3CWEALTHPLANNINGANDMANAGEMENTLectureNo 5

WEALTH PLANNING AND
MANAGEMENT
LECTURE No. 5
WEALTH ALLOCATION PROCESS
(Part III)
CONTENTS
Identifying Risks and Constraints
Introduction to risk tools
Portfolio performance evaluation
Ways of measuring returns
Ways of adjusting returns for risks
Ways of reporting and presenting performance
Potential Investment Channel
Structured products
Summary
References
2
Identifying risks and constraints
Introduction to risk tools:
One of the key principles in building a portfolio of
investments (stocks, bonds, mutual funds, ETFs,
cash, etc) is managing the amount of risk you're
willing to take. Risk is a difficult thing to measure,
but, a number of tools are available to measure
risks.
The first modern risk measurement tool was
introduced decades ago, having developed
through the work of Markotwiz and Sharpe.

3
Identifying risks and constraints
(Contd)
Introduction to risk tools (Contd)
The Treynor measure considers the excess return
earned per unit of systematic risk
The Sharpe measure indicates the excess return per
unit of standard deviation
Jensen and Information ratio measures evaluate
performance in terms of the systematic risk involved.
Value at Risk (VAR) focuses on holdings currently in
the portfolio and has a way of decomposing risk
characteristics of complex securities such as
convertibles and derivatives

4
Portfolio Performance Evaluation
Portfolio managers are required to meet 3
major requirements in discharging their
duties:
1. Meet objectives spelled out in the clients
investment policy statement
2 Earn superior returns for each given risk
class
3 Achieve portfolio diversification to
eliminate unsystematic (diversifiable) risks

5
(Contd)
Historically, the focus in the asset management
industry has been on returns. Performance
evaluation should not focus on returns alone. It
should give due recognition to both returns and
the riskiness of the investments.
Superior performance can be achieved by either
superior security selection or superior timing.
From the perspective of asset allocation, this can
be thought of in terms of superior asset
allocation strategies, such as tactical asset
allocation.
6
(Contd)
Performance in terms of returns can be
thought of in two ways. First, it can be
thought of in absolute terms i.e., how much
money was made or lost. Second, it can be
measured in relative terms i.e., compared
against a bogey or benchmark, or against the
average returns for similar investment
products, or against a peer group or universe
comparison.

7
(Contd)
Ways of Measuring Returns
1. Dollar-Weighted Returns
This simple format takes the difference between the beginning and end
values of the portfolio and divides it by the beginning value. The answer
in decimal form is then converted into percentage form by multiplying it
by 100:
Dollar Weighted Return (%)= (End Value Beginning Value ) x100
Beginning Value
All dividends or other forms of distribution received in the interim period
are included in the end value of the portfolio.

8
(Contd)
2. Chain-Linked Returns
This step is necessary to establish the compound return for
an investment held over several investment periods during
which returns for each period were calculated using the
Dollar Weighted Returns method described above.
Chain-Linked Returns = [ (1+ PR
1
) x (1 + PR
2
) + (1 + PR
3
)
x x (1+PR
n
)] 1
Where PR is the decimal form return for the respective
periods 1, 2, 3,..n
The periods need not be of equal lengths of time. For
example, PR1 may be the return for a 1-month period and
PR2 in respect of period 2 may be for a period of 6 months.

9
10
Year Return Return
(Decimal)
Return
(%)
Cumulative return Formula Cumulative
Return
1 R1 0.1 10% R1 10.0%
2 R2 0.091 9.1% (1+R1) (1+R2) 1 20.0%
3 R2 0.034 3.4% (1+R1) (1+R2) (1+R3) 1 24.1%
4 R4 0.12 12.0% (1+R1) (1+R2) (1+R3) (1+R4) - 1 39.0%
5 R5 0.23 23.0% (1+R1) (1+R2) (1+R3) (1+R4) (1+R5) - 1 70.9%
3. Cumulative Returns
The cumulative return is simply specified by chain-linking the total
returns up to the previous period to the next periods return as
illustrated below (Table 3.12 and table 3.13):

Table 3.12
(Contd)
(Contd)
Applying the chain-linked returns concept allows
us to spell out the cumulative returns for an
investment. This information can be relayed to
the investor in 2 ways (Figure 3.13):
Actual growth in absolute Ringgit terms - use the
returns to show how one Ringgit in value of the
original investment would have grown over the period
reviewed
Displaying the cumulative percentage return over
time. By this means, we can display the end value
return expressed as a percentage of the initial
investment.

