UNIT-5

EVALUATION OF PORTFOLIO

Portfolio evaluation is an essential aspect of investment analysis. It involves assessing the

quality of investment approaches and determining changes to improve investment results.

A portfolio combines investment products, including bonds, shares, securities, and mutual
funds. Experienced portfolio managers customize this combination based on the client’s risk
tolerance to create a long-term return portfolio.

Performance evaluation is necessary for both investors and portfolio managers. Portfolio
management uses evaluation to assess the manager’s portfolio performance and determine
their compensation.

Investors can assess portfolio performance by comparing it to a relevant benchmark within the
specified category and determine whether it has outperformed, underperformed, or
performed comparably. A well-balanced portfolio minimizes risks, grows in value, shields
investors from loss, and improves liquidity.

Need For Portfolio Evaluation

These pointers below highlight the underlying need for active portfolio evaluation –

 It helps to cushion investment-oriented risks and increases the scope of generating more
profits.

 Helps to develop sound strategies and rebalance asset composition as per their current
market condition so that investors can make the most of existing investment.

 It enables quick customization based on immediate financial needs and market

conditions.

 Helps understand which investments work best under which market situation and how
to distribute resources into different asset classes.

The best way to build a sound investment portfolio is by determining its financial objective and
rebalancing its components frequently. Subsequently, investors should focus more on
diversifying their resources to attain the best possible rewards at manageable risks in all
situations.

Types of Formula Plans in Portfolio Revision

1. Constant Rupee value plan :

The constant rupee value plan indicates that the rupee value remains constant in the stock
portfolio of the total portfolio. Whenever the stock value rises the shares of the investor
should be sold to maintain a constant portfolio. Likewise, the investor should buy shares
whenever prices fall in order to maintain a constant portfolio.
The investor invests a part of his funds in the aggressive portfolio and a portion of his total
funds should be invested in a conservative portfolio.
Advantages of Constant Rupee Value Plan

The constant rupee value plan offers the following advantages.

1. It is very simple to operate. The investor need not make any complicated calculations.
2. This plan brings funds to the investor for investment.
3. Constant rupee value plan specifies the percentage of the aggressive portfolio for the
investment fund. Specified as a percentage to the total fund, the aggressive portfolio will have
a constant amount.
2. Constant ratio plan :

There is a slight difference between the constant rupee value plan and the constant ratio plan.
Constant ratio plan specifies the ratio of the value in the aggressive portfolio to the value of the
conservative portfolio. The aggressive portfolio is divided by the market value of the total
portfolio and the resultant ratio will be held constant. This can be expressed as a formula.
K = Market value of common stock / Market value of total portfolio
Constant ratio plan works as follows:
1. When the value of stock rises, it must be sold to make it constant with the value of the
conservative portfolio. When the value of stock falls, the investor should transfer funds to
common stock.
2. The investor should keep the aggressive value constant of the portfolio’s total value. When
the prices of stock fall, the investor should transfer from conservative to aggressive value.
3. The core of constant ratio plan lies in the purchase of stock in less aggressive manner as the
prices fall.
4. When the stock prices rise, sale of stock is effected in less aggressive manner.
Advantages of Constant Rupee Value Plan

The constant rupee value plan offers the following advantages.

1. It is very simple to operate. The investor need not make any complicated calculations.
2. This plan brings funds to the investor for investment.
3. Constant rupee value plan specifies the percentage of the aggressive portfolio for the
investment fund. Specified as a percentage to the total fund, the aggressive portfolio will have
a constant amount.
3. Variable ratio plans:

The variable ratio plans can be understood by studying the following points.
1. When stock prices rise, the investor should sell stock and purchase bonds. Similarly, when
the stock prices fall, stock should be bought and bonds should be sold.
2. There should be different proportions of stock prices.
3. Forecasting is the most important technique of variable ratio plan.
4. This plan is found to be profitable when there are large number of fluctuations in prices.
5. The variable ratio plan works with indicators like market index, the economic activity index,
etc.

