Portfolio Management

Portfolio Management and Performance Evaluation

Portfolio Management

Definition: Portfolio management is the process of selecting and managing a mix of investments to achieve a specific financial goal, while balancing risk and return. It involves creating a strategy for investing based on the investor's financial situation, objectives, and risk tolerance.

Types of Portfolios:

• Market Portfolio:
  • A theoretical concept in which a portfolio includes all available assets in the market, weighted according to their market values. This portfolio is used in theories like the Capital Market Line (CML) in the Capital Asset Pricing Model (CAPM).
  • Purpose: Represents a diversified portfolio that is considered to be optimal.
• Zero Investment Portfolio:
  • A portfolio that has no net investment, meaning the total value of the investments is zero. This can be achieved by taking long positions in some securities and short positions in others.
  • Purpose: Often used for arbitrage strategies to exploit pricing discrepancies between related assets.

Types of Portfolio Management:

• Active Portfolio Management:
  • Description: Involves frequent buying and selling of securities to outperform the market.
  • Objective: Achieve returns above the market average by exploiting market inefficiencies.
  • Approach: Managers conduct detailed analysis and make investment decisions based on market conditions, trends, and forecasts.
• Passive Portfolio Management:
  • Description: Involves creating a portfolio that mimics a market index or benchmark.
  • Objective: Match market returns with lower costs and minimal trading.
  • Approach: Managers use index funds or exchange-traded funds (ETFs) to replicate the performance of a market index.
• Discretionary Portfolio Management:
  • Description: The portfolio manager makes all investment decisions on behalf of the client.
  • Objective: Provide a hands-off investment experience for the client, with the manager taking full control over asset selection and management.
  • Approach: Managers make decisions based on their expertise and the client's financial goals.
• Non-Discretionary Portfolio Management:
  • Description: The portfolio manager provides investment advice, but the client makes the final investment decisions.
  • Objective: Allow clients to retain control while benefiting from professional advice.
  • Approach: Managers offer recommendations and guidance but do not execute trades without client approval.

Need for Portfolio Management:

• Customized Investment Plans: Tailors investment strategies to individual needs, risk tolerance, and financial goals.
• Risk Reduction: Diversifies investments to minimize potential losses and manage risk effectively.
• Maximizing Returns: Seeks to achieve the highest possible returns based on the investor’s risk profile and investment horizon.

Portfolio Performance Evaluation

Definition: Portfolio performance evaluation is the process of assessing how well a portfolio has performed relative to a benchmark or objective. It helps investors and managers determine if the portfolio has met its goals and provides insights for future adjustments.

Evaluation Methods:

• Conventional Methods:
  • Benchmark Comparison: Compares the portfolio's performance to a relevant market index or benchmark. It assesses whether the portfolio has achieved returns that are in line with its benchmark.
  • Style Comparison: Evaluates the portfolio’s performance based on its investment style (e.g., growth vs. value) and compares it to similar funds or benchmarks.
• Risk-Adjusted Methods:
  • Sharpe Ratio:
    • Formula: $\mathrm{Sharpe } \mathrm{Ratio}=\frac{R_p-R_f}{{\sigma }_p}$
    • Description: Measures the return per unit of total risk (standard deviation). Higher ratios indicate better risk-adjusted returns.
  • Treynor Ratio:
    • Formula: $\mathrm{Treynor }\mathrm{Ratio}=\frac{R_p-R_f}{{\beta }_p}$
    • Description: Measures the return per unit of systematic risk (beta). It evaluates the portfolio’s performance relative to its exposure to market risk.
  • Jensen’s Alpha:
    • Formula:$\alpha =R_p-[R_f+{\beta }_p\cdot (R_m-R_f\left)\right]$
    • Description: Measures the excess return of the portfolio above the expected return predicted by CAPM. A positive alpha indicates outperformance relative to the expected return.
  • Modigliani-Modigliani (M2) Measure:
    • Formula: $M{2}^{}=R_p-R_f-\mathrm{risk}-\mathrm{free} \mathrm{rate}$

• • • × market risk premium

• Description: Adjusts the portfolio’s return for risk, comparing it to the market. It provides a measure of how the portfolio would perform if it had the same risk as the market.
• Treynor Squared:
  • Description: An extension of the Treynor Ratio, adjusting for risk levels and providing more detailed insights into portfolio performance.

Importance of Performance Evaluation:

• Investor Insight: Helps investors understand the effectiveness of their investments and whether they need to make adjustments.
• Manager Evaluation: Assists in evaluating the performance of portfolio managers and determining their compensation based on their performance.
• Rebalancing: Provides information needed to rebalance the portfolio to align with the investor’s goals and risk tolerance.

Summary:

• Portfolio Management involves the strategic selection and management of investments to meet financial goals while balancing risk and return. It includes various approaches like active, passive, discretionary, and non-discretionary management.
• Performance Evaluation assesses how well a portfolio has performed relative to benchmarks, using methods like benchmark comparison, Sharpe Ratio, Treynor Ratio, Jensen’s Alpha, and M2 Measure. This evaluation is crucial for optimizing investment strategies, assessing manager effectiveness, and making informed investment decisions.

Portfolio Management Services (PMS)

Definition:

PMS involves professional management of an individual's or institution's investment portfolio. Portfolio managers craft and execute investment strategies based on the client's financial goals and risk appetite.