11
12
Table 3.13 Cumulative Returns Over a 5-Year Period

(Contd)

Year Return Return
(Decimal)
Return
(%)
Cumulative return Formula Cumulative
Return
$
Growth
1 R1 0.1 10% R1 10.0% .100
2 R2 0.091 9.1% (1+R1) (1+R2) 1 20.0% .200
3 R2 0.034 3.4% (1+R1) (1+R2) (1+R3) 1 24.1% .241
4 R4 0.12 12.0% (1+R1) (1+R2) (1+R3) (1+R4) - 1 39.0% .390
5 R5 0.23 23.0% (1+R1) (1+R2) (1+R3) (1+R4)
(1+R5) - 1
70.9% .709
13
MYR 1.00
MYR 1.10
MYR 1.20
MYR 1.30
MYR 1.40
MYR 1.50
MYR 1.60
MYR 1.70
MYR 1.80
0 1 2 3 4 5
D
o
l
l
a
r

G
r
o
w
t
h
Year
Cumulative Growth of MYR 1
Figure 3.13 Dollar Growth Presentation in Absolute Ringgit Terms

14
Cumulative Return Chart
0%
10%
20%
30%
40%
50%
60%
70%
80%
0 1 2 3 4 5
R
e
t
u
r
n
Year
(Contd)
4.Annualised Time-Weighted Returns
The returns for a period shorter than one year may be
expressed in annualized return form. Also, the absolute
return over a number of years may be averaged over the
period to arrive at annualised returns. Simply averaging
the cumulative returns over the number of years will yield
misleading results. Instead, the best results are yielded by
geometric average returns derived by taking the n
th
root of
the return relative in decimal form arrived at by dividing
the end of period portfolio value less interim cash inflows
by beginning value of the portfolio, then subtracting 1.00
from it, where n is the number of years the original
portfolio has been invested.

15
(Contd)
16
1 Return) Dollar Cumulative (1
n
+
Annualised Return =
Using the preceding numerical example of cumulative
dollar returns for 5 years expressed in decimal form and
computed on the original investment,

17
1 ) 709 . 0 (1
5
+
Annualised
Return
=
=

11.32%
(Contd)
(Contd)
5. Simple Cash-flow Adjusted Returns
Where there are interim cash-flows, cash- flow
adjusted Dollar weighted returns (CFADWR)
can be calculated
CFADWR = [End Market Value Beginning
Market Value Net Interim Cash Inflows]
[Beginning Market Value + Net Interim Cash
Inflows]

18
(Contd)
This method takes no cognisance of the timing
of the cash flows within the period invested.
As a result, it is more accurate only if the
interim cash flows occur in the early part of
the investment period. More accurate
formulae incorporating the timing of interim
cash flows are discussed below.

19
(Contd)
6. Time-Weighted Return Approach
The first form of the time-adjusted cash flow method
we look at is the Daily Valuation Approach to
determining the Time-Weighted Return. In this
approach, the portfolio is valued at the end of the
business day before each interim cash flow occurs and
accrued income is included in the value of the
portfolio. The return for the period between initial
investment and the day before the first interim cash
flow is derived. This process is repeated for the period
between the first interim cash flow and the day before
the second interim cash flow.

20
(Contd)
Time-Weighted Return
= [(1+R
1
) (1 + R
2
) ... (1 + R
n
)]
1/n
-1
However, where the interim cash flow is very large and
cannot be immediately invested in the underlying
securities, or if investment of a large sum without driving
up the prices of relatively illiquid securities is not possible,
or if the interim cash flows or payouts are fixed by
contractual agreements between the investment manager
and the investor (such that the investment manager is
forced to sell securities at the appointed but inopportune
point in time), valuing the portfolio on business days prior
to the interim cash flows under this approach may be
unfair.

21
(Contd)
The use of the Daily Valuation Method results in the exact
Time Weighted Returns but is extremely involved, requiring
calculating the value of the portfolio every time a cash flow
occurs, whether due to fresh funds received to be invested
or due to withdrawals. In the example tabulated below in
Table 3.14, beginning with a portfolio carried forward from
2004 valued at RM7,560.08, the portfolio receives RM100
approximately once a month from the investor, who
evidently uses the dollar cost averaging strategy. On 23
rd

March 2005, he makes a withdrawal of RM5, 000. At the
end of the period on 1
st
August 2005, the portfolio is valued
at RM5, 452.93 before the cash inflow of RM100
22
(Contd)
The beginning market value (MVB) is always
based on the number of shares immediately prior
to the inflow/outflow of cash in the current
period. The MVE is the number of shares owned
at the end of the previous period (which is the
same as the number at the end of the period
before purchases/sales resulting from cash flows)
multiplied by the price on the date of the
valuation (i.e., the date the fresh cash flows
occur). The cumulative return, derived from the
return relative in the extreme right column, is in
this example, 33.3%.

