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THE HINDU COLLEGE-MBA, MACHILIPATNAM 1

SECURITY ANALYSIS

AND

PORTFOLIO

MANAGEMENT

PROF.V.V.S.K.PRASAD

THE HINDU COLLEGE –MBA

MACHILIPATNAM


SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

UNIT -1

Financial Investment - Meaning, its Need

It is human nature to plan for rainy days. An individual must plan and keep aside some amount

of money for any unavoidable circumstance which might arise in days to come.

Future is uncertain and one must invest wisely to avoid financial crisis in any point of time.

Let us first understand what is investment

Investment is nothing but goods or commodities purchased today to be used in future or at

the times of crisis. An individual must plan his future well to ensure happiness for himself as

well as his immediate family members. Consuming everything today and saving nothing for the

future is foolish. Not everyday is a bed of roses, you never know what your future has in store

for you.

What is Financial Investment ?

Financial investment refers to putting aside a fixed amount of money and expecting some kind

of gain out of it within a stipulated time frame.

What is Important in Financial Investment ?

Planning plays a pivotal role in Financial Investment. Don‘t just invest just for the sake of

investing. Understand why you really need to invest money? Investing just because your friend

has said you to do so is foolish. Careful analysis and focused approach are mandatory before

investing.

Explore all the investment plans available in the market. Go through the pros and cons of

each plan in detail. Analyze the risk factors carefully before finalizing the plan. Invest in

something which will give you the maximum return.

Appoint a good financial planning manager who takes care of all your investment needs.

He must understand your requirement, family income, stability etc to decide the best plan for

you.


One needs to be a little careful and sensible while investing. An individual must read the

documents carefully before investing.

Types of Financial Investment

An individual can invest in any of the following:

Mutual Funds

Fixed Deposits

Bonds

Stock

Equities

Real Estate (Residential/Commercial Property)

Gold /Silver

Precious stones

Need for Financial Investment

Financial Investment ensures all your dreams turn real and you enjoy life to the fullest without

actually worrying about the future.

Financial investment ensures you save for rainy days. Careful investment makes your future

secure.

Financial investment controls an individual‘s spending pattern. It decides how and what amount

one should spend so that he has sufficient money for future.

INVESTMENT ALTERNATIVES / OPTIONS

Summarised below are the short-term and long-term financial investment options available for

Indian investors.

Short-term investing

Savings bank account

Use only for short-term (less than 30 days) surpluses

Money market funds

Offer better returns than savings account without compromising liquidity

Bank fixed deposits

For investors with low risk appetite, best for 6-12 months investment period

Long-term investing

Post Office savings

Low risk and no TDS

http://www.moneycontrol.com/planning_desk/fininvoption.php#1





Public Provident Fund

Best fixed-income investment for high tax payers

Company fixed deposits

Option to maximise returns within a fixed-income portfolio

Bonds and debentures

Option for large investments or to avail of some capital gains tax rebates

Mutual Funds

Unless you rate high on our Investment IQ Test, use mutual funds as a vehicle to invest

Life Insurance Policies

Don't buy life insurance solely as an investment

Equity shares

Maximum returns over the long-term, invest funds you do not need for at least five years

1. Savings Bank Account

Use only for short-term (less than 30 days) surpluses

Often the first banking product people use, savings accounts offer low interest (4%-5% p.a.),

making them only marginally better than safe deposit lockers.

2. Money Market Funds (also known as liquid funds)

Offer better returns than savings account without compromising liquidity

Money market funds are a specialized form of mutual funds that invest in extremely short-term

fixed income instruments. Unlike most mutual funds, money market funds are primarily oriented

towards protecting your capital and then, aim to maximise returns.

Money market funds usually yield better returns than savings accounts, but lower than bank

fixed deposits. With the flexibility to issue cheques from a money market fund account now

available, explore this option before putting your money in a savings account.

3. Bank Fixed Deposit (Bank FDs)

For investors with low risk appetite, best for 6-12 months investment period

Also referred to as term deposits, this product would be offered by all banks. Minimum

investment period for bank FDs is 30 days.

The ideal investment time for bank FDs is 6 to 12 months as normally interest on bank less than

6 months bank FDs is likely to be lower than money market fund returns.








It is important to plan your investment time frame while investing in this instrument because

early withdrawals typically carry a penalty.

1. Post Office Savings Schemes (POSS)

Low risk and no TDS

POSS are popular because they typically yield a higher return than bank FDs. The monthly

income plan could suit you if you are a retired individual or have regular income needs.

Besides the low (Government) risk, the fact that there is no tax deducted at source (TDS) in a

POSS is amongst the key attractive features.

The Post Office offers various schemes that include National Savings Certificates (NSC),

National Savings Scheme(NSS), Kisan Vikas Patra, Monthly Income Scheme and Recurring

Deposit Scheme.

2. Public Provident Fund (PPF)

Best fixed-income investment for high tax payers

PPF is a very attractive fixed income investment option for small investors primarily because of -

1. An 11% post-tax return - effective pre-tax rate of 15.7% assuming a 30% tax rate

2. A tax-rebate - deduction of 20% of the amount invested from your tax liability for the year,

subject to a maximum Rs60,000 for a tax rebate

3. Low risk - risk attached is Government risk

So, what's the catch? Lack of liquidity is a big negative. You can withdraw your investment

made in Year 1 only in Year 7 (although there are some loan options that begin earlier).

If you are willing to live with poor liquidity, you should invest as much as you can in this

scheme before looking for other fixed income investment options.

3. Company Fixed Deposits (FDs)

Option to maximise returns within a fixed-income portfolio

FDs are instruments used by companies to borrow from small investors. Typically FDs are open

throughout the year. Invest in FDs only if you have surplus funds for more than 12 months.

Select your investment period carefully as most FDs are not encashable prior to their maturity.

Just as in any other instrument, risk is an embedded feature of FDs, more so because it is not


mandatory for non-finance companies to get a credit rating for this instrument.

Investors should consciously (either though a credit rating or through an expert) select the

companies they invest in. Quite a few small investors have lost their life's savings by investing in

FDs issued by companies that have run into financial problems.

4. Bonds and Debentures

Option for large investments or to avail of some capital gains tax rebates

Besides company FDs, bonds and debentures are the other fixed-income instruments issued by

companies. As a result of an illiquid secondary market and a lack-lustre primary market,

investment in these instruments is largely skewed towards issues from financial institutions.

While you might find some high-yielding options in the secondary market, if you do not want the

problems associated with bad deliveries and the transfer process or you want to invest a large

sum of money, the primary market is the better option.

5. Mutual Funds

Unless you rate high on our Investment IQ Test, use mutual funds as a vehicle to invest

. Investors pool together their money to buy stocks, bonds, or any other investments.

Investing through mutual funds allows an investor to -

1. Avail the services of a professional money manager (who manages the mutual fund)

2. Access a diversified portfolio despite making a limited investment

6. Life Insurance Policies

Don't buy life insurance solely as an investment

Life insurance premiums, depending upon the policy selected, include the costs of -

1) death-benefit coverage

2) built-in investment returns (average 8.0% to 9.5% post-tax)

3) significant overheads, including commissions.

This implies that if you buy insurance solely as an investment, you are incurring costs that you

would not incur in alternate investment options.

It is, however, important to insure your life if your financial needs and profile so require.

http://www.moneycontrol.com/planning_desk/investmentiq.php


7. Equity Shares

Maximum returns over the long-term, invest funds you do not need for at least five years

There are two ways in which you can invest in equities-

1. through the secondary market (by buying shares that are listed on the stock exchanges)

2. through the primary market (by applying for shares that are offered to the public)

Over the long term, equity shares have offered the maximum return to investors. As an

investment option, investing in equity shares is also perceived to carry a high level of risk.

Choosing the Right Investment Options

The choice of the best investment options for you will depend on your personal circumstances as

well as general market conditions. For example, a good investment for a long-term retirement

plan may not be a good investment for higher education expenses. In most cases, the right

investment is a balance of three things: Liquidity, Safety and Return.

To a large extent, the choice of the right investment option will also depend upon your financial

goals. For example, if you want to invest for funding your vacation next year, don't choose an

investment vehicle that has a three-year lock-in. Similarly, if you want to invest for your


daughter's marriage after 10 years, don't invest in 1yr bonds for the next 10 years. Instead,

choose an option that matches your investment horizon.

Financial Markets

A market is a place where two parties are involved in transaction of goods and services in

exchange of money. The two parties involved are:

Buyer

Seller

In a market the buyer and seller comes on a common platform, where buyer purchases goods

and services from the seller in exchange of money.

What is a Financial Market ?

A place where individuals are involved in any kind of financial transaction refers to

financial market. Financial market is a platform where buyers and sellers are involved in sale

and purchase of financial products like shares, mutual funds, bonds and so on.

Let us go through the various types of financial market:

Capital Market

A market where individuals invest for a longer duration i.e. more than a year is called as capital

market. In a capital market various financial institutions raise money from individuals and invest

it for a longer period.

Capital Market is further divided into:

i. Primary Market: Primary Market is a form of capital market where various companies

issue new stock, shares and bonds to investors in the form of IPO‘s (Initial Public

Offering).Primary Market is a form of market where stocks and securities are issued for

the first time by organizations.

ii. Secondary Market: Secondary market is a form of capital market where stocks and

securities which have been previously issued are bought and sold.

Types of Capital Market


1. Stock Markets: Stock Market is a type of Capital market which deals with the issuance

and trading of shares and stocks at a certain price.

2. Bond Markets: Bond Market is a form of capital market where buyers and sellers are

involved in the trading of bonds.

3. Commodity Market: A market which facilitates the sale and purchase of raw goods is

called a commodity market.

Commodity market like any other market includes a buyer and a seller. In such a market

buyer purchases raw products like rice, wheat, grain, cattle and so on from the seller at a

mutually agreed rate.

4. Money Market: As the name suggests, money market involves individuals who deal

with the lending and borrowing of money for a short time frame.

5. Derivatives Market: The market which deals with the trading of contracts which are

derived from any other asset is called as derivative market.

6. Future Market: Future market is a type of financial market which deals with the trading

of financial instruments at a specific rate where in the delivery takes place in future.

7. Insurance Market: Insurance market deals with the trading of insurance products.

Insurance companies pay a certain amount to the immediate family members of owner of

the policy in case of his untimely death.

8. Foreign Exchange Market: Foreign exchange market is a globally operating market

dealing in the sale and purchase of foreign currencies.

9. Private Market: Private market is a form of market where transaction of financial

products takes place between two parties directly.

10. Mortgage Market: A type of market where various financial organizations are involved

in providing loans to individuals on various residential and commercial properties for a

specific duration is called a mortgage market. The payment is made to the individual

concerned on submitting certain necessary documents and fulfilling certain basic criteria.

Shares and Stock Market - An Overview

An organization in order to raise money divides its entire capital into small units of equal value.

Each unit is called a share.

A share is nothing but an indivisible unit of a company‘s capital to be sold among individuals to

increase profit of the organization.

Shareholder

An individual owning one or more than one share of an organization is called a shareholder. In

simpler words, an individual purchasing one or more than one share from any private or public

organization is called a shareholder.

A shareholder can sell his shares anytime depending on the current value of the share.

He/she can purchase any new share issued by any other or same organization.


A shareholder has the right to declared dividend.

Dividend

Why do people invest in shares ?

An organization pays the shareholders for investing in their company‘s shares. The income

earned by an individual by investing in an organization‘s share (private or public) is called as

dividend.

What is Retained Earnings ?

The profit earned by an organization is put into use in the following two ways:

It is paid to the shareholders as dividend.

The profit earned by the organization is not distributed amongst the shareholders but is

retained and reinvested in the organization. This portion of the income is called retained

earnings.

What is a Share Certificate ?

When an individual purchases shares from any organization, he/she is issued a certificate as a

proof of his investment. Such a certificate issued by an organization to the shareholders is called

a share certificate.

Types of Shares

1. Equity Shares

Equity shares also called as ordinary shares are the shares where the payment of dividend

is directly proportional to the profits earned by the organization. Higher the profits

earned, higher the dividend, lower the profits, and lower the dividend. In an equity share,

dividends are paid at a fluctuating/floating rate.

2. Preference Shares

Shares which enjoy preference over payment of dividends are called preference shares.

Shareholders enjoy fixed rate of dividends in case of preference shares.

3. Founder Shares

Shares held by the management or founders of the organization are called as founder

shares.

4. Bonus Shares


Bonus shares are often issued to the shareholders when the organization earns surplus

profits. The company officials may decide to pay the extra profits to the shareholders

either as cash (dividend) or issue a bonus share to them.

Bonus shares are often issued by organizations to the shareholders free of charge as a gift

in proportion to their existing shares with the organization.

How to buy shares ?

Find a good broker for yourself. Make sure he has good knowledge about the share

market and can guide you properly.

To invest in shares one needs to open a DEMAT Account for online trading. A DEMAT

Account is mandatory for sale and purchase of shares anytime and anywhere.

An individual needs to have his PAN Card, a bank account, other necessary Identity

proofs, address proofs and so on.

Money Market and its Instruments

Money Market: Money market means market where money or its equivalent can be traded.

Money is synonym of liquidity. Money market consists of financial institutions and dealers in

money or credit who wish to generate liquidity. It is better known as a place where large

institutions and government manage their short term cash needs. For generation of liquidity,

short

term borrowing and lending is done by these financial institutions and dealers. Money Market is

part of financial market where instruments with high liquidity and very short term maturities are

traded. Due to highly liquid nature of securities and their short term maturities, money market is

treated as a safe place. Hence, money market is a market where short term obligations such as

treasury bills, commercial papers and banker’s acceptances are bought and sold.

Benefits and functions of Money Market: Money markets exist to facilitate efficient transfer of

short-term funds between holders and borrowers of cash assets. For the lender/investor, it

provides a good return on their funds. For the borrower, it enables rapid and relatively

inexpensive acquisition of cash to cover short-term liabilities. One of the primary functions of

money market is to provide focal point for RBI‘s intervention for influencing liquidity and

general levels of interest rates in the economy. RBI being the main constituent in the money

market aims at ensuring that liquidity and short term interest rates are consistent with the

monetary policy objectives.

Money Market & Capital Market: Money Market is a place for short term lending and


borrowing, typically within a year. It deals in short term debt financing and investments. On the

other hand, Capital Market refers to stock market, which refers to trading in shares and bonds of

companies on recognized stock exchanges. Individual players cannot invest in money market as

the value of investments is large, on the other hand, in capital market, anybody can make

investments through a broker. Stock Market is associated with high risk and high return as

against

money market which is more secure. Further, in case of money market, deals are transacted on

phone or through electronic systems as against capital market where trading is through

recognized stock exchanges.

Money Market Futures and Options: Active trading in money market futures and options

occurs on number of commodity exchanges. They function in the similar manner like any other

futures and options.

Money Market Instruments: Investment in money market is done through money market

instruments. Money market instrument meets short term requirements of the borrowers and

provides liquidity to the lenders. Common Money Market Instruments are as follows:

T reasury Bills (T-Bills): Treasury Bills, one of the safest money market instruments, are

short term borrowing instruments of the Central Government of the Country issued through

the Central Bank (RBI in India). They are zero risk instruments, and hence the returns are not

so attractive. It is available both in primary market as well as secondary market. It is a

promise to pay a said sum after a specified period. T-bills are short-term securities that

mature in one year or less from their issue date. They are issued with three-month, six-month

and one-year maturity periods. The Central Government issues T- Bills at a price less than

their face value (par value). They are issued with a promise to pay full face value on maturity.

So, when the T-Bills mature, the government pays the holder its face value. The difference

between the purchase price and the maturity value is the interest income earned by the

purchaser of the instrument. T-Bills are issued through a bidding process at auctions. The bid

can be prepared either competitively or non-competitively. In the second type of bidding,

return required is not specified and the one determined at the auction is received on maturity.

Whereas, in case of competitive bidding, the return required on maturity is specified in the

bid. In case the return specified is too high then the T-Bill might not be issued to the bidder.

At present, the Government of India issues three types of treasury bills through auctions,


namely, 91-day, 182-day and 364-day. There are no treasury bills issued by State

Governments. Treasury bills are available for a minimum amount of Rs.25K and in its

multiples. While 91-day T-bills are auctioned every week on Wednesdays, 182-day and 364-

day T-bills are auctioned every alternate week on Wednesdays. The Reserve Bank of India

issues a quarterly calendar of T-bill auctions which is available at the Banks‘ website. It also

announces the exact dates of auction, the amount to be auctioned and payment dates by

issuing press releases prior to every auction. Payment by allottees at the auction is required to

be made by debit to their/ custodian‘s current account. T-bills auctions are held on the

Negotiated Dealing System (NDS) and the members electronically submit their bids on the

system. NDS is an electronic platform for facilitating dealing in Government Securities and

Money Market Instruments. RBI issues these instruments to absorb liquidity from the market

by contracting the money supply. In banking terms, this is called Reverse Repurchase

(Reverse Repo). On the other hand, when RBI purchases back these instruments at a specified

date mentioned at the time of transaction, liquidity is infused in the market. This is called

Repo (Repurchase) transaction.

R epurchase Agreements: Repurchase transactions, called Repo or Reverse Repo are

transactions or short term loans in which two parties agree to sell and repurchase the same

security. They are usually used for overnight borrowing. Repo/Reverse Repo transactions can

be done only between the parties approved by RBI and in RBI approved securities viz. GOI

and State Govt Securities, T-Bills, PSU Bonds, FI Bonds, Corporate Bonds etc. Under

repurchase agreement the seller sells specified securities with an agreement to repurchase the

same at a mutually decided future date and price. Similarly, the buyer purchases the securities

with an agreement to resell the same to the seller on an agreed date at a predetermined price.

Such a transaction is called a Repo when viewed from the perspective of the seller of the

securities and Reverse Repo when viewed from the perspective of the buyer of the securities.

Thus, whether a given agreement is termed as a Repo or Reverse Repo depends on which

party initiated the transaction. The lender or buyer in a Repo is entitled to receive

compensation for use of funds provided to the counterparty. Effectively the seller of the

security borrows money for a period of time (Repo period) at a particular rate of interest

mutually agreed with the buyer of the security who has lent the funds to the seller. The rate of

interest agreed upon is called the Repo rate. The Repo rate is negotiated by the counterparties


independently of the coupon rate or rates of the underlying securities and is influenced by

overall money market conditions.

