems which act as
constraints in portfolio revision. Some of these are discussed below:

• Transaction cost: Buying and selling of securities involve transaction costs such
as commission and brokerage. Frequent buying and selling of securities for
portfolio revision may push up transaction costs thereby reducing the gains from
portfolio revision. Hence, the transaction costs involved in portfolio revision may
act as a constraint to timely revision of portfolios.
 • Taxes: Tax is payable on the capital gains arising from sale of securities. Usually,
long-term capital gains are taxed at a lower rate than short-term capital gains. To
qualify as long-term capital gain, a security must be held by an investor for a
period of not less than 12 months before sale. Frequent sale of securities in the
course of periodic portfolio revision or adjustment will result in short-term capital
gains, which would be taxed at a higher rate compared to long-term capital gains.
The higher tax of short-term capital gains may act as a constraint to frequent
portfolio revisions.
• Statutory stipulations: The large portfolios in every country are managed by
investment companies and mutual funds. These institutional investors are
normally governed by certain statutory stipulations regarding their investment
activity. These stipulations often act as constraints in timely portfolio revision.

• Intrinsic difficulty: Portfolio revision is a difficult and a time consuming

exercise. The methodology to be followed for portfolio revision is also not clearly
established. Different approaches may be adopted for the purpose. The difficulty
of carrying out portfolio revision itself may act as a constraint to portfolio
revision.

PORTFOLIO REVISION STRATEGIES

Two different strategies may be adopted for portfolio revision, namely, an active
revision strategy and a passive revision strategy. The choice of the strategy would
depend on the investors objectives, skills, resources and time.
Active revision strategy involves frequent and sometimes substantial adjustments
to the portfolio. Investors who take active revision strategy believe that the securities
markets are not continuously efficient. They believe that the securities can be mispriced
at times giving an opportunity for earning excess returns through trading in them.
Moreover, they believe that different investors have divergent expectations regarding the
risk and return of the securities in the market. The practitioners of the active revision
strategy are confident of developing a better estimate of the true risk and return of the
security than the rest of the market. They hope to use their better estimated to generate
excess returns. Thus the objective of active revision strategy is to beat the market.
Portfolio revision strategy, in contrast, involves only minor and infrequent
adjustments to the portfolio over time. The practitioners of passive revision strategy
believe in market efficiency and homogeneity of expectation among investors. They find
little incentive for actively trading and revising portfolios practically.
Under passive revision strategy, adjustment to the portfolio is carried out according to
certain predetermined rules and procedures designated as Formula Plans. These Formula
Plans help the investor to adjust his portfolio according to changes in the securities
market.

FORMULA PLANS:
In the market the prices of securities fluctuate. Ideally, investors should buy when prices
are low and sell when prices are high. If portfolio revision is done according to this
principle, investors would be able to benefit from the price fluctuations in the securities
market. But investors are hesitant to buy when prices are low either expecting the prices
to fall further or fearing that the prices would not move further up again. Similarly, when
prices are high, investors hesitate to sell because they feel that the prices will fall further
and they may realize larger profits.
Thus, left to themselves, investors will not be acting in a way required to benefit
from price fluctuations. Hence certain mechanical revision techniques have been
developed to enable the investor to take advantage of the price fluctuations in the market.
The technique is referred as Formula Plans.
Formula plans represent an attempt to exploit the price fluctuations in the market
and make them a source of profit to the investor. They make the decisions on the timing
of buying and selling securities automatically and eliminate the emotions surrounding the
timing decisions. Formula plans consist of predetermined rules regarding when to buy or
sell and how much to buy and sell. These predetermined rules call for specific actions
when there are changes in the securities market.
aggressive portfolio constant, i.e. at the original amount invested in the aggressive
portfolio.
As share prices fluctuate, the value of the aggressive portfolio keeps changing. When
share prices are increasing, the total value of the aggressive portfolio increases. The
investor has to sell some of his shares from his portfolio to bring down the total value of
the aggressive portfolio to the level of his original investment in it. The sale proceeds will
be invested I the defensive portfolio by buying bonds and debentures
On the contrary, when share prices are falling, the total value of the aggressive portfolio
would also decline. To keep the total value of the aggressive portfolio at its original level,
the investor has to buy some shares from the market to be included in his portfolio. For
this purpose, a part of the defensive portfolio will be liquidated to raise the money needed
to buy additional shares.