23
24
Date
Cash
flow
(RM) Reason
Price
of
Shares
(RM)
Number
of Shares
Owned
Value of
Portfolio
(RM)
MVB
(Beginning
Market
Value) (RM)
MVE (End
Market
Value) (RM)
MVE/M
VB
Cumulative
Return
Relative
1-Jan b/f 0.090 84,001 7,560.08 -
3-Jan 100.00 investment 0.090 85,112 7,660.08 7,560.08 7,560.08 1.0000
1-Feb 100.00 investment 0.095 86,165 8,185.64 7,660.08 8,085.64 1.0556 1.0556
1-Mar 100.00 investment 0.100 87,165 8,716.46 8,185.64 8,616.46 1.0526 1.1111
23-Mar
5,000.0
0 withdrawal 0.110 41,710 4,588.11 8,716.46 9,588.11 1.1000 1.2222
3-Apr 100.00 investment 0.105 42,662 4,479.56 4,588.11 4,379.56 0.9545 1.1667
1-May 100.00 investment 0.100 43,662 4,366.25 4,479.56 4,266.25 0.9524 1.1111
1-Jun 100.00 investment 0.110 44,572 4,902.87 4,366.25 4,802.87 1.1000 1.2222
1-Jul 100.00 investment 0.115 45,441 5,225.73 4,902.87 5,125.73 1.0455 1.2778
1-Aug 100.00 investment 0.120 46,274 5,552.93 5,225.73 5,452.93 1.0435 1.3333
(Contd)
An approximation that allows bypassing involved computations above is the Modified Dietz
approximation formula described below:
Modified Dietz = End Market Value Beginning Market Value Net Inflows
Beginning Market Value + ETime Weighted Cash flows
where each Time Weighted Cash flow = No. of Days Invested X Cash flow
Total No. of Days in the Period

In the example above, the returns estimated using the Modified Dietz formula are calculated
as follows:
End Market Value = 5,552.93
Beginning Market Value = 7,560.08
Total Inflows = 800.00
Total Outflows = 5,000.00

25
26
Time Weighted Cash Flows are calculated as follows
Cash flow Dated No of Days Invested Amount (RM) Time Weighted Cash flow
3-Jan 210 100.00 99.06
1-Feb 181 100.00 85.38
1-Mar 153 100.00 72.17
23-Mar 79 5,000.00 -1,863.21
3-Apr 120 100.00 56.60
1-May 92 100.00 43.40
1-Jun 61 100.00 28.77
1-Jul 31 100.00 14.62
1-Aug - 100.00 -
Total 212 -1,463.21
Table 3.15 Total No of Days During the Period: 212 days

27
Numerator
5,552.93 7,560.08 + 4,200 =
2,192.85
Denominator
7,560.08 - 1,463.21 =
6,096.87
Modified Dietz
Return = 2,192.85 / 6,096.87
= 35.97%
Table 3.16 Modified Dietz Return

Modified Dietz Return = 2,192.85 6,096.87 = 35.97%
The result of Modified Dietz Return in Table 3.16 is reasonably close
to the value of 33.33% obtained using the Daily Valuation Method.
If absolute accuracy is not required, this method allows a handy rule
of thumb computation to be made and the return estimated.

Ways of Adjusting Returns for Risks
We use the following Risk Tools
Sharpe ratio
Treynor measure
Jensens alpha
Modiglianis Square and Treynor Square
Information Ratio or Non-Systematic Risk ratio
Downside Deviation of Risk of Loss Measure
The Sortino Ratio
Value at Risk

28
Sharpe Ratio
The Sharpe ratio formula is:
SR = [E (r
p
) r
f
]/
p

Where
E (r
p
) = Expected portfolio return
r
f
= risk free rate

p
= portfolio standard
deviation
29
Sharpe Ratio (Contd)
What Does Sharpe Ratio Mean?
A ratio developed by Nobel laureate William F.
Sharpe to measure risk-adjusted
performance. The Sharpe ratio is calculated by
subtracting the risk-free rate - such as that of
the 10-year U.S. Treasury bond - from the rate of
return for a portfolio and dividing the result by
the standard deviation of the portfolio returns.

30
The Sharpe ratio tells us whether a portfolio's returns are
due to smart investment decisions or a result of excess risk.
This measurement is very useful because although one
portfolio or fund can reap higher returns than its peers, it is
only a good investment if those higher returns do not come
with too much additional risk. The greater a portfolio's
Sharpe ratio, the better its risk-adjusted performance has
been. A negative Sharpe ratio indicates that a risk-less asset
would perform better than the security being analyzed.

A variation of the Sharpe ratio is the Sortino ratio, which
removes the effects of upward price movements on
standard deviation to measure only return against
downward price volatility.
31
For example, if manager A generates a return of 15% while
manager B generates a return of 12%, it would appear that
manager A is a better performer. However, if manager A, who
produced the 15% return, took much larger risks than manager B, it
may actually be the case that manager B has a better risk-adjusted
return.