C ommercial Papers: Commercial paper is a low-cost alternative to bank loans. It is a short

term unsecured promissory note issued by corporates and financial institutions at a

discounted value on face value. They are usually issued with fixed maturity between one to

270 days and for financing of accounts receivables, inventories and meeting short term

liabilities. Say, for example, a company has receivables of Rs 1 lacs with credit period 6

months. It will not be able to liquidate its receivables before 6 months. The company is in

need of funds. It can issue commercial papers in form of unsecured promissory notes at

discount of 10% on face value of Rs 1 lacs to be matured after 6 months. The company has

strong credit rating and finds buyers easily. The company is able to liquidate its receivables

immediately and the buyer is able to earn interest of Rs 10K over a period of 6 months. They

yield higher returns as compared to T-Bills as they are less secure in comparison to these

bills; however chances of default are almost negligible but are not zero risk instruments.

Commercial paper being an instrument not backed by any collateral, only firms with high

quality credit ratings will find buyers easily without offering any substantial discounts. They

are issued by corporates to impart flexibility in raising working capital resources at market

determined rates. Commercial Papers are actively traded in the secondary market since they

are issued in the form of promissory notes and are freely transferable in demat form.

C ertificate of Deposit: It is a short term borrowing more like a bank term deposit account. It

is a promissory note issued by a bank in form of a certificate entitling the bearer to receive

interest. The certificate bears the maturity date, the fixed rate of interest and the value. It can

be issued in any denomination. They are stamped and transferred by endorsement. Its term

generally ranges from three months to five years and restricts the holders to withdraw funds

on demand. However, on payment of certain penalty the money can be withdrawn on demand

also. The returns on certificate of deposits are higher than T-Bills because it assumes higher

level of risk. While buying Certificate of Deposit, return method should be seen. Returns can

be based on Annual Percentage Yield (APY) or Annual Percentage Rate (APR). In APY,

interest earned is based on compounded interest calculation. However, in APR method,

simple interest calculation is done to generate the return. Accordingly, if the interest is paid

annually, equal return is generated by both APY and APR methods. However, if interest is


paid more than once in a year, it is beneficial to opt APY over APR.

B anker’s Acceptance: It is a short term credit investment created by a non financial firm and

guaranteed by a bank to make payment. It is simply a bill of exchange drawn by a person and

accepted by a bank. It is a buyer‘s promise to pay to the seller a certain specified amount at

certain date. The same is guaranteed by the banker of the buyer in exchange for a claim on

the goods as collateral. The person drawing the bill must have a good credit rating otherwise

the Banker‘s Acceptance will not be tradable. The most common term for these instruments

is 90 days. However, they can very from 30 days to180 days. For corporations, it acts as a

negotiable time draft for financing imports, exports and other transactions in goods and is

highly useful when the credit worthiness of the foreign trade party is unknown. The seller

need not hold it until maturity and can sell off the same in secondary market at discount from

the face value to liquidate its receivables.

An individual player cannot invest in majority of the Money Market Instruments, hence

for

retail market, money market instruments are repackaged into Money Market Funds. A

money market fund is an investment fund that invests in low risk and low return bucket of

securities viz money market instruments. It is like a mutual fund, except the fact mutual funds

cater to capital market and money market funds cater to money market. Money Market funds can

be categorized as taxable funds or non taxable funds.

Having understood, two modes of investment in money market viz Direct Investment in Money

Market Instruments & Investment in Money Market Funds, lets move forward to understand

functioning of money market account.

Money Market Account: It can be opened at any bank in the similar fashion as a savings

account. However, it is less liquid as compared to regular savings account. It is a low risk

account

where the money parked by the investor is used by the bank for investing in money market

instruments and interest is earned by the account holder for allowing bank to make such

investment. Interest is usually compounded daily and paid monthly. There are two types of

money market accounts:

Money Market Transactional Account: By opening such type of account, the account

holder can enter into transactions also besides investments, although the numbers of


transactions are limited.

Money Market Investor Account: By opening such type of account, the account

holder can only do the investments with no transactions.

Money Market Index: To decide how much and where to invest in money market an investor

will refer to the Money Market Index. It provides information about the prevailing market rates.

There are various methods of identifying Money Market Index like:

Smart Money Market Index- It is a composite index based on intra day price pattern

of the money market instruments.

Salomon Smith Barney’s World Money Market Index- Money market instruments are

evaluated in various world currencies and a weighted average is calculated. This

helps in determining the index.

Banker’s Acceptance Rate- As discussed above, Banker‘s Acceptance is a money

market instrument. The prevailing market rate of this instrument i.e. the rate at which

the banker‘s acceptance is traded in secondary market, is also used as a money

market index.

LIBOR/MIBOR- London Inter Bank Offered Rate/ Mumbai Inter Bank Offered Rate

also serves as good money market index. This is the interest rate at which banks

borrow funds from other banks.

MUTUAL FUNDS

Before we move to explain what is mutual fund, it‘s very important to know the area in

which mutual funds works, the basic understanding of stocks and bonds.

Stocks

Stocks represent shares of ownership in a public company. Examples of public companies

include Reliance, ONGC and Infosys. Stocks are considered to be the most common owned

investment traded on the market.

Bonds

Bonds are basically the money which you lend to the government or a company, and in

return you can receive interest on your invested amount, which is back over predetermined

amounts of time. Bonds are considered to be the most common lending investment traded on

the market.

There are many other types of investments other than stocks and bonds (including annuities,

real estate, and precious metals), but the majority of mutual funds invest in stocks and/or


bonds.

Working of Mutual Fund

Regulatory Authorities

To protect the interest of the investors, SEBI formulates policies and regulates the mutual

funds. It notified regulations in 1993 (fully revised in 1996) and issues guidelines from time

to time. MF either promoted by public or by private sector entities including one promoted

by foreign entities is governed by these Regulations.

SEBI approved Asset Management Company (AMC) manages the funds by making

investments in various types of securities. Custodian, registered with SEBI, holds the

securities of various schemes of the fund in its custody.

According to SEBI Regulations, two thirds of the directors of Trustee Company or board of

trustees must be independent.

The Association of Mutual Funds in India (AMFI) reassures the investors in units of mutual

funds that the mutual funds function within the strict regulatory framework. Its objective is to

increase public awareness of the mutual fund industry.

AMFI also is engaged in upgrading professional standards and in promoting best industry

practices in diverse areas such as valuation, disclosure, transparency etc.

What is a Mutual Fund?

A mutual fund is just the connecting bridge or a financial intermediary that allows a group of

investors to pool their money together with a predetermined investment objective. The


mutual fund will have a fund manager who is responsible for investing the gathered money

into specific securities (stocks or bonds). When you invest in a mutual fund, you are buying

units or portions of the mutual fund and thus on investing becomes a shareholder or unit

holder of the fund.

Mutual funds are considered as one of the best available investments as compare to others

they are very cost efficient and also easy to invest in, thus by pooling money together in a

mutual fund, investors can purchase stocks or bonds with much lower trading costs than if

they tried to do it on their own. But the biggest advantage to mutual funds is diversification,

by minimizing risk & maximizing returns.

Diversification

Diversification is nothing but spreading out your money across available or different types of

investments. By choosing to diversify respective investment holdings reduces risk

tremendously up to certain extent.

The most basic level of diversification is to buy multiple stocks rather than just one stock.

Mutual funds are set up to buy many stocks. Beyond that, you can diversify even more by

purchasing different kinds of stocks, then adding bonds, then international, and so on. It

could take you weeks to buy all these investments, but if you purchased a few mutual funds

you could be done in a few hours because mutual funds automatically diversify in a

predetermined category of investments (i.e. - growth companies, emerging or mid size

companies, low-grade corporate bonds, etc).

Types of Mutual Funds Schemes in India

Wide variety of Mutual Fund Schemes exists to cater to the needs such as financial position,

risk tolerance and return expectations etc. thus mutual funds has Variety of flavors, Being a

collection of many stocks, an investors can go for picking a mutual fund might be easy.

There are over hundreds of mutual funds scheme to choose from. It is easier to think of

mutual funds in categories, mentioned below.

Overview of existing schemes existed in mutual fund category: BY STRUCTURE

1. Open - Ended Schemes:

An open-end fund is one that is available for subscription all through the year. These do not

have a fixed maturity. Investors can conveniently buy and sell units at Net Asset Value

("NAV") related prices. The key feature of open-end schemes is liquidity.

2. Close - Ended Schemes:

These schemes have a pre-specified maturity period. One can invest directly in the scheme at

the time of the initial issue. Depending on the structure of the scheme there are two exit

options available to an investor after the initial offer period closes. Investors can transact

(buy or sell) the units of the scheme on the stock exchanges where they are listed. The


market price at the stock exchanges could vary from the net asset value (NAV) of the scheme

on account of demand and supply situation, expectations of unitholder and other market

factors. Alternatively some close-ended schemes provide an additional option of selling the

units directly to the Mutual Fund through periodic repurchase at the schemes NAV; however

one cannot buy units and can only sell units during the liquidity window. SEBI Regulations

ensure that at least one of the two exit routes is provided to the investor.

3. Interval Schemes:

Interval Schemes are that scheme, which combines the features of open-ended and close-

ended schemes. The units may be traded on the stock exchange or may be open for sale or

redemption during pre-determined intervals at NAV related prices.

The risk return trade-off indicates that if investor is willing to take higher risk then

correspondingly he can expect higher returns and vise versa if he pertains to lower risk

instruments, which would be satisfied by lower returns. For example, if an investors opt for

bank FD, which provide moderate return with minimal risk. But as he moves ahead to invest

in capital protected funds and the profit-bonds that give out more return which is slightly

higher as compared to the bank deposits but the risk involved also increases in the same

proportion.

Thus investors choose mutual funds as their primary means of investing, as Mutual funds

provide professional management, diversification, convenience and liquidity. That doesn‘t

mean mutual fund investments risk free. This is because the money that is pooled in are not

invested only in debts funds which are less riskier but are also invested in the stock markets

which involves a higher risk but can expect higher returns. Hedge fund involves a very high


risk since it is mostly traded in the derivatives market which is considered very volatile.

Overview of existing schemes existed in mutual fund category:

1. Equity fund:

These funds invest a maximum part of their corpus into equities holdings. The structure of

the fund may vary different for different schemes and the fund manager‘s outlook on

different stocks. The Equity Funds are sub-classified depending upon their investment

objective, as follows:

Diversified Equity Funds

Mid-Cap Funds

Sector Specific Funds

Tax Savings Funds (ELSS)

Equity investments are meant for a longer time horizon, thus Equity funds rank high on the

risk-return matrix.

2. Debt funds:

The objective of these Funds is to invest in debt papers. Government authorities, private

companies, banks and financial institutions are some of the major issuers of debt papers. By

investing in debt instruments, these funds ensure low risk and provide stable income to the

investors. Debt funds are further classified as:

Gilt Funds: Invest their corpus in securities issued by Government, popularly known

as Government of India debt papers. These Funds carry zero Default risk but are

associated with Interest Rate risk. These schemes are safer as they invest in papers

backed by Government.

Income Funds: Invest a major portion into various debt instruments such as bonds,

corporate debentures and Government securities.

MIPs: Invests maximum of their total corpus in debt instruments while they take

minimum exposure in equities. It gets benefit of both equity and debt market. These

scheme ranks slightly high on the risk-return matrix when compared with other debt

schemes.

Short Term Plans (STPs): Meant for investment horizon for three to six months.

These funds primarily invest in short term papers like Certificate of Deposits (CDs)

and Commercial Papers (CPs). Some portion of the corpus is also invested in

corporate debentures.

Liquid Funds: Also known as Money Market Schemes, These funds provides easy

liquidity and preservation of capital. These schemes invest in short-term instruments


like Treasury Bills, inter-bank call money market, CPs and CDs. These funds are

meant for short-term cash management of corporate houses and are meant for an

investment horizon of 1day to 3 months. These schemes rank low on risk-return

matrix and are considered to be the safest amongst all categories of mutual funds.

3. Balanced funds:

As the name suggest they, are a mix of both equity and debt funds. They invest in both

equities and fixed income securities, which are in line with pre-defined investment objective

of the scheme. These schemes aim to provide investors with the best of both the worlds.

Equity part provides growth and the debt part provides stability in returns.

Further the mutual funds can be broadly classified on the basis of investment parameter

viz,

Each category of funds is backed by an investment philosophy, which is pre-defined in the

objectives of the fund. The investor can align his own investment needs with the funds

objective and invest accordingly.

By investment objective:

Growth Schemes: Growth Schemes are also known as equity schemes. The aim of

these schemes is to provide capital appreciation over medium to long term. These

schemes normally invest a major part of their fund in equities and are willing to bear

short-term decline in value for possible future appreciation.

Income Schemes:Income Schemes are also known as debt schemes. The aim of these

schemes is to provide regular and steady income to investors. These schemes

generally invest in fixed income securities such as bonds and corporate debentures.

Capital appreciation in such schemes may be limited.

Balanced Schemes: Balanced Schemes aim to provide both growth and income by

periodically distributing a part of the income and capital gains they earn. These

schemes invest in both shares and fixed income securities, in the proportion indicated

in their offer documents (normally 50:50).

Money Market Schemes: Money Market Schemes aim to provide easy liquidity,

preservation of capital and moderate income. These schemes generally invest in safer,

short-term instruments, such as treasury bills, certificates of deposit, commercial

paper and inter-bank call money.

Other schemes

Tax Saving Schemes:

Tax-saving schemes offer tax rebates to the investors under tax laws prescribed from

time to time. Under Sec.88 of the Income Tax Act, contributions made to any Equity


Linked Savings Scheme (ELSS) are eligible for rebate.

Index Schemes:

Index schemes attempt to replicate the performance of a particular index such as the

BSE Sensex or the NSE 50. The portfolio of these schemes will consist of only those

stocks that constitute the index. The percentage of each stock to the total holding will

be identical to the stocks index weightage. And hence, the returns from such schemes

would be more or less equivalent to those of the Index.

Sector Specific Schemes:

These are the funds/schemes which invest in the securities of only those sectors or

industries as specified in the offer documents. e.g. Pharmaceuticals, Software, Fast

Moving Consumer Goods (FMCG), Petroleum stocks, etc. The returns in these funds

are dependent on the performance of the respective sectors/industries. While these

funds may give higher returns, they are more risky compared to diversified funds.

Investors need to keep a watch on the performance of those sectors/industries and

must exit at an appropriate time.

Types of returns

There are three ways, where the total returns provided by mutual funds can be enjoyed by

investors:

Income is earned from dividends on stocks and interest on bonds. A fund pays out

nearly all income it receives over the year to fund owners in the form of a

distribution.

If the fund sells securities that have increased in price, the fund has a capital gain.

Most funds also pass on these gains to investors in a distribution.

If fund holdings increase in price but are not sold by the fund manager, the fund's

shares increase in price. You can then sell your mutual fund shares for a profit. Funds

will also usually give you a choice either to receive a check for distributions or to

reinvest the earnings and get more shares.

Pros & cons of investing in mutual funds:

For investments in mutual fund, one must keep in mind about the Pros and cons of

investments in mutual fund.

Advantages of Investing Mutual Funds:


1. Professional Management - The basic advantage of funds is that, they are professional

managed, by well qualified professional. Investors purchase funds because they do not have

the time or the expertise to manage their own portfolio. A mutual fund is considered to be

relatively less expensive way to make and monitor their investments.

2. Diversification - Purchasing units in a mutual fund instead of buying individual stocks or

bonds, the investors risk is spread out and minimized up to certain extent. The idea behind

diversification is to invest in a large number of assets so that a loss in any particular

investment is minimized by gains in others.

3. Economies of Scale - Mutual fund buy and sell large amounts of securities at a time, thus

help to reducing transaction costs, and help to bring down the average cost of the unit for

their investors.

4. Liquidity - Just like an individual stock, mutual fund also allows investors to liquidate

their holdings as and when they want.

5. Simplicity - Investments in mutual fund is considered to be easy, compare to other

available instruments in the market, and the minimum investment is small. Most AMC also

have automatic purchase plans whereby as little as Rs. 2000, where SIP start with just Rs.50

per month basis.

Disadvantages of Investing Mutual Funds:

1. Professional Management- Some funds doesn‘t perform in neither the market, as their

management is not dynamic enough to explore the available opportunity in the market, thus

many investors debate over whether or not the so-called professionals are any better than

mutual fund or investor him self, for picking up stocks.

2. Costs – The biggest source of AMC income, is generally from the entry & exit load which

they charge from an investors, at the time of purchase. The mutual fund industries are thus

charging extra cost under layers of jargon.

3. Dilution - Because funds have small holdings across different companies, high returns

from a few investments often don't make much difference on the overall return. Dilution is

also the result of a successful fund getting too big. When money pours into funds that have

had strong success, the manager often has trouble finding a good investment for all the new

money.

4. Taxes - when making decisions about your money, fund managers don't consider your

personal tax situation. For example, when a fund manager sells a security, a capital-gain tax

is triggered, which affects how profitable the individual is from the sale. It might have been

more advantageous for the individual to defer the capital gains liability.


UNIT-2

Price or value of debt securities

Price or value of debt securities is the present value of the stream of cash flows received from

the remaining interest and principle. On the other hand, it can be called the ―time value of

money‖. It can be approximately calculated whether the price should be above or below its par

value by comparing the market rate (the required rate of return) with the coupon rate (the rate

specified on the security).

Example: A debt security with par value of 1,000 baht paying 6 percent coupon rate

Case 1 market rate is 6 percent (equal to interest rate)

The price of this security should be equal to its par value of 1,000 baht, since there is no

difference on rate of return between holding this security and investing in other kind of

investment vehicles.

Case 2 market rate declines to 4 percent

The price of this security should be higher than its par value since a buyer is willing to pay more

for getting a coupon rate of 6 percent, higher than other investment paying only 4 percent.

Case 3 market rate increases to 8 percent

The price of this security should be lower than its par value since a buyer has a chance to receive

8 percent from other investment which is higher than 6 percent coupon rate of this security.

Difference between Dirty Price and Clean Price


Normally, the debt securities are traded with the price including accrued interest (the interest

accrued from the last coupon date to the trade date). This price is called ―dirty price or gross

price‖. The price excluding accrued interest is called ―clean price‖.

