CHAPTER EIGHT:PORTFOLIO

PERFORMANCE EVALUATION AND

REVIEW
➢Introduction
➢Evaluation of Portfolio Performance
➢Performance Measures
➢ Portfolio revision
➢Need for Revision
➢Constraints in Portfolio Revision
➢Portfolio Revision Strategies
Portfolio evaluation is the last step in the process of portfolio
management.
Portfolio analysis, selection and revision are undertaken with
the objective of maximizing returns and minimizing 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 evaluation is really a study of the impact/result
of such decisions.
Without portfolio evaluation, portfolio management would be
incomplete.
 Investment analysts and portfolio managers continuously
monitor and evaluate the results of their performance.
The revision of portfolio investments is conducted on the basis
of such monitoring and evaluation.
 The basic features of good portfolio managers are their
ability to perceive the market trends correctly and make
correct expectations & estimates regarding risk, return,
ability to make proper diversification, to reduce the
company related risk.
 This performance also depends on the timing of
investments, superior investment analysis and security
selection.
 For evaluating the performance of a portfolio it is necessary
to consider both risk and return. This is what the Sharpe
measure, Treynor measure and the Jensen measures three
popularly employed portfolio performance measures
precisely do.
 The performance measure developed by Jack Treynor is
refered to as Treynor ratio or reward to variability ratio.
 It is the ratio of the reward or risk premium to the volatility
of return as measured by the portfolio Beta.
 The formula for calculating Treynor ratio may be stated as:
Treynor ratio (TR) = (rp - rf ) / p
Where,
rp = Realized return on the Portfolio
rf = Risk free rate of return
p = Portfolio beta
 The performance measure developed by William Sharpe
is referred to as the Sharpe ratio or the reward to
variability ratio.
 It is the ratio of reward or risk premium to the variability
of return or risk as measured by the standard deviation of
return.
The formula for calculating Sharpe ratio may be stated as:
Sharpe ratio (SR) = (rp - rf ) / p
Where,
rp = Realized return on the Portfolio
rf = Risk free rate of return
p = Standard deviation of portfolio return
 This performance measure has been developed by Michael
Jensen and is referred to as the Jensen ratio.
 This ratio attempts to measure the differential between the actual
return earned on a portfolio and the return expected from the
portfolio given its level of risk. The CAPM model is used to
calculate the expected return on a portfolio.
 Jensen ratio (JR) = rp- E(rp
)
E(rp) = [rf + p(rm - rf )]
Where,
E(rp) = Expected return
rp = Realized return on the Portfolio
rf = Risk free rate of return
p = Portfolio beta
rm = Return on market index
 In portfolio management, the maximum emphasis is
placed on portfolio analysis and selection which leads to
the construction of the optimal portfolio. But the financial
markets are continually changing. In this dynamic
environment, a portfolio that was optimal when
constructed may not continue to be optimal with the
passage of time.
 The portfolio management process needs frequent
changes in the composition of stocks and bonds.
 If the policy of the investor shifts from earnings to capital
appreciation, the stocks should be revised accordingly.
Likewise, if the security does not fulfill the investors
expectation regarding return and growth, it is better to get
rid of it. If another stock offers a competitive edge over
the present stock, investment should be shifted to the
other stock.
 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 some investor related
factors also. These factors may be listed as:
➢ Ability of additional funds for investment
➢ Change in risk tolerance
➢ Change in the 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 investor’s status and preferences.
 Portfolio revision is the process of adjusting the existing
portfolio in accordance with the changes in financial
markets and investors position so as to ensure maximum
return from the portfolio with the minimum of risk.

The practice of portfolio revision involving purchase and

sale of securities gives rise to certain problems which act
as constraints in portfolio revision.
Some of these are:
 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.
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.
Frequent sales of securities in the course of periodic
portfolio revision will result in short term capital gains
which would be taxed at a higher rate compared to long
term capital gains.
The higher tax on short term capital gains may act as a
constraint to frequent portfolio revision.
Statutory Stipulations /legal or constitutional requirements:
The largest 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 time consuming exercise.
The methodology to be followed for portfolio revision is
not also 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.
 Two different strategies may be adopted for portfolio
revision, namely
➢ Active Revision Strategy
➢ Passive Revision Strategy
The choice of the strategy would depend on the
investors objectives, skill, resources and time.
Active Revision Strategy:
Active revision strategy involves frequent and sometimes
substantial adjustments to the portfolio.
The effectiveness of an actively-managed investment
portfolio obviously depends on the skill of the manager
and research staff but also on how the term active is
defined.
Investors who undertake active revision strategy believe
that security markets are not continuously efficient.
They believe that securities can be mispriced at times
giving an opportunity for earning excess returns
through trading in them.
 Active portfolio revision is essentially carrying out
portfolio analysis and portfolio selection all over again.
 It is based on an analysis of the fundamental factors
affecting the economy, industry and company as also the
technical factors like demand and supply.
Consequently, the time, skill and resources required for
implementing active revision strategy will be much higher.
The frequency of trading is likely to be much higher under
active revision strategy resulting in higher transaction
costs.
Passive Revision Strategy:
Passive portfolio strategy, in contrast, involves only minor
and infrequent adjustment to the portfolio over time. The
practitioner of passive revision strategy believe in market
efficiency and homogeneity of expectation among
investors. They find little incentive for actively trading and
revising portfolios periodically.
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/her portfolio according
to changes in the securities market.
 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 timings of buying and selling
securities automatic and eliminate the emotions surroundings
the timing decisions.
Formula plans consist of predetermined rules regarding when
to buy or sell and how much to buy or sell.
These predetermined rules call for specified actions when
there are changes in the securities market.
 The use of formula plans demands that the investor divide
his investment funds into two portfolios, one aggressive
and the other conservative or defensive.
 The aggressive policy usually consists of equity shares
while the defensive portfolio consists of bonds and
debentures.
The formula plans specify predetermined rules for the
transfer of funds from the aggressive portfolio to the
defensive portfolio. These rules enable the investor to
automatically sell shares when their prices are rising and
buy shares when their prices are falling.
Assumption –I
Certain percentage of the investor’s fund is
allocated to fixed income securities and common
stocks. The proportion of the money invested in each
component depends on the prevailing market condition.
If the stock market is in the boom condition lesser
funds are allotted to stocks. If the market is low, the
proportion may reverse.
Assumption –II
If the market moves higher, the proportion of
stocks in the portfolio may either decline or remain
constant. The portfolio is more aggressive in the low
market and defensive when the market is on the rise.
Assumption –III
The stocks are bought and sold whenever there is a
significant change in the price. The changes in the level of
market could be measured with the help of indices.
Assumption –IV
The investor should strictly follow the formula plan
once he chooses it. He should not abandon the plan but
continue to act on the plan.
Assumption –V
The investor should select good stocks that move along
with the market. They should reflect the risk and return
features of the market.