To continue with the example, say that the risk free-rate is 5%, and
manager A's portfolio has a standard deviation of 8%, while
manager B's portfolio has a standard deviation of 5%. The Sharpe
ratio for manager A would be 1.25 while manager B's ratio would
be 1.4, which is better than manager A. Based on these
calculations, manager B was able to generate a higher return on a
risk-adjusted basis.

32
To give you some insight, a ratio of 1 or better is
considered good, 2 and better is very good, and 3 and
better is considered excellent.

The Sharpe ratio is quite simple, which lends to its
popularity. It's broken down into just three
components: asset return, risk-free return and
standard deviation of return. After calculating the
excess return, it's divided by the standard deviation of
the risky asset to get its Sharpe ratio. The idea of the
ratio is to see how much additional return you are
receiving for the additional volatility of holding the
risky asset over a risk-free asset - the higher the better.
33
SHARPE RATIO
34
Eg.

B generates a higher return than A on a risk
adjusted basis.
The Sharpe ratio is an appropriate measure of
performance for an overall portfolio particularly
when it is compared to another portfolio,
40 . 1
5
5 12 ) ( (
=
=
p
rf rp E
SRB
o
Treynor Measure
The Treynor ratio (sometimes called the reward-to-
volatility ratio or Treynor measure), named after Jack
L Treynor, is a measurement of the returns earned in
excess of that which could have been earned on an
investment that has no diversifiable risk (e.g., Treasury
Bills or a completely diversified portfolio), per each unit
of market risk assumed.
The Treynor ratio relates excess return over the risk-
free rate to the additional risk taken; however,
systematic risk is used instead of total risk. The higher
the Treynor ratio, the better the performance of the
portfolio under analysis.

35
Treynor Measure (Contd)
What Does Treynor Ratio Mean?
A ratio developed by Jack Treynor that measures
returns earned in excess of that which could have
been earned on a riskless investment per each
unit of market risk.

The Treynor ratio is calculated as:

(Average Return of the Portfolio - Average Return
of the Risk-Free Rate) / Beta of the Portfolio

36
In other words, the Treynor ratio is a risk-adjusted measure of
return based on systematic risk. It is similar to the Sharpe
ratio, with the difference being that the Treynor ratio uses
beta as the measurement of volatility.
Also known as the "reward-to-volatility ratio".

Risk adjusted rate of return of Portfolio A = .043+ .09 = 13.3%

37
043 . 0
07 .
09 . 12 .
' =
=
B
=
p
Rmf Rp
s Treynor
a

In other words, the Treynor ratio is a risk-adjusted measure of
return based on systematic risk. It is similar to the Sharpe
ratio, with the difference being that the Treynor ratio uses
beta as the measurement of volatility.
Also known as the "reward-to-volatility ratio".

Risk adjusted rate of return of Portfolio A = .04+ .09 = 13%
It measures the returns earned in excess of those that could
have been earned on a riskless investment per unit of market
risk assumed.

38
04 . 0
2 . 1
09 . 14 .
' =
=
B
=
p
Rmf Rp
s Treynor
b
Beta () of a Stock or Portfolio

In finance, the Beta ) of a stock or portfolio is a number describing the
relation of its returns with that of the financial market as a whole.
An asset has a Beta of zero if its returns change independently of changes
in the market's returns. A positive beta means that the asset's returns
generally follow the market's returns, in the sense that they both tend to
be above their respective averages together, or both tend to be below
their respective averages together. A negative beta means that the asset's
returns generally move opposite the market's returns: one will tend to be
above its average when the other is below its average.
The beta coefficient is a key parameter in the capital asset pricing model
(CAPM). It measures the part of the asset's statistical variance that cannot
be removed by the diversification provided by the portfolio of many risky
assets, because of the correlation of its returns with the returns of the
other assets that are in the portfolio. Beta can be estimated for individual
companies using regression analysis against a stock market index .

39
The formula for the beta of an asset within a portfolio is

a
= Cov (r
a
, r
p
)/ Var (r
p
)
where r
a
measures rate of return of the asset,
r
p
measures the rate of return of the portfolio, and
cov(r
a
, r
p
) is the covariance between the rates of return.
The portfolio of interest in the CAPM formulation is the market portfolio
that contains all risky assets, and so the r
p
terms in the formula are
replaced by r
m
, the rate of return of the market.
Beta is also referred to as financial elasticity or correlated relative volatility
and can be referred to as a measure of the sensitivity of the assets
returns to market returns, its non-diversifiable risk, its systematic risk, or
market risk. On an individual asset level, measuring beta can give clues to
volatility and liquidity in the marketplace. In fund management,
measuring beta is thought to separate a manager's skill from his or her
willingness to take risk.

