Unit 5 - PORTFOLIO STRATEGIES

Capital Asset Pricing Model

● The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and
expected return for assets, particularly stocks.
● CAPM is widely used throughout finance for pricing risky securities and generating expected returns for
assets given the risk of those assets and cost of capital.

Understanding CAPM
● The formula for calculating the expected return of an asset given its risk is as follows:
● ERi = Rf + βi (ERm – Rf) where ERi = Expected Return on Investment; Rf = Risk-Free Rate; βi = Beta
of the Investment; (ERm – Rf) = Market Risk Premium
● Ex.: Rf = 3%; βi = 1.3; ERm = 8 %
● Then, ERi = 3% + 1.3 x (8% - 3%) = 3% + 1.3 (5%) = 3% + 6.5% = 9.5%.

CML – Lending & Borrowing

● The capital market line (CML) represents portfolios that optimally combine risk and return.
● It is a theoretical concept that represents all the portfolios that optimally combine the risk-free rate of
return and the market portfolio of risky assets.
● Under the capital asset pricing model (CAPM), all investors will choose a position on the capital market
line, in equilibrium, by borrowing or lending at the risk-free rate, since this maximizes return for a given
level of risk.
● CML is a special case of the capital allocation line (CAL) where the risk portfolio is the market portfolio.
● Thus, the slope of the CML is the Sharpe ratio of the market portfolio.
● The intercept point of CML and efficient frontier would result in the most efficient portfolio called the
tangency portfolio.
● As a generalization, buy assets if Sharpe ratio is above CML and sell if Sharpe ratio is below CML.

Security Market Line

● The security market line (SML) is a line drawn on a chart that serves as a graphical representation of
the capital asset pricing model (CAPM)—which shows different levels of systematic, or market risk, of
various marketable securities, plotted against the expected return of the entire market at any given
time.
● Also known as the "characteristic line," the SML is
a visualization of the CAPM, where the x-axis of
the chart represents risk (in terms of beta), and the
y-axis of the chart represents expected return.
● The market risk premium of a given security is
determined by where it is plotted on the chart
relative to the SML.
● The security market line (SML) is a line drawn on a
chart that serves as a graphical representation of
the capital asset pricing model (CAPM).
● The SML can help to determine whether an
investment product would offer a favorable
expected return compared to its level of risk.
● The formula for plotting the SML is required return
= risk-free rate of return + beta (market return -
risk-free rate of return).
Pricing with CAPM
● The Capital Asset Pricing Model, or CAPM, calculates the value of a security based on the expected
return relative to the risk investors incur by investing in that security.
● To calculate the value of a stock using CAPM, multiply the volatility, known as “beta,” by the additional
compensation for incurring risk, known as the “Market Risk Premium,” then add the risk-free rate to that
value.

Arbitrage Pricing Theory

● Arbitrage pricing theory (APT) is a multi-factor asset pricing model based on the idea that an asset's
returns can be predicted using the linear relationship between the asset’s expected return and a
number of macroeconomic variables that capture systematic risk.
● It is a useful tool for analyzing portfolios from a value
investing perspective, in order to identify securities that
may be temporarily mispriced.
● The arbitrage pricing theory was developed by the
economist Stephen Ross in 1976, as an alternative to the
capital asset pricing model (CAPM).
● Unlike the CAPM, which assume markets are perfectly
efficient, APT assumes markets sometimes misprice
securities, before the market eventually corrects and
securities move back to fair value.
● Using APT, arbitrageurs hope to take advantage of any
deviations from fair market value.
Portfolio Evaluation
● Portfolio manager evaluates his portfolio performance and identifies the sources of strength and
weakness.
● The evaluation of the portfolio provides a feed back about the performance to evolve better
management strategy.
● Even though evaluation of portfolio performance is considered to be the last stage of investment
process, it is a continuous process.

Mutual Funds
● The managed portfolios are commonly known as mutual funds.
● Various managed portfolios are prevalent in the capital market.
● Their relative merits of return and risk criteria have to be evaluated.
● Mutual fund is an investment vehicle that pools together funds from investors to purchase stocks,
bonds or other securities.
● An investor can participate in the mutual fund by buying the units of the fund.
● Each unit is backed by a diversified pool of assets, where the funds have been invested.
● The gain or loss made by the mutual fund is passed on to the investors after deducting the
administrative expenses and investment management fees.
● The gains are distributed to the unit holder in the form of dividend or reinvested by the fund to generate
further gains.

Fund Classifications
● Closed – End Funds
● Open – End Funds

Closed – End Funds

● A closed-end fund has a fixed number of units outstanding.
● It is open for a specific period for investors to buy it.
● The initial offer period is terminated at the end of the pre-determined period.
● The closed-end schemes are listed in the stock exchanges.
● The investor can trade the units in the stock markets just like other securities.
● The prices may be either quoted at a premium or discount.

