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Management
Doc. Nguyen Dinh Dat
What is Portfolio Management?
Portfolio management is the art of selecting the best investment mix in
the right proportion and continuously shifting them in the portfolio to
increase the return on the investment and maximize the wealth of the
investors. Here, portfolio refers to a range of financial products such as
stocks, bonds, mutual funds and so forth that are held by the investors.
The content
• A portfolio perspective on investing
• Investment clients
• Pooled investments
1. Portfolio perspective or
Portfolio approach.
• It refers to evaluating individual investment by contribution to the risk
and return of an investor’s portfolio.
Portfolio Approach
• Example:
X
Why do we need a portfolio
diversification?
Why do we need a portfolio
diversification?
- Portfolio diversification helps investors avoid disastrous investment
outcomes.
X
-Portfolio diversification can also help investors reduce risk.
X Y Z
Note: The overall risk of this portfolio is going to be less than the risk of
holding a single stock. This is called a diversification benefit.
Diversification ratio
•
Example:
Three stocks and each of them has the standard deviation of return is 15% (the
standard deviation of returns as a measure of risk). The standard deviation of return for
the overall portfolio is 10%.
The reason why the standard deviation of return for the overall portfolio is lower than
the standard deviation of return for one single stock is because the movement of these
stocks is not all necessarily in the same direction. So, because of diversification, the
overall risk is a little less.
Diversification ratio
• Notice:
A lower the ratio is the better because the lower ratio is showing a
lower risk of portfolio as a result of higher degree of diversification.
Does portfolio diversification always
protect your investor wealth?
No, Portfolio diversification does not offer proper protection of risk
especially during the financial crisis where all the assets might lose
their values.
2. Types of investors
Time
Investors Risk Tolerance Income Needs Liquidity Needs
Horizon
Individuals Vary Vary Vary Vary
DB pensions Long High Depends on age Low
Banks Short Low Pay interest High
Endowments Long High Spending level Low
Long-life
Insurance Low Low High
Short-P&C
Mutual funds Vary Vary Vary High
3.Steps in the portfolio
management process
• To interpret the clients 'needs
• To come up with IPS (investment policy statement)
Planning
• To monitor and rebalance the portfolio to match with benchmark portfolio identified
Feedback
A top-down analysis and bottom-up
security analysis
• As a top-down analysis, a portfolio manager will examine current
economic conditions and forecasts of such macroeconomic variables
as GDP growth, inflation,… to identify the most attractive asset classes
and to invest in.
• Bottom-up securities analysis, security analysts use model valuations
for securities to identify those that appear undervalued and invest in
them.
4. The pooled investment
The definition of the pooled investment as the way of putting sums of
money from many investors into a large fund spread across many
investment and managed by professional.
Main forms of pooled
investment
Investment project Minimum investment
Mutual funds Small amount of money
Exchange traded funds Small amount of money
Separately Managed Accounts Medium amount of money
Hedge funds Large amount of money
Private Equity Funds Large amount of money
Venture capital funds Large amount of money
Mutual fund
Mutual fund is single portfolio that contain investment funds from
multiple investors. Each investor owns shares representing ownership
of a portion of the overall portfolio.
Example:
Investor Amount invested % of total Number of shares
($)
• Index mutual fund will invest in shares that are in a particular index such
as the S&P 500.
Exchange Traded Funds
• What Is an ETF?
• With closed end funds, the market price of shares can differ significantly from their
NAV whereas ETFs are designed to keep their market prices very close to their NAVs.
• Fees for ETF shares tend to be low relative to mutual funds but a brokerage fee
needs to be paid unlike mutual funds.
A separately managed account
• A separately managed account is a portfolio that is owned by a single
investor and the portfolio manager managed account on behalf of
that investor’s needs and preference. No shares are issued, as the
single investors owns the entire account.
Hedge funds
Hedge funds are limited in the number of investors who are wealthy
and qualified.
• Portfolio risk
Return can come in two forms either capital gains when your
purchased asset increase in value with time or the income you receive
from interest payments of dividends.
Holding period return (HPR)
• It is simply the percentage increase in the value of an investment over
a given time period:
•Investor A bought a stock with price of $10. After one year, the price of
this stock went up to $15 and during this time, A received $1 in
dividend from this stock. Calculate the Holding period return?
Use the calculator, you can easily get the result for IRR equal to 24%.
Annualized return
Annualized return = - 1
Example:
•Investor A receive 1% return over 25 days. What is annualized return
rate of the investment?
Expected Return=WA×RA+WB×RB+WC×RC
where:
WA = Weight of security A
RA = Expected return of security A
WB = Weight of security B
RB = Expected return of security B
WC = Weight of security C
RC = Expected return of security C
Other return measures
Gross Gross return refers to the total return on a For example, a portfolio
return security portfolio prior to deducting manager earn for investor
management fees and taxes 20% return at the first place.