40
The beta coefficient was born out of linear regression analysis. It is linked to a
regression analysis of the returns of a portfolio (such as a stock index) (x-axis) in a
specific period versus the returns of an individual asset (y-axis) in a specific year.
The regression line is then called the Security Characteristic Line (SCL)

a
is called the asset's alpha and
a
is called the asset's beta coefficient. Both
coefficients have an important role in Modern portfolio theory.
For an example, in a year where the broad market or benchmark index returns
25% above the risk free rate, suppose two managers gain 50% above the risk free
rate. Because this higher return is theoretically possible merely by taking a
leveraged position in the broad market to double the beta so it is exactly 2.0, we
would expect a skilled portfolio manager to have built the outperforming portfolio
with a beta somewhat less than 2, such that the excess return not explained by the
beta is positive. If one of the managers' portfolios has an average beta of 3.0, and
the other's has a beta of only 1.5, then the CAPM simply states that the extra
return of the first manager is not sufficient to compensate us for that manager's
risk, whereas the second manager has done more than expected given the risk.
Whether investors can expect the second manager to duplicate that performance
in future periods is of course a different question.

41
Jensens Ratio or Alpha
What Does Jensen's Measure Mean?
A risk-adjusted performance measure
that represents the average return on a portfolio
over and above that predicted by the capital
asset pricing model (CAPM), given the portfolio's
beta and the average market return. This is the
portfolio's alpha. In fact, the concept is
sometimes referred to as "Jensen's alpha."

42
Jensens Ratio or Alpha (Contd)
Jensens measure is calculated as

p
= E(r
p
) - [r
f
+
p
{E(r
m
) r
f
}]
where
E( r
p
) = expected total portfolio return
r
f
= risk free rate = 9%

p
= Beta of the portfolio=.07
E( r
m
) = expected market return = .12

43
% 1 01 . 0 11 . 12 . 0 '
11 . ) 09 . 12 (. 07 . 09 . 0 (
or s Jensen
Er Rm
R Rm R Er
p p
f p
p
f P
= = =
= + = + =
o
|
Jensens Ratio or Alpha (Contd)
If the definition above makes your head spin, don't worry: you
aren't alone! This is a very technical term that has its roots in
financial theory.

The basic idea is that to analyze the performance of an investment
manager you must look not only at the overall return of a portfolio,
but also at the risk of that portfolio. For example, if there are two
mutual funds that both have a 12% return, a rational investor will
want the fund that is less risky. Jensen's measure is one of the ways
to help determine if a portfolio is earning the proper return for its
level of risk. If the value is positive, then the portfolio is earning
excess returns. In other words, a positive value for Jensen's alpha
means a fund manager has "beat the market" with his or her stock
picking skills.

44

Modigliani-Square or M
2
Measure and the
TreynorSquare or T
2
Measure

The former measure is named after the authors of the
formula, Nobel laureate Franco Modigliani and his
niece, Leah Modigliani, a Morgan Stanley strategist.
Like the preceding approaches, the M
2
ratio attempts
to adjust the returns for risks. The M
2
approach is to
leverage/de-lever the portfolio until its volatility
matches that of its benchmark. This follows from the
CAPM methodology that assumes that the investor will
leverage (borrow or lend at the risk-free rate). The
effect is that the investor can mix one risky asset with a
risk-free asset to obtain the same standard deviation of
returns as the market portfolio.

45

2
Measure and
the TreynorSquare or T
2
Measure

Suppose the market rate of return was 15.0%. If an
investor had just one risky asset A, which offered an
expected return of 25.0% and had a standard deviation of
returns of 51% compared to 33% for the market portfolio,
the investor must lower the standard deviation of his
portfolio of risky assets. He can do this by buying riskless
assets offering say for example, returns of 3.0% of such that
a 33/51 or 64.7% proportion is made up of A and a (1
0.647) or 35.3% is made up of riskless assets.
The expected return of the new portfolio is then (0.647 x
25.0%) + (0.353 x 3.0%) = 17.2%.
This is higher than the market rate of return of 15.0%,
leaving the M
2
measure at (17.2 15.0) = 2.2%.

46
2
Measure and
2
Measure
A similar operation can be made to adjust the beta of a
portfolio of risky assets to the market portfolio. This
approach is called the T
2
Ratio calculated as follows:
Suppose the market rate of return was again, 15.0%. If
an investor had the same one risky asset A, which
offered an expected return of 25.0% (hence an excess
return of 22% over the risk-free rate of 3.0% and had a
beta of 1.7 compared (the beta of the market portfolio
is always 1.0), the investor must lower the beta of his
portfolio of risky assets.
47
2
Measure and
2
Measure
He can do this by buying riskless assets which have a
beta of 0.0, offering excess returns over the risk-free
rate of 3.0% such that a 1.0/1.7 or 58.8% proportion is
made up of A and a (1 0.588) or 42.2% is made up of
riskless assets. The excess return of the portfolio made
up entirely of A, denoted as R
A
is 25% - 3% = 22% while
the excess return of the constructed portfolio R
P
= 22%
x 0.588 = 12.94%.
The T
2
measure of the constructed portfolio
= (R
P
excess return of market portfolio)
= 12.94% - (15%-3%) = 0.94%.