Under this plan, the investor is effectively transferring funds from the aggressive
portfolio to the defensive portfolio and thereby booking profit when share prices are
increasing. Funds are transferred from the defensive portfolio to the aggressive portfolio
when share prices are low. Thus the plan helps the investor to buy shares when their
prices are low and sell them when their prices are high.

In order to implement this plan, the investor has to decide the action points, i.e., when he
should make the transfer of funds to keep the rupee value of the aggressive portfolio
constant. These action points, or revision points, should be predetermined and should be
chosen carefully. The revision points have a significant effect on the returns of the
investor. For instance, the revision points may be predetermined as 10 per cent, 15 per
cent, 20 per cent etc. above or below the original investment in the aggressive portfolio.
If the revision points are too close, the number of transactions would be more and the
transaction costs would increase reducing the benefits of revision. If the revision points
are set too far apart, it may not be possible to profit from the price fluctuations occurring
between these revision points.
 There are different formula plans for implementing passive portfolio revision.
Some of them are enumerated below: -
Constant Rupee Value Plan:
This is one of the most commonly used formula plans. In this plan the investor constructs
two portfolios, one aggressive consisting of equity shares and the other one defensive
consisting of bonds and debentures. The purpose of this plan is to keep the value of the
Example: We can understand the working of the “constant rupee value plan” by
considering an example. Let us consider an investor who has Rs. 1,00,000 for investment.
He decides to invest Rs. 50,000 in an aggressive portfolio of equity shares and the
remaining Rs. 50,000 in a defensive portfolio of bonds and debentures. He purchases
1250 shares selling at Rs. 40 per share for his aggressive portfolio. The revision points
are fixed as 20 per cent above or below the original investment of Rs. 50,000.

After the construction of the portfolios, the share price will fluctuate. If the price of the
share increases to Rs. 45, the value of the aggressive portfolio increases to Rs. 56,250
(that is, 1250 x Rs. 45). Since the revision points are fixed at 20 per cent above or below
the original investment, the investor will act only when the value of the aggressive
portfolio increases to Rs. 60,000 or falls to Rs. 40,000. If the price of the share increases
to Rs. 48 or above, the value of the aggressive portfolio will exceed Rs. 60,000. Let us
suppose that the price of the share increases to Rs. 50, the value of the aggressive
portfolio will be Rs. 62,500. The investor will sell shares worth Rs. 12,500 (that is 250
shares at Rs. 50 per share) and transfer the amount to the defensive portfolio by buying
bonds for Rs. 12,500. The value of the aggressive and defensive portfolios would now be
Rs. 50,000 and Rs. 62,500 respectively. The aggressive portfolio now has only 1000
shares valued at Rs. 50 per share.

Let us now suppose that the share price falls to Rs. 40 per share. The value of the
aggressive portfolio would then be Rs. 40,000 (i.e., 1000 shares x Rs. 40) which is 20 per
cent less than the original investment. The investor now has to buy shares worth Rs.
10,000 (that is, 250 shares at Rs. 40 per share) to bring the value of the aggressive
portfolio to its original level of Rs. 50,000. The money required for buying the shares will
be raised by selling bonds from the defensive portfolio.