The gross return will be:
20%
Net return Net return refers to the return after deducting In this case is 2%, therefore
management fees the net return will be
20%-2% = 18%
Pre-tax nominal Pre-tax nominal return is the return before So Pre-tax nomital return is
return paying taxes 18%
After tax Is return after tax liability is deducted Let say, it is 30%. As the
nominal return result, after tax nominal
return will be
18%(1-0.3)= 12.6%
Real return is the nominal return adjusted for inflation In this case, the inflation is
3%.
Real return will be
12.6%- 3% = 9.6%
Variance (standard deviation) for returns for an
individual security
• The variance is a measure of the volatility of the asset returns. The
returns fluctuate significantly over the period of time. That means the
risk related to the asset is high.
Formulas to calculate variance
where:
=
Portfolio expected return and
variance
•We have a formula for calculating portfolio expected return:
E() = +
Expected return(R)
-----------------------------
18%
15% --------------------
12% 20%
The characteristics of major
assets
Asset class
classes
Annual average return Standard deviation
(Geometric mean)
• Utility theory
• Indifference curves
X Y
X Y
X Y
where:
E(r) is the expected return of an investment
A is a measure of risk aversion.
is a measure of risk of the investment.
Notice: when using this formula is that you must do all calculations in decimals.
So if the data given is in percent, you must convert it into decimal beforehand.
Example:
•Investor X has the risk aversion of 2 and owns a risk-free asset returning
5%. What is the utility of X’s investment?
E(r)= 0.06
Risk
0 0.1
Indifference curves
Expected return
The line which connects all the points where
0.05
the investor has the same level of satisfaction
or Utility is called indifference curve. This is
the indifference curve for the investor X where
the level of utility is 0.05
0.06
The indifference curve tells us the different risk
and return numbers at which the investor is
0.05
equally happy.
Risk
0 0.1
Indifference curves
Expected return
0.06 0.05
Risk
0 0.1. 0.2
Does the investors seem to be happier with higher utility?
Expected return
0.06 0.05
0.06
0.05
Risk
0 0.1. 0.2
Types of indifference curves
Expected return
A risk-averse
Risk Neutral
Risk-seeking
Risk
3. Application of Utility theory to
portfolio selection:
Utility function is an effective tool that helps portfolio managers to
make good decisions in portfolio selection.
Capital Allocation Line (CAL)
•Example:
We have a portfolio of two assets including:
- A risk-free asset (σ = 0 ) a= 5%
- A risky asset with = 10% and σ = 20%.
• To calculate the risk and return of the portfolio when adjusting the
proportion of the portfolio invested in Asset 2 from 0 to 100%.
Portfolio expected return and
variance
We
• have a formula for calculating portfolio expected return:
E() = +
• = =
Expected return
0% 0 5%
25 % 5% 6.25%
50 % 10% 7.5%
5%
Where is the the investor’s Optimal portfolio? Or Where will the investor X be the most satisfied?
5%
Content
• Risk and return for different values of
Correlation measures the linear relationship between two variables with values ranging between -1
and +1.
When the correlation equal to 1 means that there is perfect positive correlation between two variables,
they move up and down together. Therefore, there is no diversification benefit.
Diversification benefit which means that the overall risk of the portfolio is going to be less than the risk
of holding a single stock as the stocks in the portfolio tend to have different movements.
If correlation decrease, the standard deviation will decrease or the risk of the portfolio decreases and the
diversification benefit increase.
Risk and Return for Different Values
of
Example:
Two assets are X and Y. X has an expected return of 12% and a standard
deviation of 16%. Y has an expected return of 20% and a standard
deviation of 30%.
What will happen to a portfolio’s risk when = 1.
•= = *+ *
Return
Y
20%
12% X
The straight line represents the situation when the correlation of the portfolio is 1. There is no diversification benefit.
The Investor will receive higher rate of return and at the same time, higher risk.
What will happen to a portfolio’s risk
when =0.5
Return Y
20%
X
12%
Portfolio 1 Portfolio 2
The answer is yes. As long as assume homogeneity of expectations what this means
that all investors have a similar view of the market and have the same expectation
about risk and return related to every single security. In addition, they also have
similar expectation about the correlation between different securities.
A B C
Investors
The equation for the capital market
line
•The equation for a straight line is given by:
y= c + m.x
where: m is the slope of the line
c is the intercept on the y-axis
= +[ ]
Content
• Systematic and unsystematic risk
• Calculate and interpret of Beta
• Capital asset pricing model
• Security market line (SML)
• Comparing the SML and CML
• Calculate and interpret the Sharpe ratio, Treynor ratio, , Jensen’s alpha
What is risk?