48

Information Ratio, also known as Excess Return
to Non-systematic Risk Ratio or Appraisal Ratio

The information ratio measures the investment
managers performance against a benchmark. It
measures the consistency by which a portfolio or fund
beats the benchmark. The ratio is therefore alpha
(measured by the average of a funds excess monthly
return over a benchmark), divided by the standard
deviation of the alpha. The formula is of the form

49

return monthly excess of deviation standard
return monthly excess mean
Ratio n Informatio =

Downside Deviation or Risk of Loss
Measure

The downside risk measures just one portion of
the area under the normal distribution curve that
is used to define the standard deviation of
returns. In Figure 3.14, it is represented by the
portion under the probability distribution curve
shaded in red lying to the left of the vertical line
NN that sets the frequency distribution or
probability of 0% return. The area measures the
cumulative probability of a loss and measures the
Downside Deviation Risk.

50
51
Probability

Figure 3.14

N

N

52
The associated formula is computed as follows:

Downside Deviation Risk =
N
Return Mean Return (Portfolio )
2

where N is the number of observations where the losses occurred or where the
portfolio underperformed the mean returns. Where the Downside Deviation Risk
is computed based on periods other than yearly (i.e., monthly or quarterly) data, an
adjustment is required if annualised results are to be obtained:

Annualised Downside Deviation Risk
= Downside Deviation Risk x \(No of periods required to make up one year)

For example, if quarterly data is used, the Downside Deviation Risk will be
multiplied by a factor of \4 = 2.
The Sortino Ratio
This ratio adopts the downside deviation risk as a measure of
portfolio risk. Unlike the Sharpe Ratio, the Sortino Ratio
measures the excess return not over the risk free rate but
over a target or expected rate and adjusts the annualised
portfolio excess return over the mean or annualised target
return by a factor represented by the Annualised Downside
Deviation Risk:
Sortino Ratio = Annualised Portfolio Return Annualised Target Return
Annualised Downside Deviation
53
The Sortino Ratio
A negative value indicates expected portfolio returns
lower than the target rate of return. Generally, the
higher the value the better the risk-adjusted return. A
large positive value for a numerator will be negated if
the denominator was large as well, leaving the risk-
adjusted return the same. The interpretation of this
ratio may lead to conclusions conflicting with that of
the Sharpe Ratio since focusing just on the standard
deviation of returns may result in the selection of a
portfolio for a client who may in fact be averse to
losses more than outright volatility of returns, in
which event, the Sortino Ratio may be a useful gauge
of which is the preferred portfolio.

54
Value At Risk (VAR)
VAR or sometimes (VaR) has been called the "new
science of risk management", but you do not need to
be a scientist to use VAR. Here, we look at the idea
behind VAR and the three basic methods of
calculating it
For investors, risk is about the odds of losing money,
and VAR is based on that common-sense fact. By
assuming investors care about the odds of a really big
loss, VAR answers the question, "What is my worst-
case scenario?" or "How much could I lose in a really
bad month?"

55
Value At Risk (VAR) (Contd)
The most popular and traditional measure of risk is
volatility. The main problem with volatility, however, is that
it does not care about the direction of an investment's
movement: a stock can be volatile because it suddenly
jumps higher. Of course, investors are not distressed by
gains!
For investors, risk is about the odds of losing money, and
VAR is based on that common-sense fact. By assuming
investors care about the odds of a really big loss, VAR
answers the question, "What is my worst-case scenario?"
or "How much could I lose in a really bad month?"

56
Now let's get specific. A VAR statistic has three components: a time
period, a confidence level and a loss amount (or loss percentage).
Keep these three parts in mind as we give some examples of
variations of the question that VAR answers:
What is the most I can - with a 95% or 99% level of confidence -
expect to lose in dollars over the next month?
What is the maximum percentage I can - with 95% or 99%
confidence - expect to lose over the next year?
You can see how the "VAR question" has three elements: a
relatively high level of confidence (typically either 95% or 99%), a
time period (a day, a month or a year) and an estimate of
investment loss (expressed either in dollar or percentage terms).
57
Methods of Calculating VAR
Institutional investors use VAR to evaluate portfolio
risk, but we will use it to evaluate the risk of a single
index that trades like a stock: the Nasdaq 100 Index,
which trades under the ticker QQQQ. The QQQQ is a
very popular index of the largest non-financial stocks
that trade on the Nasdaq exchange.
There are three methods of calculating VAR:
the historical method,
the variance-covariance method and
the Monte Carlo simulation
58
1. Historical Method

The historical method simply re-organizes actual historical returns,
putting them in order from worst to best. It then assumes that
history will repeat itself, from a risk perspective.