RUPEE COST AVERAGING (RCA)

Rupee Cost Averaging (RCA) is an investment technique where an individual invests a fixed
amount of money at regular intervals, regardless of the market's ups and down. In simple
terms, it is a Systematic Investment Plan (SIP) which has the potential to help investors build
wealth. In this process one buys more units of a mutual fund when prices are low and fewer
units when prices are high. Over time, this strategy aims to reduce the impact of market
volatility on overall investment.

Importance/ advantages of Rupee Cost Averaging (RCA):

1. Mitigating Market Volatility: The primary benefit of RCA is its ability to mitigate the
impact of market volatility. When one invests a fixed amount at regular intervals, one
automatically buys more units when prices are low and fewer units when prices are
high.
2. Disciplined Investing: RCA brings discipline in investment approach. It encourages one
to stay invested over the long term, regardless of market fluctuations.
3. Emotional Control: RCA removes the need for emotional decision-making. You invest
systematically, regardless of whether the market is bullish or bearish, which can help
you avoid impulsive decisions driven by fear or greed.
4. Potential for Lower Average Cost: By consistently investing a fixed amount, one
automatically buys more units when prices are low. Over time, this lowers average cost
per unit. This means that even if the market experiences fluctuations, investor will
benefit when the market eventually rises.
5. Magic of compounding with SIP (RCA): Rupee cost averaging is generally considered
ideal for long-term wealth accumulation goals, such as retirement planning or saving for
your child's education.

Conclusion:
Rupee Cost Averaging is considered as a simple yet a good strategy for mutual fund investors.
SIP investing uses the rupee cost averaging approach. It has the ability to mitigate the impact
of market volatility, promotes disciplined investing, and aims to allow investor to benefit from
the power of compounding over the long term.

Risk-Adjusted Returns
A risk-adjusted return is a calculation of the profit or potential profit from an investment that
considers the degree of risk that must be accepted to achieve it. The risk is measured in
comparison to that of a virtually risk-free investment.
Depending on the method used, the risk calculation is expressed as a number or a rating. Risk-
adjusted returns are applied to individual stocks, investment funds, and entire portfolios.
There are four key risk adjusted performance measures – Alpha, Sharpe Ratio, Treynor Ratio,
and Information Ratio. It is very important to factor in risk while evaluating a portfolio’s
performance. These risk adjusted measures can help reduce the tendency of investors to
simply focus on returns, without considering the investment risks.
Types of Risk Adjusted Measures
Alpha: This measures how much of the return generated by an investment portfolio is
attributed or due to the portfolio manager’s investment decisions.

Having stated the above, Alpha essentially measures the excess return on a portfolio over a
predetermined benchmark or market index. Investors in mutual funds or ETF’s may want a high
alpha because it indicates to them that the investment decisions of the portfolio manager led
to a superior return for every unit of risk taken by him or her.

In its simplest form:

Alpha = Portfolio’s Absolute Return – Benchmark Return

As a result, if Alpha is greater (lesser) than zero, it means that the portfolio manager has
outperformed (underperformed) the benchmark.

Sharpe Ratio: This is a measure used to compare the performance of mutual funds. It involves
the measurement of a portfolio manager’s returns in excess of the risk-free rate (for example,
the yield on US Treasury Bill) while factoring in risk taken on by the manager. The Sharpe ratio
is probably the most widely used and followed risk-adjusted measure for investment funds.

The Sharpe ratio compares the excess return to the total risk, as measured by standard
deviations of returns (also known as volatility) of the portfolio. This enables investors to
compare investments on a risk-adjusted basis.

The formula of Sharpe ratio is:

Sharpe ratio = Rp – rf/σ

Rp – rf = Excess returns (i.e. return on a portfolio minus the risk-free rate)

σ = Standard deviation (of returns)

The higher the Sharpe ratio, the more favorable the investment return, relative to the risk
being taken.
Treynor ratio: This measures a portfolio manager’s returns in excess of the risk-free rate, while
also factoring in risk. This ratio compares the excess returns to systematic risk only. Therefore,
the Treynor ratio is very similar to the Sharpe ratio, but instead of using the standard
deviations of returns as a measure of risk, it uses beta. Beta is a measure of systematic risk and
calculates the extent to which a portfolio or stock correlates or moves along with the broader
market.