Other Factors Affecting Price of Debt Securities

In addition to market interest rate, there are also other factors influencing price of debt securities,

e.g., credit rating either of the securities themselves or of the issuers. In a case where the

securities or the issuers are downgraded, the investors will ask for higher investment return rate

as a risk premium, resulting in the decrease of the securities price. Besides, other economic

factors such as an inflation rate also have an impact on interest rate expectation which then affect

the price of the securities as well.

Valuation of Corporate Securities

In financial terms, the value of an asset derives from the cash flows associated with that

asset. This applies whether the asset is a financial asset or a real asset.

The cash flows must be evaluated on a present value basis. Thus the value of any asset at time 0

would then be the discounted value of net cash flows over a relevant time horizon.

General Valuation Model

In financial terms, the value of an asset flows derives from the cash flows associated with that

asset. This applies whether the asset is a financial asset or a real asset. The cash flows must be

evaluated on a present value basis. Thus the value of any asset at time 0 might be modeled in the

following fashion.

where:V0 = Value at time 0

C = Year's cash flow

i = Annual interest rate

n = Number of years

V0 =

C1

+

C2

+ . . . +

Cn

(1 + i)1 (1 + i)2 (1 + i)n


For instance, a three-year asset with cash flows of $2000 in year one, $3000 in year two, and

$5000 in year three would be valued at $9144 if interest is 4%.

Year Cash Flow × PVIF @ 4% = Discounted Cash Flow

1 $2000 × .962 = $1924

2 $3000 × .925 = $2775

3 $5000 × .889 = $4445

$9144

So the discounted value of the cash flows for this assets is $9144. Does this mean that the price

of the asset at time 0 would be $9144? It does if the market for the asset is efficientEfficient

Markets:. So in an efficient market, V0 = P0. Thus to value or price an asset in an efficient

market, simply identify the cash flows associated with the asset and discount them down to

present value.

Valuing Bonds

Bonds are a corporate security representing debt of the company. They are easily valued since

the cash flows are easy to identify. The cash flows associated with bonds are the coupon

paymentsCoupon Payments: on the bond each coupon period and the maturity valueMaturity

Value: or face valueFace Value: of the bond. Most bonds in the U.S. pay coupons semiannually

and most bonds have maturity values of $1000 each. The following example illustrates how

easily bonds are priced.

Price a 5% coupon, $1000 bond with 5 years to maturity if other bonds of similar quality are sold

to yield 8%.

The coupon payments would be $50 per year (5% of $1000) or $25 each six months. There will

be 10 compounding periods (2 × 5 years.) The maturity value is $1000. The bonds will be

discounted at the market rate which is 8% per year or 4% each six months.

Periods Cash Flow × PVIF @ 4% = Discounted Cash Flow

1-10 $25 × 8.111 = $202.78

10 $1000 × .676 = $676.00

$878.78

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If one wanted to sell this bond for $980, no one would want to buy it. The only way the holder of

the bond could unload it would be to lower the price. On the other hand, if one said they would

sell the bond for $750, there would be a rush into the market to buy the bond. Thus, demand

would be greater than supply and the price of the bond would rise. To how much? To $878.78,

all other things being equal. Thus the $878.78 is the equilibrium priceEquilibrium Price: for the

bond until market conditions change.

Bond Yields

In the previous example the market rate of discount was 8%. That did not mean that all bonds

sold in the market had coupon rates of 8%. Rather it meant that all bonds of similar quality went

through the same auction price as the bond in the example. If the bond sold for a

discountDiscount:, that would increase the yield. If it sold at a premiumPremium:, that would

decrease the yield, all other things being equal. The yield to maturityYield to Maturity: is

actually the internal rate of returnInternal Rate of Return: on a bond. To find the internal rate of

return, use a financial calculator, a bond yield table, or a spreadsheet program. However, an

approximation of the yield to maturity may be found by employing the following formula.

where:I = Annual Interest in Dollars

FV = Face Value of Bond

MP = Market Price of Bond

n = Number of Years Until Maturity

YTM Approx =

I +

FV − MP

n

FV + MP

2

An example shows the approximate yield to maturity for a 5%, $1000 bond selling for $990 with

6 years to maturity.

YTM Approx =

50 +

1000 − 990

6

= 5.19%

1000 + 990







2

Note that in using this approximation formula that the semiannual payments are not adjusted. In

an efficient market, the yield, market rate of discount, and investors' required rate of return are

all equal.

Valuing Preferred Stock

Although preferred stock is an equity instrumentEquity Instrument:, it is easy valued.

Technically it is a perpetuity. As previously explained in time value of money, to value a

perpetuity, simply take the annual return in dollars and divide by the appropriate discount rate.

The annual return in dollars for a share of preferred stock would be the dividend rate, which is

found by taking the dividend rate and multiplying it by the par value for the preferred. The

formula for valuing preferred stock could then be written as follows.

where:D = Annual Dividend in Dollars

kp = Investors' required rate on similar preferred

P0 =

D

kp

An example illustrates the use of the formula. A share of preferred that pays a 5.25% dividend

has a par value of $100. If the investors' required rate of return is 9%, what would be the price?

P0 =

5.25

= $58.33

.09

The yield on a share of preferred may be calculated by a simple manipulation of the pricing

formula.

Kp =

D

P0

So if a 3.25%, $100 par preferred were selling for $50, the investors' required rate of return

would be 6.5%.

Kp = 3.25 = 0.065 = 6.5%



50

Valuing Common Stock

Common stock is not so easy to value. The cash flows are not stable or easily identified. One

simple model that is sometimes used to value common stock is the Gordon Dividend Valuation

Model.

where:D1 = Dividends Year 1

ks = Investors' Required Rate of Return

g = Growth Rate in Dividends

P0 =

D1

ks − g

D1 would be calculated by multiplying current dividends by (1 + g).

For example, price a share of common stock with current dividends of $5, a dividend growth rate

of 3% if the investors' required rate of return is 15%.

P0 =

5.15

= $42.92

.15 − .03

D1 was found by multiplying the current dividends of $5 by 1.03 (1 + .03).

Rate of Return

Investors' Required Rate of Return on Common Stock

By manipulating the Gordon formula, the investors' required rate of return may be estimated.

ks =

D1

+ g

P0

For example, find the investors' required rate of return on a share of common stock selling for

$100, current dividends of $3 and a dividend growth rate of 4%.


ks =

3.12

+ .04 = 7.12%

100

VALUATION MODELS

Stock Valuation Methods

Stocks have two types of valuations. One is a value created using some type of cash flow, sales

or fundamental earnings analysis. The other value is dictated by how much an investor is willing

to pay for a particular share of stock and by how much other investors are willing to sell a stock

for (in other words, by supply and demand). Both of these values change over time as investors

change the way they analyze stocks and as they become more or less confident in the future of

stocks. Let me discuss both types of valuations.

First, the fundamental valuation. This is the valuation that people use to justify stock prices. The

most common example of this type of valuation methodology is P/E ratio, which stands for Price

to Earnings Ratio. This form of valuation is based on historic ratios and statistics and aims to

assign value to a stock based on measurable attributes. This form of valuation is typically what

drives long-term stock prices.

The other way stocks are valued is based on supply and demand. The more people that want to

buy the stock, the higher its price will be. And conversely, the more people that want to sell the

stock, the lower the price will be. This form of valuation is very hard to understand or predict,

and is often drives the short-term stock market trends.

In short, there are many different ways to value stocks. I will list several of them here. The key

is to take each approach into account while formulating an overall opinion of the stock. Look at

each valuation technique and ask yourself why the stock is valued this way. If it is lower or

higher than other similar stocks, then try to determine why. And remember, a great company is

not always a great investment. Here are the basic valuation techniques:

Earnings Per Share (EPS). You've heard the term many times, but do you really know what it

means. EPS is the total net income of the company divided by the number of shares outstanding.

It sounds simple but unfortunately it gets quite a bit more complicated. Companies usually

report many EPS numbers. They usually have a GAAP EPS number (which means that it is

computed using all of mutually agreed upon accounting rules) and a Pro Forma EPS figure

(which means that they have adjusted the income to exclude any one time items as well as some

non-cash items like amortization of goodwill or stock option expenses). The most important

thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is

not trying to manipulate their EPS numbers to make it look like they are more profitable. Also,

look at the growth in EPS over the past several quarters / years to understand how volatile their

EPS is, and to see if they are an underachiever or an overachiever. In other words, have they

consistently beaten expectations or are they constantly restating and lowering their forecasts?

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The EPS number that most analysts use is the pro forma EPS. To compute this number, use the

net income that excludes any one-time gains or losses and excludes any non-cash expenses like

stock options or amortization of goodwill. Then divide this number by the number of fully

diluted shares outstanding. You can easily find historical EPS figures and to see forecasts for the

next 1-2 years by visiting free financial sites such as Yahoo Finance (enter the ticker and then

click on "estimates").

By doing your fundamental investment research you'll be able to arrive at your own EPS

forecasts, which you can then apply to the other valuation techniques below.

Price to Earnings (P/E). Now that you have several EPS figures (historical and forecasts),

you'll be able to look at the most common valuation technique used by analysts, the price to

earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual

EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times.

To get a good feeling of what P/E multiple a stock trades at, be sure to look at the historical and

forward ratios.

Historical P/Es are computed by taking the current price divided by the sum of the EPS for the

last four quarters, or for the previous year. You should also look at the historical trends of the

P/E by viewing a chart of its historical P/E over the last several years (you can find on most

finance sites like Yahoo Finance). Specifically you want to find out what range the P/E has

traded in so that you can determine if the current P/E is high or low versus its historical average.

Forward P/Es are probably the single most important valuation method because they reflect the

future growth of the company into the figure. And remember, all stocks are priced based on their

future earnings, not on their past earnings. However, past earnings are sometimes a good

indicator for future earnings. Forward P/Es are computed by taking the current stock price

divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for

next calendar of fiscal year or two. I always use the Forward P/E for the next two calendar years

to compute my forward P/Es. That way I can easily compare the P/E of one company to that of

it's competitors and to that of the market. For example, Cisco's fiscal year ends in July, so to

compute the P/E for that calendar year, I would add together the quarterly EPS estimates (or

actuals in some cases) for its quarters ended April, July, October and the next January. Use the

current price divided by this number to arrive at the P/E.

Also, it is important to remember that P/Es change constantly. If there is a large price change in

a stock you are watching, or if the earnings (EPS) estimates change, be sure to recompute the

ratio.

Growth Rate. Valuations rely very heavily on the expected growth rate of a company. For

starters, you can look at the historical growth rate of both sales and income to get a feeling for

what type of future growth that you can expect. However, companies are constantly changing, as

well as the economy, so don't rely on historical growth rates to predict the future, but instead use

them as a guideline for what future growth could look like if similar circumstances are

encountered by the company. To calculate your future growth rate, you'll need to do your own

investment research. The easiest way to arrive at this forecast is to listen to the company's

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quarterly conference call, or if it has already happened, then read a press release or other

company article that discusses the company's growth guidance. However, remember that

although company's are in the best position to forecast their own growth, they are not very

accurate, and things change rapidly in the economy and in their industry. So before you forecast

a growth rate, try to take all of these factors into account.

And for any valuation technique, you really want to look at a range of forecast values. For

example, if the company you are valuing has been growing earnings between 5 and 10% each

year for the last 5 years but suddenly thinks it will grow 15 - 20% this year, you may want to be

a little more conservative than the company and use a growth rate of 10 - 15%. Another example

would be for a company that has been going through restructuring. They may have been

growing earnings at 10 - 15% over the past several quarters / years because of cost cutting, but

their sales growth could be only 0 - 5%. This would signal that their earnings growth will

probably slow when the cost cutting has fully taken effect. Therefore you would want to forecast

earnings growth closer to the 0 - 5% rate than the 15 - 20%. The point I'm trying to make is that

you really need to use a lot of gut feel to make a forecast. That is why the analysts are often

inaccurate and that is why you should get as familiar with the company as you can before

making these forecasts.

PEG Ratio. This valuation technique has really become popular over the past decade or so. It is

better than just looking at a P/E because it takes three factors into account; the price, earnings,

and earnings growth rates. To compute the PEG ratio (a.k.a. Price Earnings to Growth ratio)

divide the Forward P/E by the expected earnings growth rate (you can also use historical P/E and

historical growth rate to see where it's traded in the past). This will yield a ratio that is usually

expressed as a percentage. The theory goes that as the percentage rises over 100% the stock

becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes

more and more undervalued. The theory is based on a belief that P/E ratios should approximate

the long-term growth rate of a company's earnings. Whether or not this is true will never be

proven and the theory is therefore just a rule of thumb to use in the overall valuation process.

Here's an example of how to use the PEG ratio. Say you are comparing two stocks that you are

thinking about buying. Stock A is trading at a forward P/E of 15 and expected to grow at 20%.

Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock

A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a

better purchase because it has a lower PEG ratio, or in other words, you can purchase it's future

earnings growth for a lower relative price than that of Stock B.

Return on Invested Capital (ROIC). This valuation technique measures how much money the

company makes each year per dollar of invested capital. Invested Capital is the amount of

money invested in the company by both stockholders and debtors. The ratio is expressed as a

percent and you should look for a percent that approximates the level of growth that you expect.

In it's simplest definition, this ratio measures the investment return that management is able to

get for its capital. The higher the number, the better the return.

To compute the ratio, take the pro forma net income (same one used in the EPS figure mentioned

above) and divide it by the invested capital. Invested capital can be estimated by adding together



the stockholders equity, the total long and short term debt and accounts payable, and then

subtracting accounts receivable and cash (all of these numbers can be found on the company's

latest quarterly balance sheet). This ratio is much more useful when you compare it to other

companies that you are valuing.

Return on Assets (ROA). Similar to ROIC, ROA, expressed as a percent, measures the

company's ability to make money from its assets. To measure the ROA, take the pro forma net

income divided by the total assets. However, because of very common irregularities in balance

sheets (due to things like Goodwill, write-offs, discontinuations, etc.) this ratio is not always a

good indicator of the company's potential. If the ratio is higher or lower than you expected, be

sure to look closely at the assets to see what could be over or understating the figure.

Price to Sales (P/S). This figure is useful because it compares the current stock price to the

annual sales. In other words, it tells you how much the stock costs per dollar of sales earned. To

compute it, take the current stock price divided by the annual sales per share. The annual sales

per share should be calculated by taking the net sales for the last four quarters divided by the

fully diluted shares outstanding (both of these figures can be found by looking at the press

releases or quarterly reports). The price to sales ratio is useful, but it does not take into account

any debt the company has. For example, if a company is heavily financed by debt instead of

equity, then the sales per share will seem high (the P/S will be lower). All things equal, a lower

P/S ratio is better. However, this ratio is best looked at when comparing more than one company.

Market Cap. Market Cap, which is short for Market Capitalization, is the value of all of the

company's stock. To measure it, multiply the current stock price by the fully diluted shares

outstanding. Remember, the market cap is only the value of the stock. To get a more complete

picture, you'll want to look at the Enterprise Value.

Enterprise Value (EV). Enterprise Value is equal to the total value of the company, as it is

trading for on the stock market. To compute it, add the market cap (see above) and the total net

debt of the company. The total net debt is equal to total long and short term debt plus accounts

payable, minus accounts receivable, minus cash. The Enterprise Value is the best approximation

of what a company is worth at any point in time because it takes into account the actual stock

price instead of balance sheet prices. When analysts say that a company is a "billion dollar"

company, they are often referring to it's total enterprise value. Enterprise Value fluctuates

rapidly based on stock price changes.

EV to Sales. This ratio measures the total company value as compared to its annual sales. A

high ratio means that the company's value is much more than its sales. To compute it, divide the

EV by the net sales for the last four quarters. This ratio is especially useful when valuing

companies that do not have earnings, or that are going through unusually rough times. For

example, if a company is facing restructuring and it is currently losing money, then the P/E ratio

would be irrelevant. However, by applying a EV to Sales ratio, you could compute what that

company could trade for when it's restructuring is over and its earnings are back to normal.

EBITDA. EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is

one of the best measures of a company's cash flow and is used for valuing both public and



private companies. To compute EBITDA, use a companies income statement, take the net

income and then add back interest, taxes, depreciation, amortization and any other non-cash or

one-time charges. This leaves you with a number that approximates how much cash the

company is producing. EBITDA is a very popular figure because it can easily be compared

across companies, even if all of the companies are not profitable.

EV to EBITDA. This is perhaps one of the best measurements of whether or not a company is

cheap or expensive. To compute, divide the EV by EBITDA (see above for calculations). The

higher the number, the more expensive the company is. However, remember that more

expensive companies are often valued higher because they are growing faster or because they are

a higher quality company. With that said, the best way to use EV/EBITDA is to compare it to

that of other similar companies.

Now that we've covered many of the stock valuation ratios, it's time to do your competitive

analysis.

Gordon Growth Model

A model for determining the intrinsic value of a stock, based on a future series of dividends that

grow at a constant rate. Given a dividend per share that is payable in one year,

and the assumption that the dividend grows at a constant rate in perpetuity, the model solves for

the present value of the infinite series of future dividends.

Where:

D = Expected dividend per share one year from now

k = Required rate of return for equity investor

G = Growth rate in dividends (in perpetuity)

Gordon Constant Growth Model

Because the model simplistically assumes a constant growth rate, it is generally only used for

mature companies (or broad market indices) with low to moderate growth rates.

Constant Growth Stock Valuation

Stock Valuation is more difficult than Bond Valuation because stocks do not have a finite

maturity and the future cash flows, i.e., dividends, are not specified. Therefore, the techniques

used for stock valuation must make some assumptions regarding the structure of the dividends.

http://www.abcstockinvesting.com/competitive-analysis.html

http://www.abcstockinvesting.com/competitive-analysis.html


A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the

foreseeable future. This condition fits many established firms, which tend to grow over the long

run at the same rate as the economy, fairly well. The value of a constant growth stock can be

determined using the following equation:

where

P0 = the stock price at time 0,

D0 = the current dividend,

D1 = the next dividend (i.e., at time 1),

g = the growth rate in dividends, and

r = the required return on the stock, and

g < r.