The QQQ started trading in Mar 1999, and if we calculate each daily
return, we produce a rich data set of almost 1,400 points. Let's put
them in a histogram that compares the frequency of return
"buckets". For example, at the highest point of the histogram (the
highest bar), there were more than 250 days when the daily return
was between 0% and 1%. At the far right, you can barely see a tiny
bar at 13%; it represents the one single day (in Jan 2000) within a
period of five-plus years when the daily return for the QQQ was a
stunning 12.4%!

59
60
Notice the red bars that compose the "left tail" of the
histogram. These are the lowest 5% of daily returns (since
the returns are ordered from left to right, the worst are
always the "left tail"). The red bars run from daily losses of
4% to 8%. Because these are the worst 5% of all daily
returns, we can say with 95% confidence that the worst
daily loss will not exceed 4%. Put another way, we expect
with 95% confidence that our gain will exceed -4%. That is
VAR in a nutshell. Let's re-phrase the statistic into both
percentage and dollar terms:
With 95% confidence, we expect that our worst daily loss
will not exceed 4%.
If we invest $100, we are 95% confident that our worst
daily loss will not exceed $4 ($100 x -4%).

61
You can see that VAR indeed allows for an outcome
that is worse than a return of -4%. It does not express
absolute certainty but instead makes a probabilistic
estimate. If we want to increase our confidence, we
need only to "move to the left" on the same histogram,
to where the first two red bars, at -8% and -7%
represent the worst 1% of daily returns:
With 99% confidence, we expect that the worst daily
loss will not exceed 7%.
Or, if we invest $100, we are 99% confident that our
worst daily loss will not exceed $7.

62
2. The Variance-Covariance Method
This method assumes that stock returns are
normally distributed. In other words, it
requires that we estimate only two factors - an
expected (or average) return and a standard
deviation - which allow us to plot a normal
distribution curve. Here we plot the normal
curve against the same actual return data:

63
64
The idea behind the variance-covariance is similar to
the ideas behind the historical method - except that
we use the familiar normal curve instead of actual
data. The advantage of the normal curve is that we
automatically know where the worst 5% and 1% lie
on the curve. They are a function of our desired
confidence and the standard deviation ( ):

65
The blue curve above is based on the actual daily
standard deviation of the QQQ, which is 2.64%. The
average daily return happened to be fairly close to zero,
so we will assume an average return of zero for
illustrative purposes. Here are the results of plugging the
actual standard deviation into the formulas above:

66
3. Monte Carlo Simulation

The third method involves developing a model for future stock price
returns and running multiple hypothetical trials through the model. A
Monte Carlo simulation refers to any method that randomly generates
trials, but by itself does not tell us anything about the underlying
methodology.

For most users, a Monte Carlo simulation amounts to a "black box"
generator of random outcomes. Without going into further details, we
ran a Monte Carlo simulation on the QQQ based on its historical
trading pattern. In our simulation, 100 trials were conducted. If we ran
it again, we would get a different result--although it is highly likely that
the differences would be narrow. Here is the result arranged into a
histogram (please note that while the previous graphs have shown
daily returns, this graph displays monthly returns):

67
68
To summarize, we ran 100 hypothetical trials of monthly returns for
the QQQ. Among them, two outcomes were between -15% and -
20%; and three were between -20% and 25%. That means the worst
five outcomes (that is, the worst 5%) were less than -15%. The
Monte Carlo simulation therefore leads to the following VAR-type
conclusion: with 95% confidence, we do not expect to lose more
than 15% during any given month.

Summary
Value at Risk (VAR) calculates the maximum loss expected (or worst
case scenario) on an investment, over a given time period and given
a specified degree of confidence. We looked at three methods
commonly used to calculate VAR. But keep in mind that two of our
methods calculated a daily VAR and the third method calculated
monthly VAR
69
Potential Investment Channel
One of the more unusual developments in investment
in 2004 was the introduction of the first Shariah
compliant fund of hedge funds. The fund had been in
development for more than two years, tapped four
prominent Shariah scholars on three continents to
approve investment strategies whose methodologies
might differ from conventional short sales, derivatives,
and leverage but whose fiscal result would be similar.
The fund went to market late in the year and
reportedly set a goal of US$200 million on initial close.