Treyner Ratio = Rp – rf/ β

Rp – rf = Excess returns (i.e. return on a portfolio minus the risk-free rate)

Β = Systematic risk

The higher the Treynor ratio, the better the performance of the portfolio manager.

Jensen’s model: This measures the excess return on a portfolio over the benchmark, which is a
predetermined one, relative to the variability of that excess return. This ratio helps investors
answer two questions: does the active manager outperform the passive benchmark, and is he
or she able to outperform the benchmark consistently?

Jensen ratio = (Rp – RB)/ σ (p-B)

(Rp – RB) = Excess returns over benchmark (i.e. return on a portfolio – return on a benchmark,
also called ‘’Active Return’)

σ (p-B) = Standard deviation of these excess returns – this is also known as active risk or
tracking error.

The higher this ratio, the better it is considered. If the information ratio is less than zero, the
active manager has failed in outperforming the benchmark.

PROBLEMS ON SHARPE’S, TREYNOR’S AND JENSEN’S MODELS

1. Satya firm is trying to decide two out of the four investment funds. From the past
performance they are able to calculate the following average returns and standard
deviation of these funds. The current risk free return is 9%.
Particulars Alpha Vinu Menu Arvind
fund fund fund fund
Average return 17 18 16 14
Standard 19 20 13 12
deviation
Evaluate through Sharpe and Treynor’s index and discuss.
2. Mr. Kumar is having units in a mutual fund for the past 3 years. He wants to evaluate its
performance by comparing it to the market. Find out Sharp and Treynor indices and
Comment.
Fund Market
Return 70.06 41.40
Standard 41.31 19.44
deviation risk 2% 2
free rate 1.12 -
beta
Find out Sharpe and Treynor indices and comment.
3. Nithya firm is trying to decide two out of investment funds. From the past performance,
they were able to calculate the following average returns and standard deviations of
these funds. The current risk free rate of interest is 9%.
Fund- Fund- Fund- Fund-
A B C D
AVERAGE 15 16 18 16
RETURNS 14 18 15 14
STANDARD
DEVIATION

4. An investor holds units in mutual funds that’s why and z. The risk rate of return is 9%.
Find the missing figures in the table given below.
FUND SHARPE’S STANDARD RETURN
MEASURE DEVIATION ON
FUND
X ? 41.30 71
Y 0.43 ? 17
Z 0.54 13 ?

5. The rate of return and risk for three growth oriented firms are as follows.
Growt Return Risk
h firms (%) (%)
A 15 16
B 13 18
C 12 11
Rank each form by Sharpe’s index and Treynor’s index of portfolio performance if the
risk free rate is 7%.
6. Consider the following information for 3 mutual funds P,Q and R and the market.
MEAN STANDARD BETA
RETURNS DEVIATION
P 15% 20% 0.09
Q 17% 24% 1.10
 R 19% 27% 1.20
MARKE 16% 20% 1.00
T
INDEX
The main risk free rate was 10%. Calculate the Treynor measure, Sharpe measure and a
Jensen measure for the three mutual funds and the market index.
7. With the given details, evaluate the performances of the different funds using Sharpe
and Treynor performance evaluation techniques.
FUND RETURM (%) STANDARD BETA
DEVIATION (%)
A 12 18 0.7
B 19 25 1.3
M(MARKET 15 20 1.0
)
The Risk free rate of return is 4%.
8. Three mutual funds have reported the following rate of return and risk over the last 5
years.
Growth Return Risk (%) Beta
fund (%)
Shriram 17 18 1.15
Birla 15 20 1.25
ICICI 14 13 0.09
Rank each fund by Sharpe and Treynor performance evaluation criteria, given the risk
free return is 7%.

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