Constant Growth Stock Valuation Example

Find the stock price given that the current dividend is $2 per

share, dividends are expected to grow at a rate of 6% in the

forseeable future, and the required return is 12%.

10.1 Dividend Yield and Capital Gains Yield

The constant growth stock equation can be rearranged to

obtain an expression for the expected return on the stock as

follows:

When expressed in this manner, it is apparent that the

expected return on the stock equals the expected dividend

yield plus the expected capital gains yield where the

dividend yield and capital gains yield are defined as follows:

A more general form of the Constant Growth Stock Valuation formula which can be used to find

the price of the stock at any period t in the future is given by the following:


Multistage Dividend Discount Model

The two-stage model has an unstable initial growth rate, and can be either positive or

negative. This initial phase lasts for a specified time and is followed by stable growth which

lasts forever. The problem with this model is that the growth rate from the initial phase is

assumed to change to the stable growth rate overnight.

The H-model has an initial growth rate that is already high, which then declines to a stable

growth rate over time. This model assumes that a company's dividend payout ratio and

cost of equity remains constant, which is its biggest downfall.

Finally the three-stage model has an initial phase of stable high growth that lasts for a

certain period. In the second phase the growth rate declines linearly until it reaches the a

final stable growth rate. This model improves upon both previous models and can be

applied to nearly all firms.

The Gordon Growth Model

The Gordon growth model is a type of dividend discount model used to value companies

expected to grow at a constant rate forever. Most valuation models forecast growth for a certain

time period before reverting to a Gordon growth model to estimate the ending value.

The Gordon growth model formula is V(0) = [D(0)(1+g)]/(r-g)

where V(0) is the value today, D(0) is the current annual dividend, g is the annual growth rate

and r is the required return on the stock. This can also be expressed as V(0) = D(1)/(r-g) where

D(1) is next year‘s dividend. If the dividend grows in line with the expected growth rate the two

formulae are equivalent.

http://financial-education.com/2007/10/07/the-gordon-growth-model/


UNIT-3

Portfolio Management - Meaning and Importance

It is essential for individuals to invest wisely for the rainy days and to make their future secure.

What is a Portfolio ?

A portfolio refers to a collection of investment tools such as stocks, shares, mutual funds, bonds,

cash and so on depending on the investor‘s income, budget and convenient time frame.

Following are the two types of Portfolio:

1. Market Portfolio

2. Zero Investment Portfolio

What is Portfolio Management ?

The art of selecting the right investment policy for the individuals in terms of minimum

risk and maximum return is called as portfolio management.

Portfolio management refers to managing an individual‘s investments in the form of bonds,

shares, cash, mutual funds etc so that he earns the maximum profits within the stipulated time

frame.

Portfolio management refers to managing money of an individual under the expert guidance of

portfolio managers.

In a layman‘s language, the art of managing an individual‘s investment is called as portfolio

management.

Need for Portfolio Management

Portfolio management presents the best investment plan to the individuals as per their income,

budget, age and ability to undertake risks.


Portfolio management minimizes the risks involved in investing and also increases the chance

of making profits.

Portfolio managers understand the client‘s financial needs and suggest the best and unique

investment policy for them with minimum risks involved.

Portfolio management enables the portfolio managers to provide customized investment

solutions to clients as per their needs and requirements.

Types of Portfolio Management

Portfolio Management is further of the following types:

Active Portfolio Management: As the name suggests, in an active portfolio

management service, the portfolio managers are actively involved in buying and selling

of securities to ensure maximum profits to individuals.

Passive Portfolio Management: In a passive portfolio management, the portfolio

manager deals with a fixed portfolio designed to match the current market scenario.

Discretionary Portfolio management services: In Discretionary portfolio management

services, an individual authorizes a portfolio manager to take care of his financial needs

on his behalf. The individual issues money to the portfolio manager who in turn takes

care of all his investment needs, paper work, documentation, filing and so on. In

discretionary portfolio management, the portfolio manager has full rights to take

decisions on his client‘s behalf.

Non-Discretionary Portfolio management services: In non discretionary portfolio

management services, the portfolio manager can merely advise the client what is good

and bad for him but the client reserves full right to take his own decisions.

Who is a Portfolio Manager ?

An individual who understands the client‘s financial needs and designs a suitable investment

plan as per his income and risk taking abilities is called a portfolio manager. A portfolio manager

is one who invests on behalf of the client.


A portfolio manager counsels the clients and advises him the best possible investment plan

which would guarantee maximum returns to the individual.

A portfolio manager must understand the client‘s financial goals and objectives and offer a tailor

made investment solution to him. No two clients can have the same financial needs.

Roles and Responsibilities of a Portfolio Manager

A portfolio manager is one who helps an individual invest in the best available investment plans

for guaranteed returns in the future.

Let us go through some roles and responsibilities of a Portfolio manager:

A portfolio manager plays a pivotal role in deciding the best investment plan for an

individual as per his income, age as well as ability to undertake risks. Investment is

essential for every earning individual. One must keep aside some amount of his/her

income for tough times. Unavoidable circumstances might arise anytime and one needs

to have sufficient funds to overcome the same.

A portfolio manager is responsible for making an individual aware of the various

investment tools available in the market and benefits associated with each plan. Make

an individual realize why he actually needs to invest and which plan would be the best

for him.

A portfolio manager is responsible for designing customized investment solutions

for the clients. No two individuals can have the same financial needs. It is essential for

the portfolio manager to first analyze the background of his client. Know an individual‘s

earnings and his capacity to invest. Sit with your client and understand his financial needs

and requirement.

A portfolio manager must keep himself abreast with the latest changes in the

financial market. Suggest the best plan for your client with minimum risks involved and

maximum returns. Make him understand the investment plans and the risks involved with

each plan in a jargon free language. A portfolio manager must be transparent with


individuals. Read out the terms and conditions and never hide anything from any of your

clients. Be honest to your client for a long term relationship.

A portfolio manager ought to be unbiased and a thorough professional. Don‘t always

look for your commissions or money. It is your responsibility to guide your client and

help him choose the best investment plan. A portfolio manager must design tailor made

investment solutions for individuals which guarantee maximum returns and benefits

within a stipulated time frame. It is the portfolio manager‘s duty to suggest the individual

where to invest and where not to invest? Keep a check on the market fluctuations and

guide the individual accordingly.

A portfolio manager needs to be a good decision maker. He should be prompt enough

to finalize the best financial plan for an individual and invest on his behalf.

Communicate with your client on a regular basis. A portfolio manager plays a major role

in setting financial goal of an individual. Be accessible to your clients. Never ignore

them. Remember you have the responsibility of putting their hard earned money into

something which would benefit them in the long run.

Be patient with your clients. You might need to meet them twice or even thrice to explain

them all the investment plans, benefits, maturity period, terms and conditions, risks

involved and so on. Don‘t ever get hyper with them.

Never sign any important document on your client’s behalf. Never pressurize your

client for any plan. It is his money and he has all the rights to select the best plan for

himself.

PORTFOLIO MANAGEMENT PROCESS

The portfolio management process is the process an investor takes to aid him in meeting his

investment goals.

The procedure is as follows:

Create a Policy Statement -A policy statement is the statement that contains the investor's goals

and constraints as it relates to his investments.

1. Develop an Investment Strategy - This entails creating a strategy that combines the

investor's goals and objectives with current financial market and economic conditions.

2. Implement the Plan Created -This entails putting the investment strategy to work,

investing in a portfolio thatmeets the client's goals and constraint requirements.


3. Monitor and Update the Plan -Both markets and investors' needs change as time

changes. As such, it is important to monitor for these changes as they occur and to update

the plan toadjust for the changes that have occurred.

Policy Statement

A policy statement is the statement that contains the investor's goals and constraints as it relates

to his investments. This could be considered to be the most important of all the steps in the

portfolio management process. The statement requires the investor to consider his true financial

needs, both in the short run and the long run. It helps to guide the investment portfolio manager

in meeting the investor's needs. When there is market uncertainty or the investor's needs change,

the policy statement will help to guide the investor in making the necessary adjustments the

portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and Return

Return objectives are important to determine. They help to focus an investor on meeting his

financial goals and objectives. However, risk must be considered as well. An investor may

require a high rate of return. A high rate of return is typically accompanied by a higher

risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is

attached to that higher return portfolio. As such, it is important to consider not only return, but

the risk of the investor in a policy statement.

Factors Affecting Risk Tolerance

An investor's risk tolerance can be affected by many factors:

Age- an investor may have lower risk tolerance as they get older and financial constraints

are more prevalent.

Family situation - an investor may have higher income needs if they are supporting a

child in college or an elderly relative.

Wealth and income - an investor may have a greater ability to invest in a portfolio if he

or she has existing wealth or high income.

Psychological - an investor may simply have a lower tolerance for risk based on his

personality.

Return Objectives and Investment Constraints

Return objectives can be divided into the following needs:

1. Capital Preservation - Capital preservation is the need to maintain capital. To

accomplish this objective, the return objective should, at a minimum, be equal to the

inflation rate. In other words, nominal rate of return would equal the inflation rate. With

this objective, an investor simply wants to preserve his existing capital.

2. Capital Appreciation -Capital appreciation is the need to grow, rather than simply

preserve, capital. To accomplish this objective, the return objective should be equal to a

return that exceeds the expected inflation. With this objective, an investor's intention is to

grow his existing capital base.


3. Current Income -Current income is the need to create income from the investor's capital

base. With this objective, an investor needs to generate income from his investments.

This is frequently seen with retired investors who no longer have income from work and

need to generate income off of their investments to meet living expenses and other

spending needs.

4. Total Return - Total return is the need to grow the capital base through both capital

appreciation and reinvestment of that appreciation.

Investment Constraints

When creating a policy statement, it is important to consider an investor's constraints. There are

five types of constraints that need to be considered when creating a policy statement. They are as

follows:

1. Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity, or

cash. For example, within the next year, an investor needs $50,000 for the purchase of a

new home. The $50,000 would be considered a liquidity constraint because it needs to be

set aside (be liquid) for the investor.

2. Time Horizon - A time horizon constraint develops a timeline of an investor's various

financial needs. The time horizon also affects an investor's ability to accept risk. If an

investor has a long time horizon, the investor may have a greater ability to accept risk

because he would have a longer time period to recoup any losses. This is unlike an

investor with a shorter time horizon whose ability to accept risk may be lower because he

would not have the ability to recoup any losses.

3. Tax Concerns - After-tax returns are the returns investors are focused on when creating

an investment portfolio. If an investor is currently in a high tax bracket as a result of his

income, it may be important to focus on investments that would not make the investor's

situation worse, like investing more heavily in tax-deferred investments.

4. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint

and must be considered. An example of this would occur in a trust. A trust could require

that no more than 10% of the trust be distributed each year. Legal and

regulatoryconstraints such as this one often can't be changed and must not be overlooked.

5. Unique Circumstances - Any special needs or constraints not recognized in any of the

constraints listed above would fall in this category. An example of a unique circumstance

would be the constraint an investor might place on investing in any company that is not

socially responsible, such as a tobacco company.

The Importance of Asset Allocation

Asset Allocation is the process of dividing a portfolio among major asset categories such as

bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying the

portfolio.

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a

young executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree

would be more likely to have 80% in fixed income and 20% equities.

Citizens in other countries around the world would have different asset allocation strategies


depending on the types and risks of securities available for placement in their portfolio. For

example, a retiree located in the United States would most likely have a large portion of his

portfolio allocated to U.S. treasuries, since the U.S. Government is considered to have an

extremely low risk of default. On the other hand, a retiree in a country with political unrest

would most likely have a large portion of their portfolio allocated to foreign treasury securities,

such as that of the U.S.

What is investment portfolio?

A portfolio is a collection of securities. Since it is rarely desirable to invest the entire funds of an

individual or an institution in a single security, it is essential that every security be viewed in a

portfolio context. A portfolio comprising of different types of securities and assets.

As the investors acquire different sets of assets of financial nature, such as gold, silver, real

estate, buildings, insurance policies, post office certificates, NSC etc., they are making a

provision for future. The risk of each of such investments is to be understood before hand.

Normally the average householder keeps most of his income in cash or bank deposits and

assumes that they are safe and least risky. Little does he realize that they also carry a risk with

them – the fear of loss or actual loss or theft and loss of real value of these assets through the rise

price or inflation in the economy? Cash carries no interest or income and bank deposits carry a

nominal rate of 4% on savings deposits, no interest on current account and a maximum of 9% on

term deposits of one year. The liquidity on fixed deposits is poor as one has to wait for the period

to maturity or take loan on such amount but at a loss of income due to penal rate. Generally risk

averters invest only in banks, Post office and UTI and Mutual funds. Gold, silver real estate and

chit funds are the other avenues of investment for average Householder, of middle and lower

income groups. If the investor desired to have a real rate of return which is substantially higher

than the inflation rate he has to invest in relatively more risky areas of investment like shares and

debenture of companies or bonds of Government and semi-Government agencies or deposits

with companies and firms. Investment in Chit funds, Company deposits, and in private limited

companies has a highest risk. But the basic principle is that the higher the risk, the higher is the

return and the investor should have a clear perception of the elements of risk and return when he

makes investments. Risk Return analysis is thus essential for the investment and portfolio

management.

Why Portfolio:

You will recall that expected return from individual securities carries some degree of risk. Risk

was defined as the standard deviation around the expected return. In effect we equated a

security‘s risk with the variability of its return. More dispersion or variability about a security‘s

expected return meant the security was riskier than one with less dispersion.

The simple fact that securities carry differing degrees of expected risk leads most investors to the

notion of holding more than one security at a time, in an attempt to spread risks by not putting all


their eggs into one basket. Diversification of one‘s holdings is intended to reduce risk in an

economy in which every asset‘s returns are subject to some degree of uncertainty. Even the value

of cash suffers from the inroads of inflation. Most investors hope that if they hold several assets,

even if one goes bad, the others will provide some protection from an extreme loss.

Definition of Portfolio Management:

It is a process of encompassing many activities of investment in assets and securities. The

portfolio management includes the planning, supervision, timing, rationalism and conservatism

in the selection of securities to meet investor‘s objectives. It is the process of selecting a list of

securities that will provide the investor with a maximum yield constant with the risk he wishes to

assume.

The portfolio management is growing rapidly serving broad array of investors – both individual

and institutional – with investment portfolio ranging in asset size from few thousands to crores of

rupees. Despite growing importance, the subject of portfolio and investment management is new

in the country and is largely misunderstood. In most cases, portfolio management has been

practiced as a investment management counseling in which the investor has been advised to seek

assets that would grow in value and / or provide income.

Portfolio management is concerned with efficient management of investment in the securities.

An investment is defined as the current commitment of funds for a period of time in order to

derive a future flow of funds that will compensate the investing unit:

- For the time the funds are committed.

- For the expected rate of inflation, and

- For the uncertainty involved in the future flow of funds.

The portfolio management deals with the process of selection of securities from the number of

opportunities available with different expected returns and carrying different levels of risk and

the selection of securities is made with a view to provide the investors the maximum yield for a

given level of risk or ensure minimize risk for a given level of return.

Investors invest his funds in a portfolio expecting to get a good return consistent with the risk

that he has to bear. The return realized from the portfolio has to be measured and the

performance of the portfolio has to be evaluated.

It is evident that rational investment activity involves creation of an investment portfolio.

Portfolio management comprises all the processes involved in the creation and maintenance of

an investment portfolio. It deals specially with security analysis, portfolio analysis, portfolio

selection, portfolio revision and portfolio evaluation. Portfolio management makes use of

analytical techniques of analysis and conceptual theories regarding rational allocation of funds.

Portfolio management is a complex process, which tries to make investment activity more

rewarding and less risky.

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Application to portfolio Management:

Portfolio Management involves time element and time horizon. The present value of future

return/cash flows by discounting is useful for share valuation and bond valuation. The

investment strategy in portfolio construction should have a time horizon, say 3 to 5 year; to

produce the desired results of say 20-30% return per annum.

Besides portfolio management should also take into account tax benefits and investment

incentives. As the returns are taken by investors net of tax payments, and there is always an

element of inflation, returns net of taxation and inflation are more relevant to tax paying

investors. These are called net real rates of returns, which should be more than other returns.

They should encompass risk free return plus a reasonable risk premium, depending upon the risk

taken, on the instruments/assets invested.

Objectives of Portfolio Management:-

The objective of portfolio management is to invest in securities is securities in such a way that

one maximizes one‘s returns and minimizes risks in order to achieve one‘s investment objective.

A good portfolio should have multiple objectives and achieve a sound balance among them. Any

one objective should not be given undue importance at the cost of others. Presented below are

some important objectives of portfolio management.

1. Stable Current Return: -

Once investment safety is guaranteed, the portfolio should yield a steady current income. The

current returns should at least match the opportunity cost of the funds of the investor. What we

are referring to here current income by way of interest of dividends, not capital gains.

2. Marketability: -

A good portfolio consists of investment, which can be marketed without difficulty. If there are

too many unlisted or inactive shares in your portfolio, you will face problems in encasing them,

and switching from one investment to another. It is desirable to invest in companies listed on

major stock exchanges, which are actively traded.

3. Tax Planning: -

Since taxation is an important variable in total planning, a good portfolio should enable its owner

to enjoy a favorable tax shelter. The portfolio should be developed considering not only income

tax, but capital gains tax, and gift tax, as well. What a good portfolio aims at is tax planning, not

tax evasion or tax avoidance.

4. Appreciation in the value of capital:

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A good portfolio should appreciate in value in order to protect the investor from any erosion in

purchasing power due to inflation. In other words, a balanced portfolio must consist of certain

investments, which tend to appreciate in real value after adjusting for inflation.

5. Liquidity:

The portfolio should ensure that there are enough funds available at short notice to take care of

the investor‘s liquidity requirements. It is desirable to keep a line of credit from a bank for use in

case it becomes necessary to participate in right issues, or for any other personal needs.

6. Safety of the investment:

The first important objective of a portfolio, no matter who owns it, is to ensure that the

investment is absolutely safe. Other considerations like income, growth, etc., only come into the

picture after the safety of your investment is ensured.

Investment safety or minimization of risks is one of the important objectives of portfolio

management. There are many types of risks, which are associated with investment in equity

stocks, including super stocks. Bear in mind that there is no such thing as a zero risk investment.