70
Potential Investment Channel (Contd)
An Islamic fund of hedge funds is only the latest milestone in the
development of Islamic alternative investment, an opportunity lying
somewhere between US$200 billion to US$300 billion, depending
on the source. Historically, alternative investments have been
reserved for wealthier accredited investors. However, we are now
seeing more and more private-client advisers turning to alternative
investments: private markets (venture capital, leveraged buyouts,
private equity, mezzanine financing, and distressed debt), natural
resources (timberland, water, agriculture, oil, and gas), real estate,
and hedge funds. These investments are called alternative
because, unlike stock and bond investments, advisers actively
manage them and seek absolute rather than relative rates of return
(unambiguous, measurable, investable, specified-in-advance
benchmarks are difficult to devise).

71
Strictly speaking, hedge funds are really more of an
alternative strategy than an alternative investment.
Though some hedge funds invest in alternative
investments, many invest in the same readily
marketable securities that are available to ordinary unit
trust funds. But unlike unit trust funds, hedge funds
can use myriad investing and trading strategies that
may or may not hedge risk.
Financial planner should note that the familiar tools
and methods for assessing portfolios of conventional
assets, such as using historical data and optimizations,
may not applicable for portfolios that combine
conventional and alternative investments.
72
Financial planner should note that the familiar tools
and methods for assessing portfolios of conventional
assets, such as using historical data and optimizations,
may not applicable for portfolios that combine
conventional and alternative investments. Therefore,
investors will be better served by eschewing the
familiar approaches for identifying (or defining)
return and risk characteristics that reflect underlying
drivers of performance and replacing them with
simulations that are useful for identifying appropriate
policy mixes combining conventional and alternative
investments.

73
Structured Products

In the pioneering days of structured products,
customer demand revolved around two mutually
exclusive objectives of income or growth. Both
objectives were underpinned by a strong
common desire to maintain capital values or to
strictly limit loss.
Today, both practitioners and investors often
misinterpret structured products as guaranteed
or capital protected vehicles because of this
legacy.
74
Structured Products (Contd)

But more worryingly, investor expectation regarding
structured products would seem to be somewhat misplaced
as many look to structures as a means of achieving multiple
objectives from a single product. It is therefore important for
Islamic financial planners to have a good understanding of
structured products although some of the investment
approaches in these products may not be Shariah compliant.
Structured products can be defined as any investment
vehicle designed to fulfill a principal objective by combining a
range of techniques or elements, which individually could not
achieve the same result.

75
Applying this definition helps to demonstrate the width and depth
of this sector. The usual suspects can be found such as capital
protected or enhanced growth and income vehicles. These are
typically underpinned by a zero coupon with a derivative overlay
and have struck a chord with private investors. For those who cant
afford their own structure the market is awash with new retail
issues and a secondary market, created by the product provider,
which can also be accessed.
Other areas of structured a product that is most commonly talked
about is the hedge fund, which comes in many shapes and sizes
from single to multiple strategies to well-diversified funds of hedge
funds while exchange-traded funds offer the structured alternative
to index tracking unit trusts.

76
Investment and private banks, asset and fund
managers and the life companies are all offering some
form of structured product. They aim to differentiate
their offering through the wrapper in which the
structure is placed or the innovative concept
underpinning the structure.
In structured products, investors typically seek returns
comparable with equities over the long term but
without the same degree of associated risk. Structured
products can give investors access to a multi-asset,
multi-manager, multi-style, multi-currency structure,
which is, at its heart, a sophisticated neutral asset
allocation model.
77
The advantages of this structure are five-fold:
Firstly, the multi-asset approach means that a
clients assets are invested equally across fixed
income, property, equities and hedge funds,
giving them excellent diversification across a full
range of asset classes. These typically have
different economic cycles ensuring that two asset
classes will always outperform the remaining
two. This will either act as a driver for growth or a
brake when certain markets fall.

78
Secondly, the multi-manager approach allows the
selection of a range of managers who are particularly
skilled to manage the different assets classes. These
managers track records and skill place the clients
assets in the hands of individuals who are most likely
to add value to the portfolio.
Thirdly, using a multi-style approach means that within
each asset class, the investment team get to blend
investment styles and approaches. This adds further
diversification and reduces the possibility of
duplicating holdings, further reducing risk.

79
Fourthly, the implementation of a multi-currency approach
led to the development where the underlying exposure is
kept to the base currency of the fund. This reduces
currency risk and is fundamental for conservative or
medium risk investors.
Finally, a neutral asset allocation means that the portfolio
is rebalanced on a monthly basis to ensure that investors
exposure to the four asset classes is virtually equal. This
means that customers are not exposed to a deliberate over
or underweight asset allocation strategy. This increases risk,
but remains neutral. This neutral position allows the fund
to take profit from rising asset classes and reinvest into
falling ones. In effect, it is continuous dollar cost averaging
and profit taking
80
However, Islamic financial planners should
access structured products with due care
because such products normally involve short-
selling and securities borrowing and lending,
where many Shariah scholars are still divided
on the legitimacy of such practices since there
are no parallel in classical Fiqh al-mualamat.
81
Thank you
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