Open – End Funds

● In the open-end schemes, units are sold and bought continuously.
● The investors can directly approach the fund managers to buy or sell the units.
● The price of the unit is based on the net asset value of the particular scheme.
● The net asset value of the fund is the value of the underlying securities of the scheme.
● The net asset value is calculated on a daily or weekly basis.
Advantages of MFs
● Professional Management
● Diversification
● Convenient Administration
● Return Potential
● Low Costs
● Liquidity
● Transparency
● Flexibility
● Choice of Scheme
● Well - Regulated

Types of Performance Index

● Sharpe’s Performance Index
● Treynor’s Performance Index
● Jensen’s Performance Index

Sharpe’s Performance Index

● Sharpe’s performance index gives a single value to be used for the performance ranking of various
funds or portfolios.
● Sharpe index measures the risk premium of the portfolio relative to the total amount of risk in the
portfolio.
● This risk premium is the difference between the portfolio’s average rate of return and the riskless rate of
return.
● The standard deviation of the portfolio indicates the risk.
● The index assigns the highest values to assets that have best risk-adjusted average rate of return

Formula

Example
Risk & Return of Funds

Interpretation
● The larger the S, better the fund has performed.
● Thus, A ranked as better fund because its index .457> .427, even though the portfolio B had a higher
return of 13.47 percent.
● The reason is that the fund ‘B’s managers took such a great risk to earn the higher returns and its risk
adjusted return was not the most desirable.
● Sharpe index can be used to rank the desirability of funds or portfolios, but not the individual assets.
● The individual asset contains its diversifiable risk.

Treynor’s Performance Index

● To understand the Treynor index, an investor should know the concept of characteristic line.
● The relationship between a given market return and the fund’s return is given by the characteristic line.
● The fund’s performance is measured in relation to the market performance.
● The ideal fund’s return rises at a faster rate than the general market performance when the market is
moving upwards and its rate of return declines slowly than the market return, in the decline.
● The ideal fund may place its fund in the treasury bills or short sell the stock during the decline and earn
positive return.
● The relationship between the ideal fund’s rate of return and the market’s rate of return is given by the
below figure.

Characteristic Line
● This linear relationship is shown by the characteristic line.
● Each fund establishes a performance relationship with the market.
● The CL can be drawn by plotting the fund’s rate of return for a given period against the market’s return
for the same period.
● The slope of the line reflects the volatility of the fund’s return.
● A steep slope would indicate that the fund is very sensitive to the market performance.
● If the fund is not so sensitive then the slope would be a slope of less inclination.
● The market return is given on the horizontal axis and the fund’s rate of return on the vertical axis.
● When the market rate of return increases, the fund’s rate of return increases more than proportional
and vice-versa.
● In the figure the fund’s rate of return is 20 per cent when the market’s rate of return is 10 per cent, and
when the market return is —10, the fund’s return is 10 per cent.
● The relationship between the market return and fund’s return is assumed to be linear.
Example
Performance of Funds

Jensen’s Performance Index

● The absolute risk adjusted return measure was developed by Michael Jensen and commonly known as
Jensen’s measure.
● It is mentioned as a measure of absolute performance because a definite standard is set and against
that the performance is measured.
● The standard is based on the manager’s predictive ability.
● Successful prediction of security price would enable the manger to earn higher returns than the
ordinary investor expects to earn in a given level of risk.

Jensen Model - Formula Example Interpretation

Portfolio Revision
● Portfolio Revision is the process of changing the composition of securities or bonds in the portfolio
depending on the performance, expectations & the strategy.
● If the policy of investor shifts from earnings to capital appreciation the stocks should be revised
accordingly.
● An investor can sell these shares if the price of the shares considered risk, quality & tax concessions.
● If any stock offers a competitive edge over the present stock, investment should be shifted to that stock.

Need for Portfolio Revision

● An individual at certain point of time might feel the need to invest more. The need for portfolio revision
arises when an individual has some additional money to invest.
● Change in investment goal also gives rise to revision in portfolio. Depending on the cash flow, an
individual can modify his financial goal, eventually giving rise to changes in portfolio.
● Financial market is subject to risks and uncertainty. An individual might sell off some of his assets owing
to fluctuations in the financial market.

Techniques of Portfolio Revision

● Investors buy stock according to their objectives and return-risk framework.
● These fluctuations may be related to economic activity or due to other factors.
● Ideally investors should buy when prices are low and sell when prices rise to levels higher than their
normal fluctuations.
● The investor should decide how often the portfolio should be revised.
● If revision occurs too often, transaction and analysis costs may be high.
● The important factor to take into consideration is, thus, timing for revision of portfolio.

Portfolio Revision Strategies

● Active Revision Strategy
○ Active Revision Strategy involves frequent changes in an existing portfolio over a certain period
of time for maximum returns and minimum risks.
○ Active Revision Strategy helps a portfolio manager to sell and purchase securities on a regular
basis for portfolio revision.
● Passive Revision Strategy
○ Passive Revision Strategy involves rare changes in portfolio only under certain predetermined
rules. These predefined rules are known as formula plans.
○ According to passive revision strategy a portfolio manager can bring changes in the portfolio as
per the formula plans only.