More over, relatively low risk investment give correspondingly lower returns. You can try and

minimize the overall risk or bring it to an acceptable level by developing a balanced and efficient

portfolio. A good portfolio of growth stocks satisfies the entire objectives outline above.

Scope of Portfolio Management:-

Portfolio management is a continuous process. It is a dynamic activity. The following are the

basic operations of a portfolio management.

a) Monitoring the performance of portfolio by incorporating the latest market conditions.

b) Identification of the investor‘s objective, constraints and preferences.

c) Making an evaluation of portfolio income (comparison with targets and achievement).

d) Making revision in the portfolio.

e) Implementation of the strategies in tune with investment objectives.

Portfolio investment process

The ultimate aim of the portfolio manager is to reduce the risk and increase the return to the

investor in order to reach the investment objectives of an investor. The manager must be aware

of the investment process. The process of portfolio management involves many logical steps like


portfolio planning, portfolio implementation and monitoring. The portfolio investment process

applies to different situation. Portfolio is owned by different individuals and organizations with

different requirements. Investors should buy when prices are very low and sell when prices rise

to levels higher that their normal fluctuation.

Portfolio investment process is an important step to meet the needs and convenience of investors.

The portfolio investment process involves the following steps:

1. Planning of portfolio

2. Implementation of portfolio plan.

3. Monitoring the performance of portfolio.

1) Planning of portfolio:

Planning is the most important element in a proper portfolio management. The success of the

portfolio management will depend upon the careful planning. While making the plan, due

consideration will be given to the investor‘s financial capability and current capital market

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situation. After taking into consideration a set of investment and speculative policies will be

prepared in the written form. It is called as statement of investment policy. The document must

contain (1) The portfolio objective (2) Applicable strategies (3) Investment and speculative

constraints. The planning document must clearly define the asset allocation. It means an optimal

combination of various assets in an efficient market. The portfolio manager must keep in mind

about the difference between basic pure investment portfolio and actual portfolio returns. The

statement of investment policy may contain these elements. The portfolio planning comprises the

following situation for its better performance:

(A) Investor Conditions: - The first question which must be answered is this – ―What is the

purpose of the security portfolio?‖ While this question might seem obvious, it is too often

overlooked, giving way instead to the excitement of selecting the securities which are to be held.

Understanding the purpose for trading in financial securities will help to: (1) define the expected

portfolio liquidation, (2) aid in determining an acceptable level or risk, and (3) indicate whether

future consumption (liability needs) are to be paid in nominal or real money, etc. For example: a

60 year old woman with small to moderate saving probably (1) has a short investment horizon,

(2) can accept little investment risk, and (3) needs protection against short term inflation. In

contrast, a young couple investing couple investing for retirement in 30 years has (1) a very long

investment horizon, (2) an ability to accept moderate to large investment risk because they can

diversify over time, and (3) a need for protection against long-term inflation. This suggests that

the 60 year old woman should invest solely in low-default risk money market securities. The

young couple could invest in many other asset classes for diversification and accept greater

investment risks. In short, knowing the eventual purpose of the portfolio investment makes it

possible to begin sketching out appropriate investment / speculative policies.

(B) Market Condition: - The portfolio owner must known the latest developments in the

market. He may be in a position to assess the potential of future return on various capital market

instruments. The investors‘ expectation may be two types, long term expectations and short term

expectations. The most important investment decision in portfolio construction is asset

allocation. Asset allocation means the investment in different financial instruments at a

percentage in portfolio. Some investment strategies are static. The portfolio requires changes

according to investor‘s needs and knowledge. A continues changes in portfolio leads to higher

operating cost. Generally the potential volatility of equity and debt market is 2 to 3 years. The

another type of rebalancing strategy focuses on the level of prices of a given financial asset.

(C) Speculative Policies: - The portfolio owner may accept the speculative strategies in order to

reach his goals of earning to maximum extant. If no speculative strategies are used the

management of the portfolio is relatively easy. Speculative strategies may be categorized as asset

allocation timing decision or security selection decision. Small investors can do by purchasing

mutual funds which are indexed to a stock. Organization with large capital can employ

investment management firms to make their speculative trading decisions.

(D) Strategic Asset Allocation: - The most important investment decision which the owner of a

portfolio must make is the portfolio‘s asset allocation. Asset allocation refers to the percentage

invested in various security classes. Security classes are simply the type of securities: (1) Money


Market Investment, (2) Fixed Income obligations; (3) Equity Shares, (4) Real Estate Investment,

(5) International securities.

Strategic asset allocation represents the asset allocation which would be optimal for the investor

if all security prices trade at their long-term equilibrium values that is, if the markets are

efficiency priced.

2) Implementation of portfolio plan

In the implementation stage, three decisions to be made, if the percentage holdings of various

assets classes are currently different from the desired holdings as in the SIP, the portfolio should

be rebalances to the desired SAA (Strategic Asset Allocation). If the statement of investment

policy requires a pure investment strategy, this is the only thing, which is done in the

implementation stage. However, many portfolio owners engage in speculative transaction in the

belief that such transactions will generate excess risk-adjusted returns. Such speculative

transactions are usually classified as ―timing‖ or ―selection‖ decisions. Timing decisions over or

under weight various assets classes, industries, or economic sectors from the strategic asset

allocation. Such timing decision deal with securities within a given asset class, industry group, or

economic sector and attempt to determine which securities should be over or under-weighted.

(A) Tactical Asset Allocation: - If one believes that the price levels of certain asset classes,

industry, or economic sectors are temporarily too high or too low, actual portfolio holdings

should depart from the asset mix called for in the strategic asset allocation. Such timing decision

is preferred to as tactical asset allocation. As noted, TAA decisions could be made across

aggregate asset classes, industry classifications (steel, food), or various broad economic sectors

(basic manufacturing, interest-sensitive, consumer durables).

Traditionally, most tactical assets allocation has involved timing across aggregate asset classes.

For example, if equity prices are believes to be too high, one would reduce the portfolio‘s equity

allocation and increase allocation to, say, risk-free securities. If one is indeed successful at

tactical asset allocation, the abnormal returns, which would be earned, are certainly entering.

(B) Security Selection: - The second type of active speculation involves the selection of

securities within a given assets class, industry, or economic sector. The strategic asset allocation

policy would call for broad diversification through an indexed holding of virtually all securities

in the asset in the class. For example, if the total market value of HPS Corporation share

currently represents 1% of all issued equity capital, than 1% of the investor‘s portfolio allocated

to equity would be held in HPS corporation shares. The only reason to overweight or

underweight particular securities in the strategic asset allocation would be to off set risks the

investors‘ faces in other assets and liabilities outside the marketable security portfolio. Security

selection, however, actively overweight and underweight holding of particular securities in the

belief that they are temporarily mispriced.

(3) Monitoring the performance of portfolio


Portfolio monitoring is a continuous and on going assessment of present portfolio and the

portfolio manger shall incorporate the latest development which occurred in capital market. The

portfolio manager should take into consideration of investor‘s preferences, capital market

condition and expectations. Monitoring the portfolio is up-grading activity in asset composition

to take the advantage of economic, industry and market conditions. The market conditions are

depending upon the Government policy. Any change in Government policy would reflect the

stock market, which in turn affects the portfolio. The continues revision of a portfolio depends

upon the following factors:

1. Change in Government policy.

2. Shifting from one industry to other

3. Shifting from one company scrip to another company scrip.

4. Shifting from one financial instrument to another.

5. The half yearly / yearly results of the corporate sector

Risk reduction is an important factor in portfolio. It will be achieved by a diversification of the

portfolio, changes in market prices may have necessitated in asset composition. The composition

has to be changed to maximize the returns to reach the goals of investor.

Portfolio Analysis

The main aim of portfolio analysis is to give a caution direction to the risk and return of an

investor on portfolio. Individual securities have risk return characteristics of their own.

Therefore, portfolio analysis indicates the future risk and return in holding of different individual

instruments. The portfolio analysis has been highly successful in tracing the efficient portfolio.

Portfolio analysis considers the determination of future risk and return in holding various blends

of individual securities. An investor can sometime reduce portfolio risk by adding another

security with greater individual risk than any other security in the portfolio. Portfolio analysis is

mainly depending on Risk and Return of the portfolio. The expected return of a portfolio should

depend on the expected return of each of the security contained in the portfolio. The amount

invested in each security is most important. The portfolio‘s expected holding period value

relative is simply a weighted average of the expected value relative of its component securities.

Using current market value as weights, the expected return of a portfolio is simply a weighted

average of the expected return of the securities comprising that portfolio. The weights are equal

to the proportion of total funds invested in each security.

Tradition security analyses recognize the key importance of risk and return to the investor.

However, direct recognition of risk and return in portfolio analysis seems very much a ―seat-of-

the-pants‖ process in the traditional approaches, which rely heavily upon intuition and insight.

The result of these rather subjective approaches to portfolio analysis has, no doubt, been highly

successfully in many instances. The problem is that the methods employed do not readily lend

themselves to analysis by others.

Most traditional method recognizes return as some dividend receipt and price appreciations aver

a forward period. But the return for individual securities is not always over the same common



holding period nor are he rates of return necessarily time adjusted. An analyst may well estimate

future earnings and P/E to derive future price. He will surely estimate the dividend. But he may

not discount the value to determine the acceptability of the return in relation to the investor‘s

requirements.

A portfolio is a group of securities held together as investment. Investments invest their funds in

a portfolio of securities rather than in a single security because they are risk averse. By

constructing a portfolio, investors attempt to spread risk by not putting all their eggs into one

basket. Thus diversification of one‘s holding is intended to reduce risk in investment.

Most investor thus tends to invest in a group of securities rather than a single security. Such a

group of securities held together as an investment is what is known as a portfolio. The process of

creating such a portfolio is called diversification. It is an attempt to spread and minimize the risk

in investment. This is sought to be achieved by holding different types of securities across

different industry groups.

THE PROCESS OF DIVERSIFICATION OF INVESTMENT PORTFOLIO

The process of diversification has various phases involving investment into various classes of

assets like equity, preference shares, money market instruments like commercial paper, inter-

corporate investments, deposits etc. Within each class of assets, there is further possibility of

diversification into various industries, different companies etc. The proportion of funds invested

into various classes of assets, instruments, industries and companies would depend upon the

objectives of investor, under portfolio management and his asset preferences, income and asset

requirements. The subject is further elaborated in another chapter.

A portfolio with the objective of regular income would invest a proportion of funds in bonds,

debentures and fixed deposits. For such investment, duration of the life of the bond/debenture,

quality of the asset as judged by the credit rating and the expected yield are the relevant

variables.

Bond market is not well developed in India but debentures, partly or fully convertible into equity

are in good demand both from individuals and mutual funds. The portfolio manager has to use

his analytical power and discretion to choose the right debentures with the required duration,

yield and quality. The duration and immunization of expected inflows of funds to the required

quantum of funds have to be well planned by the portfolio manager. Research and high degree of

analytical power in investment management and bond portfolio management are necessary.

The bond investment are thus equally challenging as equities investment and more so in respect

of money market instruments. All these facts bring out clearly the needed analytical powers and

expertise of portfolio manager.

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Naïve diversification of investment portfolio

Portfolios may be diversified in a naïve manner, without really applying the principles of

Markowitz diversification, which is discussed at length in the next paragraph. Naïve

diversification, where securities are selected on a random basis only reduces the risk of a

portfolio to a limited extent. When the securities included in such a portfolio number around ten

to twelve, the portfolio risk decreases to the level of the systematic risk in the market. It may also

be noted that beyond fifteen shares, there is no decrease in the total risk of a portfolio.

Before discussing the Markowitz diversification, what the researches of investors and investment

analysts have found is to be set out briefly. Firstly, they found that putting all eggs in one basket

is bad and most risky. Secondly, there should be adequate diversification of investment into

various securities as that will spread the risk and reduce it; if the numbers of them say 10 to 15 it

is adequate to enjoy the economies of time, scale of operations and expertise utilized by the

investors in his analysis.

Portfolio diversification with a number of securities

The benefits from diversification increase, as more and more securities with less than perfectly

positively correlated returns are included in the portfolio. As the number of securities added to a

portfolio increases, the standard deviation of the portfolio becomes smaller and smaller. Hence

an investor can make the portfolio risk arbitrarily small by including a large number of securities

with negative or zero correlation in the portfolio.

But in reality, no securities show negative or even zero correlation. Typically, securities show

some positive correlation, which is above zero but less than the perfectly positive value (+1). As

a result, diversification (that is , adding securities to a portfolio) results in some reduction in total

portfolio risk but not in complete elimination of risk. Moreover, the effects of diversification are

exhausted fairly rapidly. That is, most of the reduction in portfolio standard deviation occurs by

the time the portfolio size increases to 25 or 30 securities. Adding securities beyond this size

brings about only marginal reduction in portfolio standard deviation.

Adding securities to a portfolio reduces risk because securities are not perfectly positively

correlated. But the effects of diversification are exhausted rapidly because the securities are still

positively correlated to each other though not perfectly correlated. Had they been negatively

correlated, the portfolio risk would have continued to decline as portfolio size increased. Thus, in

practice, the benefits of diversification are limited.

The total risk of an individual security comprises two components; the market related risk called

systematic risk and the unique risk of that particular security called unsystematic risk. By

combining securities into a portfolio the unsystematic risk specific to different securities is

cancelled out. Consequently the risk of the portfolio as a whole is reduced as the size of the

portfolio increases. Ultimately when the size of the portfolio reaches a certain limit, it will

contain only the systematic risk of securities included in the portfolio. The systematic risk,

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however, cannot be eliminated. Thus a fairly large portfolio has only systematic risk and has

relatively little unsystematic risk. That is why there is no gain in adding securities to a portfolio

beyond a certain portfolio size.

International Diversification:

The benefits of diversification are well perceived by portfolio managers, that many in developed

countries started investing in foreign bonds, stocks and other instruments. They found that can

extend diversification principle to foreign stocks, bonds etc, to improve returns for a given risk

by adopting proper techniques of diversification.

Need of International Diversification:

The size and character of international Equity and bond markets are widely varying that it

will increase the scope for larger investment and larger diversification.

The returns in local currencies of some foreign countries are higher than in domestic

markets. Thus, for example in Singapore, Malaysia, Taiwan and India the returns in local

currencies are higher than in U S economy.

The economic trends, business conditions and local profitability and earnings ratio differ

widely among countries that the EPS in some developing countries is higher and give

opportunity for better diversification and higher returns, through international

investments.

International investment is advantageous due to larger investment avenues now open in

the first place and secondly due to the imperfect correlation among the international

investment markets. The total risk of a portfolio including the international investment

will be lower than with only domestic investment. The degree of volatility, and all risk

measures, indicates that these risks vary among the countries and in different degrees and

the possibility of covariance, or high correlation will be low.

The frontier of efficiency portfolio can be widened, by inclusion of foreign investment in a

portfolio. Thus many international portfolio managers prefer to invest in India and so will be the

case of India n portfolio managers, if they can diversify into international investment. There are

some directions however, which will increase risk in such investment.

Risk-Return relationship in investments

The entire scenario of security analysis is built on two concepts of security: Return and risk. The

risk and return constitute the framework for taking investment decision. Return from equity

comprises dividend and capital appreciation. To earn return on investment, that is, to earn

dividend and to get capital appreciation, investment has to be made for some period which in

turn implies passage of time. Dealing with the return to be achieved requires estimated of the

return on investment over the time period. Risk denotes deviation of actual return from the

estimated return. This deviation of actual return from expected return may be on either side –

both above and below the expected return. However, investors are more concerned with the

downside risk.

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The risk in holding security deviation of return deviation of dividend and capital appreciation

from the expected return may arise due to internal and external forces. That part of the risk which

is internal that in unique and related to the firm and industry is called ‗unsystematic risk‘. That

part of the risk which is external and which affects all securities and is broad in its effect is called

‗systematic risk‘.

The fact that investors do not hold a single security which they consider most profitable is

enough to say that they are not only interested in the maximization of return, but also

minimization of risks. The unsystematic risk is eliminated through holding more diversified

securities. Systematic risk is also known as non-diversifiable risk as this can not be eliminated

through more securities and is also called ‗market risk‘. Therefore, diversification leads to risk

reduction but only to the minimum level of market risk.

The investors increase their required return as perceived uncertainty increases. The rate of return

differs substantially among alternative investments, and because the required return on specific

investments change over time, the factors that influence the required rate of return must be

considered.

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Above chart-A represent the relationship between risk and return. The slop of the market line

indicates the return per unit of risk required by all investors highly risk-averse investors would

have a steeper line, and Yields on apparently similar may differ. Difference in price, and

therefore yield, reflect the market‘s assessment of the issuing company‘s standing and of the risk

elements in the particular stocks. A high yield in relation to the market in general shows an

above average risk element. This is shown in the Char-B

Risk and Return in Portfolio investments

Return:

The typical objective of investment is to make current income from the investment in the form of

dividends and interest income. Suitable securities are those whose prices are relatively stable but

still pay reasonable dividends or interest, such as blue chip companies. The investment should

earn reasonable and expected return on the investments. Before the selection of investment the

investor should keep in mind that certain investment like, Bank deposits, Public deposits,

Debenture, Bonds, etc. will carry fixed rate of return payable periodically. On investments made

in shares of companies, the periodical payments are not assured but it may ensure higher returns

from fixed income securities. But these instruments carry higher risk than fixed income

instruments.

Risk:

The Webster‘s New Collegiate Dictionary definition of risk includes the following meanings:

―……. Possibility of loss or injury ….. the degree or probability of such loss‖. This conforms to

the connotations put on the term by most investors. Professional often speaks of ―downside risk‖

and ―upside potential‖. The idea is straightforward enough: Risk has to do with bad outcomes,

potential with good ones.

In considering economic and political factors, investors commonly identify five kinds of hazards

to which their investments are exposed. The following tables show components of risk:

(A) SYSTEMATIC RISK:

1. Market Risk

2. Interest Rate Risk

3. Purchasing power Risk

(B) UNSYSTEMATIC RISK:

1. Business Risk

2. Financial Risk

(A) Systematic Risk:


Systematic risk refers to the portion of total variability in return caused by factors affecting the

prices of all securities. Economic, Political and Sociological charges are sources of systematic

risk. Their effect is to cause prices of nearly all individual common stocks or security to move

together in the same manner. For example; if the Economy is moving toward a recession &

corporate profits shift downward, stock prices may decline across a broad front. Nearly all stocks

listed on the BSE / NSE move in the same direction as the BSE / NSE index.