The two portfolios now will have values of Rs. 50,000 (aggressive) and Rs. 52,500 (i.e.,
Rs. 62,500 - Rs. 10,000) (defensive), aggregating to Rs. 1,02,500. It may be recalled that
the investor started with Rs. 1,00,000 as investment in the two portfolios. Thus, when the
`constant rupee value plan' is being implemented, funds will be transferred from one
portfolio to the other, whenever the value of the aggressive portfolio increases or declines
to the predetermined levels.

Constant Ratio Plan

This is a variation of the constant rupee value plan. Here again the investor would
construct two portfolios, one aggressive and the other defensive with his investment
funds. The ratio between the investments in the aggressive portfolio and the defensive
portfolio would be predetermined such as 1:1 or 1.5:1 etc. The purpose of this plan is to
keep this ratio constant by readjusting the two portfolios when share prices fluctuate from
time to time. For this purpose, a revision point will also have to be predetermined. The
revision points may be fixed as ± 0.10 for example. This means that when the ratio
between the values of the aggressive portfolio and the defensive portfolio moves up by
0.10 points or moves down by 0.10 points, the portfolios would be adjusted by transfer of
funds from one to the other.

Let us assume that an investor starts with Rs. 20,000, investing Rs. 10,000 each in the
aggressive portfolio and the defensive portfolio. The initial ratio is then 1:1. He has
predetermined the revision points as ± 0.20. As share price increases the value of the
aggressive portfolio would rise. When the value of the aggressive portfolio rises to Rs.
12,000, the ratio becomes 1.2:1 (i.e., Rs. 12,000: Rs. 10,000). Shares worth Rs. 1,000 will
be sold and the amount transferred to the defensive portfolio by buying bonds. Now the
value of both the portfolios would be Rs. 11,000 and the ratio would become 1:1.
Now let us assume that the share prices are falling. The value of the aggressive portfolio
would start declining. If, for instance, the value declines to Rs. 8,500, the ratio becomes
0.77:1 (i.e., Rs. 8.500: Rs. 1,000). The ratio has declined by more than 0.20 points. The
investor now has to make the value of both portfolios equal. He has to buy shares worth
Rs. 1,250 by selling bonds for an equivalent amount from his defensive portfolio. Now
the value of the aggressive portfolio increases by Rs. 1.250 and that of the defensive
portfolio decreases by Rs. 1,250. The values of both portfolios become Rs. 9,750 and the
ratio becomes 1:1.The adjustment of portfolios is done periodically in this manner.
Dollar Cost Averaging
This is another method of passive portfolio revision. This is, however, different from the
two Formula Plans discussed above. All Formula Plans assume that stock prices fluctuate
up and down in cycles. Dollar cost averaging utilizes this cyclic movement in share
prices to construct a portfolio at low cost.

The Plan stipulates that the investor invest a constant sum, such as Rs. 5,000, Rs. 10,000,
etc, in a specified share or portfolio of shares regularly at periodical intervals, such as a
month, two months, a quarter, etc. regardless of the price of the shares at the time of
investment. This periodic investment is to be continued over a fairly long period to cover
a complete cycle of share price movements.

If the Plan is implemented over a complete cycle of stock prices, the investor will obtain
his shares at a lower average cost per share than the average price prevailing in the
market over the period. This occurs because more shares would be purchased at lower
prices than at higher prices.

The Dollar Cost Averaging is really a technique of building up a portfolio over a period
of time. The Plan does not envisage withdrawal of funds from the portfolio in between.
When a large portfolio has been built up over a complete cycle of share price movements,
the investor may switch over to one of the other formula plans for its subsequent revision.
The “dollar cost averaging” is specially suited to investors who have periodic sums to
invest.
The various formula plans attempt to make portfolio revision a simple and almost
mechanical exercise enabling the investor to automatically buy shares when their prices
are low and sell them when their prices are high. But formula plans have their limitations.
By their very nature they are inflexible. Further, these plans do not indicate which
securities from the portfolio are to be sold and which securities are to be bought to be
included in the portfolio. Only active portfolio revision can provide answers to these
questions
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