In finance and investing, risk often refers to the chance an outcome or
investment's actual gains will differ from an expected outcome or
return.
30%
10%
Apple
-30%
Systematic and unsystematic
risk
What is unsystematic risk?
Unsystematic risk is unique to a specific company or industry.
For example, the death of Steve Job affected the price of Apple’ stock.
For example, instead of only investing in Apple, you could invest in a portfolio of
stocks.
What is systematic risk?
Systematic risk refers to the risk of a breakdown of an entire system
rather than simply the failure of individual parts.
= = = ()
Example
•The standard deviation of the return on the market index is estimated
as 20%.
- If asset A’ standard deviation is 30% and its correlation of returns with
the market index is 0.8. what is Asset A’s beta?
= () = 0.8 () = 1.2
- If the covariance of Asset A’s returns with the returns on the market
index is 0.048, what is the beta of Asset A?
= = = 1.2
The capital asset pricing model
(CAPM)
• CAPM is the most important models in finance. It allows us to
compute the expected returns of assets are based on systematic risk.
Example:
ABC’s standard deviation of returns is 25% and its correlation with the
market is 0.6. The standard deviation of returns for the market is 20%.
The expected market return is 10% and the risk free rate is 3%. What is
ABC’s expected return?
•= */ = 0.6*0.25/0.2 =0.75
= + ()
= 0.03 + 0.75(0.1-0.03) = 0.0825 = 8.25%.
CAMP is the most important models in finance and they are several applications:
• To estimate the price of an asset, the future cash flows can be discounted at
the CAPM rate.
• The CAPM rate is also used in the capital budgeting process in corporate
finance.
Example:
ABC’s cash flow from operations is $500 million at the end of the first year. We
are going to assume that cash flow will grow at a rate of just 15% for the next 10
years.
The beta of the stock is 1.2, the risk free rate is 6% and market risk premium 5%.
The number of shares outstanding is 1,068.7 millions.
The price of the stock is $3.2.
P = PV(12%,10,B2:K2) =3,249
Price per share: $3.04 < Current Price
Security market line
y= b+ a*x
Comparing the CML and the SML
- Notice that with CML/ we considered the
total risk/ whereas with the SML, we are
considering only systematic risk.
This Treynor deals with the limit of Sharpe ratio. It uses the systematic
risk. However, it is not informative enough itself.
M squared
•= - ) - - )
- M squared gives similar rakings to the Sharpe ratio. Both M squared
and Sharpe ratio use total risk.
- The benefit of this measure over the Sharpe ratio is that it get a
number which has meaning.
Jensen’s alpha
Jensen’s alpha is simply the return on a portfolio minus the return
predicted by CAMP.
For example: the return on the portfolio is equal to 15% and the number predicted by CAMP is
12%. Calculate the Jensen’s alpha and explain the result?
Chapter 3: Basic of portfolio planning and construction
Content
• Portfolio planning
• Asset allocation
• Security analysis
Execution • Portfolio construction
• Ability to take risk is based on financial factors such as wealth, time horizon, expected
income…
• The willingness to take risk is related to a client’s psychology, such as personality type and
level of financial knowledge.
For example, the client has bad experience (lost a lot of money) from his previous
investment that will impact his psychology to some extent which will impact his willingness
to take risk.
Notice that: Every client will have a somewhat different risk tolerance. It is
extremely important to specify the risk tolerance in the IPS.
Example: Risk tolerance
Client A Client B
Age: 35 Age: 40
Has high salary Has income volatility
Fairly secures jobs Has to pay mortgage monthly
Owns house Is a single mother
Client A’s ability to take risk: Client B’s ability to take risk:
Has knowledge about the financial market Has been working in financial market 15 years
Client A’s willing to take risk: Client B’ willing to take risk:
Client A’s risk tolerance: Client B’s risk tolerance:
Return objectives
• Notice that:
- Return requirement can be stated before and after fees but it should be
very clear how the fees will be calculated.
- The stated risk and return must be compatible. It would not make sense
that the risk tolerance is low but clients are seeking a relatively high return.
The example below to compute the return
objective
• The example above, this money is being invested for 30 years and
then the money will be taken out at the end of 30 years. For this
particular portfolio, the time horizon is long.
• Liquidity – the liquidity constraints must also be specified in the IPS.
This tell us about any constraints or requirements to withdrawing funds
from the portfolio.
• For example: if you have a client who need to withdraw some funds to
pay for his child’ university ’fee after 3 years that would be specified
under a liquidity requirement.