Types of PMS:

• Discretionary PMS:
  • Description: The portfolio manager has full discretion to make investment decisions without needing client approval for each transaction.
  • Characteristics:
    • Investment Strategy: Tailored based on the manager's analysis and expertise.
    • Control: Manager has the authority to buy and sell assets as they see fit.
    • Client Involvement: Minimal, as the manager makes decisions on behalf of the client.
• Non-Discretionary PMS:
  • Description: The portfolio manager provides recommendations, but the client must approve each transaction before it is executed.
  • Characteristics:
    • Investment Strategy: Based on client’s instructions and preferences.
    • Control: Client retains control over investment decisions.
    • Client Involvement: High, as the client must authorize each transaction.

Characteristics:

• Transparency:
  • Discretionary PMS: Less transparent due to limited disclosure requirements. The client may not always be fully aware of all transactions.
  • Non-Discretionary PMS: More transparent since all transactions need client approval.
• Minimum Investment:
  • Typically high, often starting at ₹25 lakh (approx. $30,000). This targets high-net-worth individuals (HNIs) due to substantial initial investments.
• Fees:
  • Entry Load: Charged at the time of investment (less common now due to regulatory changes).
  • Management Fees: Variable; may include a fixed percentage of assets under management.
  • Profit Sharing: Some PMSs charge a performance-based fee, where the manager earns a portion of the profits above a specified return.
  • Fixed Fee: Alternatively, a fixed monthly or annual fee may be charged.
• Risk:
  • Concentration: Portfolios are typically concentrated, holding 20-30 stocks, which can increase risk.
  • Diversification: Less diversified compared to mutual funds, potentially leading to higher volatility.
• Consistency:
  • Performance can be inconsistent due to reliance on the portfolio manager's skill and market conditions.
• Complexity:
  • Evaluating PMS performance can be complex; detailed and frequent reporting may not be provided.
• Liquidity:
  • Typically lower; some PMSs have lock-in periods and high exit charges.
• Taxability:
  • Capital gains are taxed on each transaction. Short-term capital gains (holding less than 12 months) are taxed at 15%, and long-term gains are taxed as per prevailing tax laws.

Mutual Funds (MF)

Definition:

Mutual funds pool money from multiple investors to invest in a diversified portfolio of assets, managed by professional fund managers. The goal is to achieve a specific investment objective such as growth, income, or a combination.

Characteristics:

• Transparency:
  • Highly regulated by bodies like SEBI (Securities and Exchange Board of India). Regular disclosures on performance, holdings, and fees are required.
• Minimum Investment:
  • Generally low, starting from as little as ₹500 (approx. $6). This makes mutual funds accessible to a broad range of investors.
• Fees:
  • Expense Ratio: Includes management fees, administrative costs, and other expenses. Typically lower compared to PMS.
  • Exit Load: A small fee charged if the investment is redeemed within a specified period (e.g., 1 year).
• Risk:
  • Diversification: Funds invest in a diversified portfolio, reducing risk compared to concentrated portfolios. Investors can choose funds based on their risk tolerance.
  • Types of Funds: Includes equity funds, debt funds, balanced funds, etc., catering to various risk appetites.
• Consistency:
  • Generally provides stable returns over the long term. Mutual funds are managed according to established investment processes and strategies.
• Complexity:
  • Easier to understand and evaluate. Comprehensive information is available on the AMC’s website and through regular reports.
• Liquidity:
  • High liquidity; investments can be redeemed easily. Liquid mutual funds do not have lock-in periods and have minimal exit loads.
• Taxability:
  • Capital gains are taxed based on the holding period. Short-term capital gains (for equity funds, holding less than 1 year) are taxed at 15%, while long-term gains (more than 1 year) are taxed at 10% for equity funds. Debt funds have different tax rates and rules.

Comparison of PMS vs. Mutual Funds

• Transparency and Regulation:
  • Mutual Funds: Highly regulated, transparent, with detailed disclosures.
  • PMS: Less regulated, with varying levels of transparency.
• Minimum Investment:
  • Mutual Funds: Low, making it accessible to a wider audience.
  • PMS: High, catering to HNIs.
• Fees:
  • Mutual Funds: Lower expense ratios and minimal exit loads.
  • PMS: Higher fees, including management, entry loads, and profit sharing.
• Risk and Diversification:
  • Mutual Funds: Generally more diversified, reducing risk.
  • PMS: Often concentrated, leading to higher risk.
• Performance and Consistency:
  • Mutual Funds: Consistent returns due to regulated management processes.
  • PMS: Variable returns based on manager’s skill and market conditions.
• Liquidity:
  • Mutual Funds: High liquidity with easy redemption.
  • PMS: Lower liquidity with potential lock-in periods and high exit charges.
• Taxation:
  • Mutual Funds: Taxes applied on redemption based on holding period.
  • PMS: Capital gains taxed on each transaction, with different rates for short-term and long-term gains.
• Complexity:
  • Mutual Funds: Simpler to understand and manage.
  • PMS: More complex and harder to evaluate due to personalized management and less frequent reporting.

Conclusion

Mutual funds are often more suitable for most investors due to their lower costs, higher liquidity, and better diversification. PMS can be advantageous for high-net-worth individuals seeking personalized investment strategies and are willing to pay higher fees for potentially higher returns.