Systematic risk is also called non-diversified risk. If is unavoidable. In short, the variability in a

securities total return in directly associated with the overall movements in the general market or

Economy is called systematic risk. Systematic risk covers market risk, Interest rate risk &

Purchasing power risk

1. Market Risk:

Market risk is referred to as stock / security variability due to changes in investor‘s reaction

towards tangible & intangible events is the chief cause affecting market risk. The first set that is

the tangible events, has a ‗real basis but the intangible events are based on psychological basis.

Here, Real Events, comprising of political, social or Economic reason. Intangible Events are

related to psychology of investors or say emotional intangibility of investors. The initial decline

or rise in market price will create an emotional instability of investors and cause a fear of loss or

create an undue confidence, relating possibility of profit. The reaction to loss will reduce selling

& purchasing prices down & the reaction to gain will bring in the activity of active buying of

securities.

2. Interest Rate Risk:

The price of all securities rise or fall depending on the change in interest rate, Interest rate risk is

the difference between the Expected interest rates & the current market interest rate. The markets

will have different interest rate fluctuations, according to market situation, supply and demand

position of cash or credit. The degree of interest rate risk is related to the length of time to

maturity of the security. If the maturity period is long, the market value of the security may

fluctuate widely. Further, the market activity & investor perceptions change with the change in

the interest rates & interest rates also depend upon the nature of instruments such as bonds,

debentures, loans and maturity period, credit worthiness of the security issues.

3. Purchasing Power Risk:

Purchasing power risk is also known as inflation risk. This risks arises out of change in the prices

of goods & services & technically it covers both inflation & deflation period. Purchasing power

risk is more relevant in case of fixed income securities; shares are regarded as hedge against

inflation. There is always a chance that the purchasing power of invested money will decline or

the real return will decline due to inflation.

The behaviour of purchasing power risk can in some way be compared to interest rate risk. They

have a systematic influence on the prices of both stocks & bonds. If the consumer price index in


a country shows a constant increase of 4% & suddenly jump to 5% in the next. Year, the required

rate of return will have to be adjusted with upward revision. Such a change in process will affect

government securities, corporate bonds & common stocks.

(B) Unsystematic Risk:

The risk arises out of the uncertainty surrounding a particular firm or industry due to factors like

labour Strike, Consumer preference & management policies are called Unsystematic risk. These

uncertainties directly affect the financing & operating environment of the firm. Unsystematic

risk is also called ―Diversifiable risk‖. It is avoidable. Unsystematic risk can be minimized or

Eliminated through diversification of security holding. Unsystematic risk covers Business risk

and Financial risk

1. Business Risk:

Business risk arises due to the uncertainty of return which depend upon the nature of business. It

relates to the variability of the business, sales, income, expenses & profits. It depends upon the

market conditions for the product mix, input supplies, strength of the competitor etc. The

business risk may be classified into two kind viz. internal risk and External risk.

Internal risk is related to the operating efficiency of the firm. This is manageable by the

firm. Interest Business risk loads to fall in revenue & profit of the companies.

External risk refers to the policies of government or strategic of competitors or

unforeseen situation in market. This risk may not be controlled & corrected by the firm.

2. Financial Risk:

Financial risk is associated with the way in which a company finances its activities. Generally,

financial risk is related to capital structure of a firm. The presence of borrowed money or debt in

capital structure creates fixed payments in the form of interest that must be sustained by the firm.

The presence of these interest commitments – fixed interest payments due to debt or fixed

dividend payments on preference share – causes the amount of retained earning availability for

equity share dividends to be more variable than if no interest payments were required. Financial

risk is avoidable risk to the extent that management has the freedom to decline to borrow or not

to borrow funds. A firm with no debt financing has no financial risk. One positive point for using

debt instruments is that it provides a low cost source of funds to a company at the same time

providing financial leverage for the equity shareholders & as long as the earning of company are

higher than cost of borrowed funds, the earning per share of equity share are increased

Portfolio Management Models

Risk Aversion

Risk aversion is an investor's general desire to avoid participation in "risky" behavior or, in this

case, risky investments. Investors typically wish to maximize their return with the least amount

of risk possible. When faced with two investment opportunities with similar returns, good


investor will always choose the investment with the least risk as there is no benefit to choosing a

higher level of risk unless there is also an increased level of return.

Insurance is a great example of investors' risk aversion. Given the potential for a car accident, an

investor would rather pay for insurance and minimize the risk of a huge outlay in the event of an

accident.

Markowitz Portfolio Theory

Harry Markowitz developed the portfolio model. This model includes not only expected return,

but also includes the level of risk for a particular return. Markowitz assumed the following about

an individual's investment behavior:

Given the same level of expected return, an investor will choose the investment with the

lowest amount of risk.

Investors measure risk in terms of an investment's variance or standard deviation.

For each investment, the investor can quantify the investment's expected return and the

probability of those returns over a specified time horizon.

Investors seek to maximize their utility.

Investors make decision based on an investment's risk and return, therefore, an investor's

utility curve is based on risk and return.

EFFICIENT FRONTIER

The efficient frontier is a concept in Modern portfolio theory introduced by Harry Markowitz

and others. A combination of assets, i.e. a portfolio, is referred to as "efficient" if it has the best

possible expected level of return for its level of risk (usually proxied by the standard deviation of

the portfolio's return). Here, every possible combination of risky assets, without including any

holdings of the risk-free asset, can be plotted in risk-expected return space, and the collection of

all such possible portfolios defines a region in this space. The upward-sloped part of the left

boundary of this region, a hyperbola, is then called the "efficient frontier".

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http://en.wikipedia.org/wiki/Return_(finance)

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http://en.wikipedia.org/wiki/Standard_deviation

http://en.wikipedia.org/wiki/Risk-free_interest_rate

http://en.wikipedia.org/wiki/Hyperbola

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Markowitz' work on an individual's investment behavior is important not only when looking at

individual investment, but also in the context of a portfolio. The risk of a portfolio takes into

account each investment's risk and return as well as the investment's correlation with the other

investments in the portfolio.

Look Out!

Risk of a portfolio is affected by the risk of each

investment in the portfolio relative to its return, as

well as each investment's correlation with the other

investments in the portfolio.

A portfolio is considered efficient if it gives the investor a higher expected return with the same

or lower level of risk as compared to another investment. The efficient frontieris simply a plot of

those efficient portfolios, as illustrated below.

While an efficient frontier illustrates each of the efficient portfolios relative to risk and return

levels, each of the efficient portfolios may not be appropriate for every investor. Recall that

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when creating an investment policy, return and risk were the key objectives. An investor's risk

profile is illustrated with indifference curves. The optimal portfolio, then, is the point on the

efficient frontier that is tangential to the investor's highest indifference curve. See our article: A

Guide to Portfolio Construction, for some essential steps when taking a systematic approach to

constructing a portfolio.

Look Out!

The optimal portfolio for a risk-averse investor will

not be as risky as the optimal portfolio of an investor

who is willing to accept more risk.

Portfolio Calculations

Individual Investment

The expected return for an individual investment is simply the sum of the probabilities of the

possible expected returns for the investment.

Formula 17.3

Expected Return E(R) = p1R1 + p2R2 + .....+ pnRn

Where: pn = the probability the return actually will

occur in state n

Rn = the expected return for state n

Example:

For Newco's stock, assume the following potential returns.

Expected returns for Newco's stock price in the various states

Scenario Probability Expected Return

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Worst Case 10% 10%

Base Case 80% 14%

Best Case 10% 18%

Given the above assumptions, determine the expected return for Newco's stock.

Answer:

E(R) = (0.10)(10%) + (0.80)(14%) + (0.10)(18%)

E(R) = 14.0%

The expected return for Newco's stock is 14%.

Portfolio

To determine the expected return on a portfolio, the weighted average expected return of the

assets that comprise the portfolio is taken.

Formula

E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn

Example:

Assume an investment manager has created a portfolio with the Stock A and Stock B. Stock A

has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected

return of 15% and a weight of 70%. What is the expected return of the portfolio?

Answer:

E(R) = (0.30)(20%) + (0.70)(15%)

= 6% + 10.5% = 16.5%

The expected return of the portfolio is 16.5%

Computing Variance and Standard Deviation for an Individual

To measure the risk of an investment, both the variance and standard deviation for that

investment can be calculated.


Formula

Variance =

Where: Pn = probability of occurrence

Rn = return in n occurrence

E(R) = expected return

Formula

Standard Deviation =

Example: Variance and Standard Deviation of an Investment

Given the following data for Newco's stock, calculate the stock's variance and standard

deviation. The expected return based on the data is 14%.

Figure: Expected return for Newco in various states

Scenario Probability Return Expected Return

Worst Case 10% 10% 0.01

Base Case 80% 14% 0.112

Best Case 10% 18% 0.018


Answer:

σ2 = (0.10)(0.10 - 0.14)

2 + (0.80)(0.14 - 0.14)

2 + (0.10)(0.18 - 0.14)

2

= 0.0003

The variance for Newco's stock is 0.0003.

Given that the standard deviation of Newco's stock is simply the square root of the variance, the

standard deviation is 0.0179 or 1.79%.

Covariance

The covariance is the measure of how two assets relate (move) together. If the covariance of the

two assets is positive, the assets move in the same direction. For example, if two assets have a

covariance of 0.50, then the assets move in the same direction. If however the two assets have a

negative covariance, the assets move in opposite directions. If the covariance of the two assets is

zero, they have no relationship.

Formula

Covariancea,b=

Example: Calculate the covariance between two assets

Assume the mean return on Asset A is 10% and the mean return on Asset B is 15%. Given the

following returns over the past 5 periods, calculate the covariance for Asset A as it relates to

Asset B.

Returns

N Ra Rb

1 10% 18%

2 15% 25%


Answer:

The covariance would equal 18 (90/5).

Correlation

The correlation coefficient is the relative measure of the relationship between two assets. It is

between +1 and -1, with a +1 indicating that the two assets move completely together and a -1

indicating that the two assets move in opposite directions from each other.

Formula

3 5% 2%

4 13% 8%

5 8% 17%

N Ra Rb Ra- Avg Ra Rb-Avg Rb Ra- Avg Ra Rb-Avg Rb

1 10 18 0 3 0

2 15 25 5 10 50

3 5 2 -5 -13 65

4 13 8 3 -7 -21

5 8 17 -2 2 -4

Sum 90.00

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Example: Calculate the correlation of Asset A with Asset B.

Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A

relative to Asset B if Asset A has a standard deviation of 4 and Asset B has a standard deviation

of 3.

Answer:

Correlation coefficient = 18/(8)(4) = 0.563

Components of the Portfolio Standard Deviation Formula

Remember that when calculating the expected return of a portfolio, it is simply the sum of the

weighted returns of each asset in the portfolio. Unfortunately, determining the standard deviation

of a portfolio, it is not that simple. Not only are the weights of the assets in the portfolio and the

standard deviation for each asset in the portfolio needed, the correlation of the assets in the

portfolio is also required to determine the portfolio standard deviation.

The equation for the standard deviation for a two asset portfolio is long, but should be

memorized for the exam.

Formula


Portfolio management refers to the art of managing various financial products and assets to help

an individual earn maximum revenues with minimum risks involved in the long run. Portfolio

management helps an individual to decide where and how to invest his hard earned money for

guaranteed returns in the future.


1. Capital Asset Pricing Model

Capital Asset Pricing Model also abbreviated as CAPM was proposed by Jack Treynor,


William Sharpe, John Lintner and Jan Mossin.

When an asset needs to be added to an already well diversified portfolio, Capital Asset

Pricing Model is used to calculate the asset‘s rate of profit or rate of return (ROI).

In Capital Asset Pricing Model, the asset responds only to:

Market risks or non diversifiable risks often represented by beta

Expected return of the market

Expected rate of return of an asset with no risks involved

What are Non Diversifiable Risks ?

Risks which are similar to the entire range of assets and liabilities are called non

diversifiable risks.

Where is Capital Asset Pricing Model Used ?

Capital Asset Pricing Model is used to determine the price of an individual security

through security market line (SML) and how it is related to systematic risks.

What is Security Market Line ?

Security Market Line is nothing but the graphical representation of capital asset pricing

model to determine the rate of return of an asset sensitive to non diversifiable risk (Beta).

2. Arbitrage Pricing Theory

Stephen Ross proposed the Arbitrage Pricing Theory in 1976.

Arbitrage Pricing Theory highlights the relationship between an asset and several similar

market risk factors.

According to Arbitrage Pricing Theory, the value of an asset is dependent on macro and

company specific factors.

3. Modern Portfolio Theory

Modern Portfolio Theory was introduced by Harry Markowitz.

According to Modern Portfolio Theory, while designing a portfolio, the ratio of each

asset must be chosen and combined carefully in a portfolio for maximum returns and

minimum risks.


In Modern Portfolio Theory emphasis is not laid on a single asset in a portfolio, but how

each asset changes in relation to the other asset in the portfolio with reference to

fluctuations in the price.

Modern Portfolio theory proposes that a portfolio manager must carefully choose various

assets while designing a portfolio for maximum guaranteed returns in the future.

4. Value at Risk Model

Value at Risk Model was proposed to calculate the risk involved in financial market.

Financial markets are characterized by risks and uncertainty over the returns earned in

future on various investment products. Market conditions can fluctuate anytime giving

rise to major crisis.

The potential risk involved and the potential loss in value of a portfolio over a certain

period of time is defined as value at risk model.

Value at Risk model is used by financial experts to estimate the risk involved in any

financial portfolio over a given period of time.

5. Jensen’s Performance Index

Jensen‘s Performance Index was proposed by Michael Jensen in 1968.

Jensen‘s Performance Index is used to calculate the abnormal return of any financial asset

(bonds, shares, securities) as compared to its expected return in any portfolio.

Also called Jensen‘s alpha, investors prefer portfolio with abnormal returns or positive

alpha.

Jensen‘s alpha = Portfolio Return – [Risk Free Rate + Portfolio Beta * (Market Return –

Risk Free Rate)

6. Treynor Index

Treynor Index model named after Jack.L Treynor is used to calculate the excess return

earned which could otherwise have been earned in a portfolio with minimum or no risk

factors involved.

Where T-Treynor ratio


UNIT -4

Capital Market Theory

The capital market theory builds upon the Markowitz portfolio model. The main assumptions of

the capital market theory are as follows:

1. All Investors are Efficient Investors - Investors follow Markowitz idea of the efficient

frontier and choose to invest in portfolios along the frontier.

2. Investors Borrow/Lend Money at the Risk-Free Rate - This rate remains static for any

amount of money.

3. The Time Horizon is equal for All Investors - When choosing investments, investors

have equal time horizons for the choseninvestments.

4. All Assets are Infinitely Divisible - This indicates that fractional shares can be purchased

and the stocks can be infinitely divisible.

5. No Taxes and Transaction Costs -assume that investors' results are not affected by taxes

and transaction costs.

6. All Investors Have the Same Probability for Outcomes -When determining the expected

return, assume that all investors have the same probability for outcomes.

7. No Inflation Exists - Returns are not affected by the inflation rate in a capital market as

none exists in capital market theory.

8. There is No Mispricing Within the Capital Markets - Assume the markets are efficient

and that no mispricings within the markets exist.

What happens when a risk-free asset is added to a portfolio of risky assets?

To begin, the risk-free asset has a standard deviation/variance equal to zero for its given level of

return, hence the "risk-free" label.

Expected Return - When the Risk-Free Asset is Added

Given its lower level of return and its lower level of risk, adding the risk-free asset to a

portfolio acts to reduce the overall return of the portfolio.

Example: Risk-Free Asset and Expected Return

Assume an investor's portfolio consists entirely of risky assets with an expected return of

16% and a standard deviation of 0.10. The investor would like to reduce the level of risk

in the portfolio and decides to transfer 10% of his existing portfolio into the risk-free rate

with an expected return of 4%. What is the expected return of the new portfolio and how

was the portfolio's expected return affected given the addition of the risk-free asset?

Answer:

The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%) = 14.4%

With the addition of the risk-free asset, the expected value of the investor's portfolio was

decreased to 14.4% from 16%.


Standard Deviation - When the Risk-Free Asset is Added

As we have seen, the addition of the risk-free asset to the portfolio of risky assets reduces

an investor's expected return. Given there is no risk with a risk-free asset, the standard

deviation of a portfolio is altered when a risk-free asset is added.

Example: Risk-free Asset and Standard Deviation

Assume an investor's portfolio consists entirely of risky assets with an expected return of

16% and a standard deviation of 0.10. The investor would like to reduce the level of risk

in the portfolio and decides to transfer 10% of his existing portfolio into the risk-free rate

with an expected return of 4%. What is the standard deviation of the new portfolio and

how was the portfolio's standard deviation affected given the addition of the risk-free

asset?

Answer:

The standard deviation equation for a portfolio of two assets is rather long, however,

given the standard deviation of the risk-free asset is zero, the equation is simplified quite

nicely. The standard deviation of the two-asset portfolio with a risky asset is the weight

of the risky assets in the portfolio multiplied by the standard deviation of the portfolio.

Standard deviation of the portfolio is: (0.9)(0.1) = 0.09

Similar to the affect the risk-free asset had on the expected return, the risk-free asset also

has the affect of reducing standard deviation, risk, in the portfolio.

The Capital Market Line

As seen previously, adjusting for the risk of an asset using the risk-free rate, an investor can

easily alter his risk profile. Keeping that in mind, in the context of the capital market line

(CML), the market portfolio consists of the combination of all risky assets and the risk-free

asset, using market value of the assets to determine the weights. The CML line is derived by the

CAPM, solving for expected return at various levels of risk.

Markowitz' idea of the efficient frontier, however, did not take into account the risk-free

asset. The CML does and, as such, the frontier is extended to the risk-free rate as illustrated

below:


Systematic and Unsystematic Risk

Total risk to a stock not only is a function of the risk inherent within the stock itself, but is also a

function of the risk in the overall market. Systematic risk is the risk associated with the

market. When analyzing the risk of an investment, the systematic risk is the risk that cannot be

diversified away.