• Notice: You are not sure about how much will be taken out and when it
will be taken out. In this case, the liquidity requirement is relatively
uncertain. Therefore, the liquidity requirement is relatively high then
the portfolio should be invested in relatively liquid securities (bonds,
stocks)
Legal and regulatory
requirements
• Legal and regulatory requirements – Constraints such as government
restrictions on portfolio contents or laws against insider trading.
Tax concerns
• Tax concerns - this deals with the tax status or the tax situation of a
client which must be specified in the IPS.
• For example, in some countries, there are very high taxes on the
dividend income then it makes sense to create a portfolio of stocks
that pay relatively low dividends.
Unique circumstances
• Restriction due to investor preferences (religious, ethical, etc.) or
other factors not already considered.
• For example: if you have a client who does not want to invest in
companies that deal with alcohol, tobacco and firearms that needs to
be specified under unique circumstances.
Gathering client information
• Active investing means that investors are actively looking for stocks
that are undervalues.
Investment approach
The core satellite approach what means is investors divide their
portfolio into two parts. The core part and a satellite.
The core part: where investors put most of this money in some sort of
index fund so they are taking only systematic risk.
Example: The two companies A and B have highly correlated return. It can be grouped
them together.
• Limitations:
- One limitation is just because of industry A and B are correlated in the past. They do not
mean they are correlated in the future.
• Another limitation is they might not economic explanation A and B are grouped together.
What is a peer group?
• A peer group is a set of similar companies and analyst will use for
valuation comparisons.
• A peer group will consist of companies with similar business activities,
demand drivers, cost structure drivers, and availability of capital.
• For example: When analyzing McDonald, we need to compare with its
peer group like KFC, Burger King…
The elements that need to be covered in a
thorough industry analysis
• Industries with low barriers to entry, firms have little pricing power
and competition reduces existing firm’s return on capital.
Barriers to entry is high and
barriers to exit is high
• The industries have both barriers to entry and barriers to exit are high
then there is big chance of price war between companies. It is
because the companies tried to minimize the total costs by producing
as many cars as possible.
• If the companies are over-producing then the set price-war then price
come down.
• Having both high barriers then the pricing power is going down.
Capacity
• In industries where is under capacity, there will be high pricing power.
The demand is high relative to supply and then the companies in this
industry can set high pricing.
• On the other hand, there are lot of capacity, there will be higher
supply than the demand therefore, the industry has low pricing
power.
Strategic analysis of industry
Equity valuation
Market value and Intrinsic value (fundamental value).
• The market value of a stock is simply the value at which it is selling in
the stock market.
• In finance, intrinsic value refers to the value of a stock determined
through fundamental analysis without reference to its market value.
• Notice: if the intrinsic value is much more than the current market
value then it would be logical to buy this share and if the intrinsic value
is less then you should either sell or go short.
Equity Valuation Models
PV = + = $100
Divided Discount Model
• Constant dividend for ever
Example: an investor invest in a stock that pay a constant dividend of
$10. The cost of equity is equal to 10%. What is the value of this stock?
PV = = $100
Divided Discount Model
• Constant growth
Example: An investor invested in stock that pay dividend at time zero is $10
and this dividend is growing at 2% constantly. The cost of equity is 10%. What
is the value of the stock?
PV = = = = 127.5
10 12 14.1 17.28
= = = 216
PV = + = $201
Free Cash Flow to Equity.
The P/E ratio represents how much a share is worth per dollar of earnings
Price multiples
• Historical or trailing multiples:
The earnings for the last 12 months or trailing 12 months.
• Forward or leading multiples:
The earnings for the next 12 months.
Using price multiples to evaluate
equity
You are trying to evaluate a company that just went public. The leading
P/E ratio in that industry is 5. This company is very much like the
industry in which it is operating. Expected or forecasted earnings for
this company is equal to $7 per share. To estimate price of this
company.
P = 5*7 = $35
Price multiples used for
valuation include:
• Price-earnings (P/E) ratio: The P/E ratio is a firm's stock price divided by
earnings per share.
• Price-sales (P/S) ratio: The P/S ratio is a firm's stock price divided by sales per
share.
• Price-book value (P/B) ratio: The P/B ratio is a firm's stock price divided by
book value of equity per share
• Price-cash ow (P/CF) ratio: The P.CF ratio is a firm's stock price divided by
cash flow per share, where cash flow may be defined as operating cash flow
or free cash flow.
Multiples based on fundamenatals
•Justified P/E
P=
= =
Example: A company has playout ratio is 60%. Cost of capital is 12%
and growth rate is 2%. To estimate Justified P/E
Justified P/E = 0.6/012-0.02 = 6
This EV/EBITDA ratio is telling us how much does the value enterprise
have per dollar of EBITDA.
Asset-based models
• Value equity = the market or fair value of assets - liabilities.
These models are most appropriate when a firm's assets are largely
tangible and have fair values that can be established easily.