Unsystematic riskis the risk inherent to a stock. This risk is the aspect of total risk that can be

diversified away when building a portfolio.

Formula

Total risk = Systematic risk + Unsystematic risk

When building a portfolio, a key concept is to gain the greatest return with the least amount of

risk. However, it is important to note, that additional return is not guaranteed for an increased

level of risk. With risk, reward can come, but losses can be magnified as well.

The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is a model that calculates expected return based on

expected rate of return on the market, the risk-free rate and the beta coefficient of the stock.

Formula

E(R) = Rf + B(Rf - Rmarket)

Example: CAPM model

Determine the expected return on Newco's stock using the capital asset pricing model. Newco's

beta is 1.2. Assume the expected return on the market is 12% and the risk-free rate is 4%.

Answer:

E(R) = 4% + 1.2(12% - 4%) = 13.6%.

Using the capital asset pricing model, the expected return on Newco's stock is 13.6%.

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The Security Market Line (SML)

Similar to the CML, the SML is derived from the CAPM, solving for expected return. However,

the level of risk used is the Beta, the slope of the SML.

The SML is illustrated below:

Beta

Beta is the measure of a stock's sensitivity of returns to changes in the market. It is a measure of

systematic risk.

Formula

Beta = B = Covariance of stock to the market

Variance of the market

Example: Beta

Assume the covariance between Newco's stock and the market is 0.001 and the variance of the

market is 0.0008. What is the beta of Newco's stock?

Answer:

BNewco = 0.001/0.0008 = 1.25

Newco's beta is 1.25.

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Determing Whether a Security is Under-, Over- or Properly Valued

As discussed, the SML line can be derived using CAPM, solving for the expected return using

beta as the measure of risk. Given that interpretation and a beta value for a specific security, we

can then determine the expected return of the security with the CAPM. Then, using the expected

return for a security derived from the CAPM, an investor can determine whether a security is

undervalued, overvalued or properly valued.

Example:Calculate the expected return on a security and evaluate whether the security is

undervalued, overvalued or properly valued.

An investor anticipates Newco's security will reach $30 by the end of one year. Newco's beta is

1.3. Assume the return on the market is expected to be 16% and the risk-free rate is

4%. Calculate the expected return of Newco's stock in one year and determine whether the stock

is undervalued, overvalued or properly valued with a current value of $25.

Answer:

E(R)Newco = 4% + 1.3(16% - 4%) = 20%

Given the expected return of Newco's stock using CAPM is 20% and the investor anticipates a

20% return, the security would be properly valued.

If the expected return using the CAPM is higher than the investor's required return, the

security is undervalued and the investor should buy it.

If the expected return using the CAPM is lower than the investor's required return, the

security is overvalued and should be sold.

The Characteristic Line

The characteristic line is line that occurs when an individual asset or portfolio is regressed to the

market. The beta is the slope coefficient for the characteristic line and is thus the measure of

systematic risk for the asset or portfolio. Recall, a beta is the measure of a stock's sensitivity of

returns to changes in the market. It is a measure of systematic risk.


EFFICIENT MARKET HYPOTHESIS

When money is put into the stock market, it is done with the aim of generating a return on the

capital invested. Many investors try not only to make a profitable return, but also to outperform,

or beat, the market.

However, market efficiency - championed in the efficient market hypothesis (EMH) formulated

by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available

information on a particular stock and/or market. Thus, according to the EMH, no investor has an

advantage in predicting a return on a stock price because no one has access to information not

already available to everyone else.

The Effect of Efficiency: Non-Predictability

The nature of information does not have to be limited to financial news and research alone;

indeed, information about political, economic and social events, combined with how investors

perceive such information, whether true or rumored, will be reflected in the stock price.

According to EMH, as prices respond only to information available in the market, and, because

all market participants are privy to the same information, no one will have the ability to out-

profit anyone else.

In efficient markets, prices become not predictable but random, so no investment pattern can be

discerned. A planned approach to investment, therefore, cannot be successful.

This "random walk" of prices, commonly spoken about in the EMH school of thought, results in

the failure of any investment strategy that aims to beat the market consistently. In fact, the EMH

suggests that given the transaction costs involved in portfolio management, it would be more

profitable for an investor to put his or her money into an index fund.

Anomalies: The Challenge to Efficiency

In the real world of investment, however, there are obvious arguments against the EMH. There

are investors who have beaten the market - Warren Buffett, whose investment strategy focuses

on undervalued stocks, made millions and set an example for numerous followers. There are

portfolio managers who have better track records than others, and there are investment houses

with more renowned research analysis than others. So how can performance be random when

people are clearly profiting from and beating the market?

Counter arguments to the EMH state that consistent patterns are present. Here are some

examples of some of the predictable anomalies thrown in the face of the EMH: the January

effect is a pattern that shows higher returns tend to be earned in the first month of the year; "blue

Monday on Wall Street" is a saying that discourages buying on Friday afternoon and Monday

morning because of the weekend effect, the tendency for prices to be higher on the day before

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and after the weekend than during the rest of the week.

Studies in behavioral finance, which look into the effects of investor psychology on stock prices,

also reveal that there are some predictable patterns in the stock market. Investors tend to buy

undervalued stocks and sell overvalued stocks and, in a market of many participants, the result

can be anything but efficient.

Paul Krugman, MIT economics professor, suggests that because of the mass mentality of the

trendy, short-term shareholder, investors pull in and out of the latest and hottest stocks. This

results in stock prices being distorted and the market being inefficient. So prices no longer reflect

all available information in the market. Prices are instead being manipulated by profit seekers.

The EMH Response

The EMH does not dismiss the possibility of anomalies in the market that result in the generation

of superior profits. In fact, market efficiency does not require prices to be equal to fair value all

of the time. Prices may be over- or undervalued only in random occurrences, so they eventually

revert back to their mean values. As such, because the deviations from a stock's fair price are in

themselves random, investment strategies that result in beating the market cannot be consistent

phenomena.

Furthermore, the hypothesis argues that an investor who outperforms the market does so not out

of skill but out of luck. EMH followers say this is due to the laws of probability: at any given

time in a market with a large number of investors, some will outperform while other will remain

average.

How Does a Market Become Efficient?

In order for a market to become efficient, investors must perceive that a market is inefficient and

possible to beat. Ironically, investment strategies intended to take advantage of inefficiencies are

actually the fuel that keeps a market efficient.

A market has to be large and liquid. Information has to be widely available in terms of

accessibility and cost and released to investors at more or less the same time. Transaction costs

have to be cheaper than the expected profits of an investment strategy. Investors must also have

enough funds to take advantage of inefficiency until, according to the EMH, it disappears again.

Most importantly, an investor has to believe that she or he can outperform the market.

Degrees of Efficiency

Accepting the EMH in its purest form may be difficult; however, there are three identified

classifications of the EMH, which are aimed at reflecting the degree to which it can be applied to

markets.

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1. Strong efficiency - This is the strongest version, which states that all information in a

market, whether public or private, is accounted for in a stock price. Not even insider

information could give an investor an advantage.

2. Semi-strong efficiency - This form of EMH implies that all public information is

calculated into a stock's current share price. Neither fundamental nor technical analysis can

be used to achieve superior gains.

3. Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in

today's stock price. Therefore, technical analysis cannot be used to predict and beat a

market.

Conclusion

EMH propagandists will state that profit seekers will, in practice, exploit whatever abnormally

exists until it disappears. In instances such as the January effect (a predictable pattern of price

movements), large transactions costs will most likely outweigh the benefits of trying to take

advantage of such a trend.

In the real world, markets cannot be absolutely efficient or wholly inefficient. It might be

reasonable to see markets as essentially a mixture of both, wherein daily decisions and events

cannot always be reflected immediately into a market. If all participants were to believe that the

market is efficient, no one would seek extraordinary profits, which is the force that keeps the

wheels of the market turning.

In the age of information technology (IT), however, markets all over the world are gaining

greater efficiency. IT allows for a more effective, faster means to disseminate information, and

electronic trading allows for prices to adjust more quickly to news entering the market. However,

while the pace at which we receive information and make transactions quickens, IT also restricts

the time it takes to verify the information used to make a trade. Thus, IT may inadvertently result

in less efficiency if the quality of the information we use no longer allows us to make profit-

generating decisions.

PORTFOLIO EVALUATION METHODS

Portfolio evaluating refers to the evaluation of the performance of the portfolio. It is essentially

the process of comparing the return earned on a portfolio with the return earned on one or more

other portfolio or on a benchmark portfolio. Portfolio evaluation essentially comprises of two

functions, performance measurement and performance evaluation. Performance measurement is

an accounting function which measures the return earned on a portfolio during the holding period

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or investment period. Performance evaluation , on the other hand, address such issues as whether

the performance was superior or inferior, whether the performance was due to skill or luck etc.

The ability of the investor depends upon the absorption of latest developments which occurred in

the market. The ability of expectations if any, we must able to cope up with the wind

immediately. Investment analysts continuously monitor and evaluate the result of the portfolio

performance. The expert portfolio constructer shall show superior performance over the market

and other factors. The performance also depends upon the timing of investments and superior

investment analysts capabilities for selection. The evolution of portfolio always followed by

revision and reconstruction. The investor will have to assess the extent to which the objectives

are achieved. For evaluation of portfolio, the investor shall keep in mind the secured average

returns, average or below average as compared to the market situation. Selection of proper

securities is the first requirement. The evaluation of a portfolio performance can be made based

on the following methods:

a) Sharpe‘s Measure

b) Treynor‘s Measure

c) Jensen‘s Measure

(a) Sharpe’ Measure:

The objective of modern portfolio theory is maximization of return or minimization of risk. In

this context the research studies have tried to evolve a composite index to measure risk based

return. The credit for evaluating the systematic, unsystematic and residual risk goes to sharpe,

Treynor and Jensen. Sharpe measure total risk by calculating standard deviation. The method

adopted by Sharpe is to rank all portfolios on the basis of evaluation measure. Reward is in the

numerator as risk premium. Total risk is in the denominator as standard deviation of its return.

We will get a measure of portfolio‘s total risk and variability of return in relation to the risk

premium. The measure of a portfolio can be done by the following formula:

SI =(Rt – Rf)/σf

Where,

SI = Sharpe‘s Index

Rt = Average return on portfolio

Rf = Risk free return

σf = Standard deviation of the portfolio return.

(b) Treynor’s Measure:


The Treynor‘s measure related a portfolio‘s excess return to non-diversifiable or systematic risk.

The Treynor‘s measure employs beta. The Treynor based his formula on the concept of

characteristic line. It is the risk measure of standard deviation, namely the total risk of the

portfolio is replaced by beta. The equation can be presented as follow:

Tn =(Rn – Rf)/βm

Where, Tn = Treynor‘s measure of performance

Rn = Return on the portfolio

Rf = Risk free rate of return

βm = Beta of the portfolio ( A measure of systematic risk)

(c) Jensen’s Measure:

Jensen attempts to construct a measure of absolute performance on a risk adjusted basis. This

measure is based on CAPM model. It measures the portfolio manager‘s predictive ability to

achieve higher return than expected for the accepted riskiness. The ability to earn returns through

successful prediction of security prices on a standard measurement. The Jensen measure of the

performance of portfolio can be calculated by applying the following formula:

Rp = Rf + (RMI – Rf) x β

Where,

Rp = Return on portfolio

RMI = Return on market index

Rf = Risk free rate of return

Many investors mistakenly base the success of their portfolios on returns alone. Few consider the

risk that they took to achieve those returns. Since the 1960s, investors have known how to

quantify and measure risk with the variability of returns, but no single measure actually looked at

both risk and return together. Today, we have three sets of performance measurement tools to

assist us with our portfolio evaluations. The Treynor, Sharpe and Jensen ratios combine risk and

return performance into a single value, but each is slightly different. Which one is best for

you? Why should you care? Let's find out.

Treynor Measure

Jack L. Treynor was the first to provide investors with a composite measure of portfolio

performance that also included risk. Treynor's objective was to find a performance measure that

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could apply to all investors, regardless of their personal risk preferences. He suggested that there

were really two components of risk: the risk produced by fluctuations in the market and the risk

arising from the fluctuations of individual securities.

Treynor introduced the concept of the security market line, which defines the relationship

between portfolio returns and market rates of returns, whereby the slope of the line measures the

relative volatility between the portfolio and the market (as represented by beta). The beta

coefficient is simply the volatility measure of a stock, portfolio or the market itself. The greater

the line's slope, the better the risk-return tradeoff.

The Treynor measure, also known as the reward to volatility ratio, can be easily defined as:

(Portfolio Return – Risk-Free Rate) / Beta

The numerator identifies the risk premium and the denominator corresponds with the risk of the

portfolio. The resulting value represents the portfolio's return per unit risk.

To better understand how this works, suppose that the 10-year annual return for the S& 500

(market portfolio) is 10%, while the average annual return on Treasury bills (a good proxy for

the risk free rate) is 5%. Then assume you are evaluating three distinct portfolio managers with

the following 10-year results:

Managers Average Annual Return Beta

Manager A 10% 0.90

Manager B 14% 1.03

Manager C 15% 1.20

Now, you can compute the Treynor value for each:

T(market) = (.10-.05)/1 = .05

T(manager A) = (.10-.05)/0.90 = .056

T(manager B) = (.14-.05)/1.03 = .087

T(manager C) = (.15-.05)/1.20 = .083

The higher the Treynor measure, the better the portfolio. If you had been evaluating the portfolio

manager (or portfolio) on performance alone, you may have inadvertently identified manager C

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as having yielded the best results. However, when considering the risks that each manager took

to attain their respective returns, Manager B demonstrated the better outcome. In this case, all

three managers performed better than the aggregate market.

Because this measure only uses systematic risk, it assumes that the investor already has an

adequately diversified portfolio and, therefore, unsystematic risk (also known as diversifiable

risk) is not considered. As a result, this performance measure should really only be used by

investors who hold diversified portfolios.

Sharpe Ratio

The Sharpe ratio is almost identical to the Treynor measure, except that the risk measure is the

standard deviation of the portfolio instead of considering only the systematic risk, as represented

by beta. Conceived by Bill Sharpe, this measure closely follows his work on the capital asset

pricing model (CAPM) and by extension uses total risk to compare portfolios to the capital

market line.

The Sharpe ratio can be easily defined as:

(Portfolio Return – Risk-Free Rate) / Standard Deviation

Using the Treynor example from above, and assuming that the S&P 500 had a standard deviation

of 18% over a 10-year period, let's determine the Sharpe ratios for the following portfolio

managers:

Manager Annual

Return

Portfolio Standard

Deviation

Manager

X 14% 0.11

Manager

Y 17% 0.20

Manager Z 19% 0.27

S(market) = (.10-.05)/.18 = .278

S(manager X) = (.14-.05)/.11 = .818

S(manager Y) = (.17-.05)/.20 = .600

S(manager Z) = (.19-.05)/.27 = .519

Once again, we find that the best portfolio is not necessarily the one with the highest return.

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Instead, it's the one with the most superior risk-adjusted return, or in this case the fund headed

by manager X.

Unlike the Treynor measure, the Sharpe ratio evaluates the portfolio manager on the basis of

both rate of return and diversification (as it considers total portfolio risk as measured by standard

deviation in its denominator). Therefore, the Sharpe ratio is more appropriate for well diversified

portfolios, because it more accurately takes into account the risks of the portfolio.

Jensen Measure

Like the previous performance measures discussed, the Jensen measure is also based on

CAPM. Named after its creator, Michael C. Jensen, the Jensen measure calculates the excess

return that a portfolio generates over its expected return. This measure is also known as alpha.

The Jensen ratio measures how much of the portfolio's rate of return is attributable to the

manager's ability to deliver above-average returns, adjusted for market risk. The higher the ratio,

the better the risk-adjusted returns. A portfolio with a consistently positive excess return will

have a positive alpha, while a portfolio with a consistently negative excess return will have a

negative alpha

The formula is broken down as follows:

Jensen's Alpha = Portfolio Return – Benchmark Portfolio Return

Where: Benchmark Return (CAPM) = Risk Free Rate of Return + Beta (Return of Market

– Risk-Free Rate of Return)

So, if we once again assume a risk-free rate of 5% and a market return of 10%, what is the alpha

for the following funds?

Manager Average Annual Return Beta

Manager D 11% 0.90

Manager E 15% 1.10

Manager F 15% 1.20

First, we calculate the portfolio's expected return:

ER(D)= .05 + 0.90 (.10-.05) = .0950 or 9.5% return

ER(E)= .05 + 1.10 (.10-.05) = .1050 or 10.50% return

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ER(F)= .05 + 1.20 (.10-.05) = .1100 or 11% return

Then, we calculate the portfolio's alpha by subtracting the expected return of the portfolio from

the actual return:

Alpha D = 11%- 9.5% = 2.5%

Alpha E = 15%- 10.5% = 4.5%

Alpha F = 15%- 11% = 4.0%

Which manager did best? Manager E did best because, although manager F had the same annual

return, it was expected that manager E would yield a lower return because the portfolio's beta

was significantly lower than that of portfolio F.

Of course, both rate of return and risk for securities (or portfolios) will vary by time period. The

Jensen measure requires the use of a different risk-free rate of return for each time interval

considered. So, let's say you wanted to evaluate the performance of a fund manager for a five-

year period using annual intervals; you would have to also examine the fund's annual returns

minus the risk free return for each year and relate it to the annual return on the market portfolio,

minus the same risk free rate. Conversely, the Treynor and Sharpe ratios examine average returns

for the total period under consideration for all variables in the formula (the portfolio, market and

risk-free asset). Like the Treynor measure, however, Jensen's alpha calculates risk premiums in

terms of beta (systematic, undiversifiable risk) and therefore assumes the portfolio is already

adequately diversified. As a result, this ratio is best applied with diversified portfolios, like

mutual funds.

Conclusion

Portfolio performance measures should be a key aspect of the investment decision process. These

tools provide the necessary information for investors to assess how effectively their money has

been invested (or may be invested). Remember, portfolio returns are only part of the story.

Without evaluating risk-adjusted returns, an investor cannot possibly see the whole investment

picture, which may inadvertently lead to clouded investment decisions.


UNIT -5

Portfolio Revision

Portfolio Revision:

Once the portfolio is constructed, it undergoes changes due to changes in market prices and

reassessment of companies. Portfolio revision means alteration of the composition of debt/equity

instruments, shifting from the one industry to another industry, changing from one company to

another company. Any portfolio requires monitoring and revision. Portfolios activities will

depend on daily basis keeping in view the market opportunities. Portfolio revision uses some

theoretical tools like security analysis that already discuss before this, Markowitz model, Risk-

Return evaluation.

Portfolio revision involves changing the existing mix of securities. This may be effected either

by changing the securities currently included in the portfolio or by altering the proportion of fund

invested in the securities. New securities may be added to the portfolio or some of the existing

securities may be removed from the portfolio. Portfolio revision thus, leads to purchasing and

sales of securities. The objective of portfolio revision is the same as the objective of portfolio

selection, i.e maximizing the return for a given level of risk or minimizing the risk foa given

level of return. The ultimate aim of portfolio revision is maximization of returns and minimizing

of risk.

Having constructed the optimal portfolio, the investor has to constantly monitor the portfolio to

ensure that it continues to be optimal. As the economy and financial markets are dynamic,

changes take place almost daily. As time passes, securities, which were once attractive, may

cease to be so. New securities with promises of high returns and low risk may emerge. The

investor now has to revise his portfolio in the light of the development in the market. This

revision leads to purchase of some new securities and sale of some of the existing securities from

the portfolio. The mixture of security and its proportion in the portfolio changes as a result of the

revision.

Portfolio revision may also be necessitated some investor related changes such as availability of

additional funds, changes in risk attitude need of cash for other alternative use etc.

Whatever be the reason for portfolio revision, it has to be done scientifically and objectively so

as to ensure the optimality of the revised portfolio. Portfolio revision is not a casual process to be

carried out without much care. In fact, in the entire process of portfolio management portfolio

revision is as important as portfolio analysis and selection. In portfolio management, the

maximum emphasis is placed on portfolio analysis and selection which leads to the construction

of the optimal portfolio. Very little discussion is seen on portfolio revision which is as important

as portfolio analysis and selection.

Portfolio revision involving purchase and sale of securities gives rise to certain problem which

acts as constraints in portfolio revision, from those constraints some may be as following:


CONSTRAINTS IN PORTFOLIO REVISION:

1. Statutory Stipulations: Investment companies and mutual funds manage the largest

portfolios in every country. These institutional investors are normally governed by certain

statutory stipulations regarding their investment activity. These stipulations often act as

constraints in timely portfolio revision.

2. 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 cost thereby reducing the gains from portfolio revision. Hence, the

transaction costs involved in portfolio revision may act as a constraint to timely revision of

portfolio.

3. Intrinsic difficulty: Portfolio revision is a difficult and time-consuming exercise. The

methodology to be followed for portfolio revision is also not clearly established. Different

approaches may be adopted for the purpose. The difficulty of carrying out portfolio revision it

self may act as a restriction to portfolio revision.

4. Taxes: Tax is payable on the capital gains arising from sale of securities. Usually, long term

capital gains are taxed at a lower than short-term capital gains. To qualify as long-term capital

gain, a security must be held by an investor for a period not less than 12 months before sale.

Frequent sales of securities in the course of periodic portfolio revision of adjustment 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 portfolios.

NEED FOR PORTFOLIO REVISION:

Portfolio needs periodic maintenance and revision because:

The needs of the beneficiary will change

The relative merits of the portfolio components will change

To keep the portfolio in accordance with the investment policy statement and investment

strategy

TECHNIQUE: An active management policy can be followed in which the composition of the

portfolio is dynamic. The portfolio manager periodically changes the portfolio components or the

components‘ proportion within the portfolio. A passive management strategy is one in which the

portfolio is largely left alone.

PORTFOLIO RE-BALANCING: Rebalancing a portfolio is the process of periodically

adjusting it to maintain the original conditions. Following strategies can be employed:

1. Constant mix strategy


• Is one to which the manager makes adjustments to maintain the relative weighting

of the asset classes within the portfolio as their prices change

• Requires the purchase of securities that have performed poorly and the sale of

securities that have performed the best

• A constant mix strategy sells stock as it rises

Example: A portfolio has a market value of $2 million. The investment policy statement

requires a target asset allocation of 60 percent stock and 30 percent bonds.

Date Portfolio Value Actual

Allocation Stock Bonds

1 Jan $2,000,000 60%/40% $1,200,000 $800,000

1 Apr $2,500,000 56%/44% $1,400,000 $1,100,000

What dollar amount of stock should the portfolio manager buy to rebalance this

portfolio? What dollar amount of bonds should he sell?

Solution: a 60%/40% asset allocation for a $2.5 million portfolio means the portfolio

should contain $1.5 million in stock and $1 million in bonds. Thus, the manager should

buy $100,000 worth of stock and sell $100,000 worth of bonds.

2. Constant proportion portfolio insurance strategy

3. Relative performance of constant mix and CPPI strategies

a. A CPPI strategy buys stock as it rises

REBALANCING WITHIN THE EQUITY PORTFOLIO:

The below mentioned models can be employed for rebalancing of portfolio within the equity

portfolio

1. Constant proportion: A constant proportion strategy within an equity portfolio

requires maintaining the same percentage investment in each stock

May be mitigated by avoidance of odd lot transactions

Constant proportion rebalancing requires selling winners and buying losers

2. Constant beta: A constant beta portfolio requires maintaining the same portfolio beta.

To increase or reduce the portfolio beta, the portfolio manager can:

Reduce or increase the amount of cash in the portfolio


Purchase stocks with higher or lower betas than the target figure

Sell high- or low-beta stocks

Buy high- or low-beta stocks

3. Change the portfolio components: Changing the portfolio components is another

portfolio revision alternative. Events sometimes deviate from what the manager expects:

The manager might sell an investment turned sour

The manager might purchase a potentially undervalued replacement security

4. Indexing: Indexing is a form of portfolio management that attempts to mirror the

performance of a market index. Index funds eliminate concerns about outperforming the market.

The tracking error refers to the extent to which a portfolio deviates from its intended behavior

COSTS INVOLVED IN PORTFOLIO REVISION: Costs of revising a portfolio can:

Be direct dollar costs

Result from the consumption of management time

Stem from tax liabilities

Result from unnecessary trading activity

Trading fees: Commissions and Transfer taxes

Market impact: The market impact of placing the trade is the change in market

price purely because of executing the trade. Market impact is a real cost of trading.

Market impact is especially pronounced for shares with modest daily trading volume

Management time: Most portfolio managers handle more than one account.

Rebalancing several dozen portfolios is time consuming.

Tax implications: Individual investors and corporate clients must pay taxes on

the realized capital gains associated with the sale of a security. Tax implications are

usually not a concern for tax-exempt organizations

FORMULA PLANS

When an investor decides to change the composition of a portfolio by selling some securities and

replacing them with others, he or she is engaging in portfolio revision. Periodically, the investor

must check to see if the portfolio continues to meet his or her needs. Such dynamic portfolio


management requires portfolio revision.

As economic conditions and individual priorities change, an investor must revise the portfolio by

reallocating and rebalancing it. As the risk-return characteristics of the securities change, the

investor should eliminate issues that no longer meet his or her objectives. Also, portfolio revision

may be needed to maintain an adequate amount of diversification. All these situations require

managing, controlling, and possibly revising the portfolio.

Formula plans are mechanical methods of portfolio management that try to take advantage of

price changes in securities that result from cyclical price movements. Formula plans, part of a

conservative strategy, are designed primarily for investors who do not wish to take excessive risk

but wish to quickly and favorably adjust their portfolio in response to cyclical security price

changes.

a. The dollar cost averaging plan involves investing a fixed dollar amount in a security at fixed

intervals. This is a passive buy-and- hold strategy in which a periodic dollar investment is

held constant. If the share price increases, fewer shares are purchased. When the share price

declines, more shares are purchased. The hoped-for outcome is growth in the value of the

selected security.

b. A constant-dollar plan uses a two-part portfolio. The speculative portion is invested in

securities having high promise of capital gain. The conservative portion consists of low-risk

investments such as bonds or money market accounts. If the speculative portion of the

portfolio rises a certain percentage or amount in value, the constant dollar plan uses its profits

Fundamentals of Investing, by Gitman and Joehnk 5

to increase the conservative portion. If the speculative portion declines in value by a

specified percentage or amount, funds are transferred to it from the conservative portion.

c. The constant-ratio plan establishes a desired fixed ratio of the speculative to the conservative

portion of the portfolio. An individual rebalances the portfolio whenever the actual ratio

differs from the desired ratio by a predetermined amount. With this plan, an investor must

decide what is the appropriate target ratio of the two portions of the portfolio and how far

from the target ratio the actual ratio should be permitted to stray before one rebalances the

portfolio. Since one expects the speculative portion of the portfolio to increase in value more

rapidly than the conservative portion, this strategy should function much like the constantdollar


plan.

d. The variable-ratio plan is a more aggressive strategy. The target ratio between the

speculative portion and the conservative portion of the portfolio is varied by the investor and

depends on the expected movement in value of the speculative securities. If the investor feels

the market movement will be generally upward, he or she increases the proportion in

speculative vehicles. If the feeling is bearish—a downward market—the proportion in

conservative vehicles is increased. This strategy is not only the most aggressive but also

requires more effort by the investor.

A limit order can be used to specify the investor's minimum sell price or the maximum price the

investor will pay to buy the security. The stop-loss order is a type of suspended order that

requests the broker to sell a security at the best available price only if it trades at a specific price

or lower. A stop- loss order is a particular kind of a limit order that becomes a market order to

sell

if a stock trades at the trigger price or lower.

If an investor issues a stop- limit order to sell a security with a limit price above the initial

purchase price, the investor ―locks-in‖ or protects the profit she has earned. If the investor issues

a stop- limit order to sell a security with a limit price below the initial purchase price, the

investor

effectively puts a floor on potential losses.

The first reason investors should maintain some funds in a low-risk, highly liquid investment is

simply to protect against the chance of a total loss. Thus, a low-risk investment acts as a buffer

against possible investment adversity.

Second, highly liquid investments can provide funds for use in pursuing future opportunities. A

sudden change in economic conditions might make it conducive for an investor to invest more

heavily invest in the stock market. In such situations, a highly marketable investment can readily

be converted into cash and the proceeds invested in the stock market. An investor with liquid

funds can take advantage of these opportunities without disturbing the existing portfolio.

The two considerations in timing investment sales are tax consequences and compatibility with


investment goals. When there is a capital loss, the investor receives the benefit of a tax

deduction. In particular, capital losses provide tax benefits by offsetting capital gains and thereby

lowering the investor's tax liability. From the point of view of investment goals, a security should

be sold if it no longer meets the needs of the portfolio's owner. For example, if a particular

security increases the risk of the portfolio to an extent that it is undesirable, that security should

be sold in the marketplace. Although taxes are important, one should not forget that the dual

concepts of risk and return remain the overriding concerns in the portfolio management and

administration process.

PORTFOLIO MANAGEMENT IN INDIA

The Securities & Exchange Board of India (Sebi), after tightening the norms for the mutual fund

industry, is now looking at portfolio management services. The market regulator will soon be

coming out stricter and comprehensive guidelines for PMS.

According to a senior banker with a leading foreign bank that offers wealth management and

portfolio management services, Sebi has been in dialogue with several service providers to get

their views on making the services more transparent and investor-friendly. ―We have been

deliberating with the regulator and it should be coming out with guidelines in the coming few

weeks,‖ the executive said on the condition of anonymity.

Earlier, a senior Sebi official has mentioned the watchdog is indeed looking at all areas for

making things transparent and investor-friendly. According to industry sources, there are several

aspects that the regulator is looking at and one important aspect is the PMS fees.

There are no restrictions now on fees charged by service providers. However, since the market is

competitive, rates remain reasonable. ―But there are instances of fee structures changing with the

market trend. During the boom of 2007-08, some charged atrocious fees, and there were also

some handsome profit sharing agreements,‖ says a Mumbai-based broker. Hence, the regulator is

expected to cap the fees charged by portfolio managers.

This, however, might not go down well with the 229-odd portfolio managers registered with

Sebi. But rthe regulator isn‘t much worried about that. ―In 1992, when we had asked brokers to


disclose the fees they charge to clients, there was an uproar, and trading closed for four days,

however, they had to comply and things are much better now,‖ said the Sebi official.

Generally, portfolio managers have three schemes, one where a flat fee of around 2% of the

portfolio amount is charged, and the service provided includes investment advice at regular

intervals and managing the portfolio. The second scheme includes a fixed fee and a profit-

sharing scheme, the latter usually kicks in when a return over the government bond (risk-free

return) rate is crossed. Then, there is the totally variable scheme where the manager charges a

total variable fee structure based on profit sharing.

The first two are said to be the more popular, and the third variety usually gains ground when the

market is booming and is offered to high-ticket clients.

The norms are also expected to cover the ‗wealth management‘ area. There are no specific norms

now for this burgeoning industry that has several service providers like banks, brokers, financial

service firms and individuals. Sebi has applied to the finance ministry to extend the definition of

the term ‗securities‘ in the Sebi Act to several instruments, especially alternative investments like

those in art and several structured products that usually beat the definition and thereby the Sebi

purview. Wealth managers are known to offer such products to their clients and there is usually

an issue in the valuation of these instruments, noted a banker. They don‘t want a Madoff- like

situation happening in India where exotic products are peddled to wealthy clients under Ponzi

schemes, he adds.

The market size of PMS is estimated to around Rs 1 lakh crore. Sebi has been tightening the

PMS norms over the years. In May 2008, Sebi had increased the networth requirement for

portfolio managers from Rs 50 lakh to Rs 2 crore and also asked the portfolio managers not to

pool accounts of clients. Pooling of clients would mean portfolio managers becoming quasi-

mutual funds, not giving customised services.

On June 23, 2009, Sebi clarified that there should be a clear segregation of each client‘s fund

through proper and clear maintenance of back-office records. It also mentioned that portfolio

managers were not allowed to use funds of one client for another client. Portfolio managers will

also have to maintain an accounting system containing separate client-wise data for their funds


and provide statement to their clients for such accounts at least every month. Importantly,

managers will have to reconcile client-wise funds with the funds in their bank account every day.

PORTFOLIO MANAGEMENT IN INDIA- SEBI GUIDELINES

1. Who is a Portfolio Manager?

A portfolio manager is a body corporate who, pursuant to a contract or arrangement

with a client, advises or directs or undertakes on behalf of the client (whether as a

discretionary portfolio manager or otherwise), the management or administration of a

portfolio of securities or the funds of the client.

2. What is the difference between a discretionary portfolio manager and a non-

discretionary portfolio manager?

The discretionary portfolio manager individually and independently manages the

funds of each client in accordance with the needs of the client.

The non-discretionary portfolio manager manages the funds in accordance with the

directions of the client.

3. What is the procedure of obtaining registration as a portfolio manager from

SEBI?

For registration as a portfolio manager, an applicant is required to pay a non-

refundable application fee of Rs.1,00,000/- by way of demand draft drawn in favour

of ‗Securities and Exchange Board of India‘, payable at Mumbai.

The application in Form A along with additional information (Form A and additional

information available on SEBI Website : www.sebi.gov.in.) submitted to the at the

below mentioned address

Investment Management Department - Division of Funds- 1

Securities and Exchange Board of India

SEBI Bhavan, 3rd

Floor A Wing,

Plot No. C4-A, ‗G‘ Block,

Bandra-Kurla Complex,

Bandra (E), Mumbai - 400 051.

4. What is the capital adequacy requirement of a portfolio manager?

The portfolio manager is required to have a minimum networth of Rs. 2 crore.

5. Is there any registration fee to be paid by the portfolio managers?

Yes. Every portfolio manager is required to pay Rs. 10 lakhs as registration fees at the

time of grant of certificate of registration by SEBI.

http://203.199.12.51/pmd/FormAPMS.pdf


6. How long does the certificate of registration remain valid?

The certificate of registration remains valid for three years. The portfolio manager

has to apply for renewal of its registration certificate to SEBI, 3 months before the

expiry of the validity of the certificate, if it wishes to continue as a registered

portfolio manager.

7. How much is the renewal fee to be paid by the portfolio manager?

The portfolio manager is required to pay Rs. 5 lakh as renewal fees to SEBI.

8. Is there any contract between the portfolio manager and its client?

Yes. The portfolio manager, before taking up an assignment of management of funds

or portfolio of securities on behalf of the client, enters into an agreement in writing

with the client, clearly defining the inter se relationship and setting out their mutual

rights, liabilities and obligations relating to the management of funds or portfolio of

securities, containing the details as specified in Schedule IV of the SEBI (Portfolio

Managers) Regulations, 1993.

9. What fees can a portfolio manager charge from its clients for the services

rendered by him?

SEBI Portfolio Manager Regulations have not prescribed any scale of fee to be

charged by the portfolio manager to its clients.

However, the regulations provide that the portfolio manager shall charge a fee as per

the agreement with the client for rendering portfolio management services. The fee so

charged may be a fixed amount or a return based fee or a combination of both. The

portfolio manager shall take specific prior permission from the client for charging

such fees for each activity for which service is rendered by the portfolio manager

directly or indirectly (where such service is outsourced).

10. Is there any specified value of funds or securities below which a portfolio

manager can’t accept from the client while opening the account for the purpose

of rendering portfolio management service to the client?

The portfolio manager is required to accept minimum Rs. 5 lakhs or securities having

a minimum worth of Rs. 5 lakhs from the client while opening the account for the

purpose of rendering portfolio management service to the client.

Portfolio manager can only invest and not borrow on behalf of his clients.

11. Are investors required to open demat accounts for PMS services?


Yes. For investment in listed securities, an investor is required to open a demat

account in his/her own name.

12. What kind of reports can the client expect from the portfolio manager?

The portfolio manager shall furnish periodically a report to the client, as agreed in the

contract, but not exceeding a period of six months and as and when required by the

client and such report shall contain the following details, namely:-

(a) the composition and the value of the portfolio, description of security, number of

securities, value of each security held in the portfolio, cash balance and aggregate

value of the portfolio as on the date of report;

(b) transactions undertaken during the period of report including date of transaction

and details of purchases and sales;

(c) beneficial interest received during that period in respect of interest, dividend,

bonus shares, rights shares and debentures;

(d) expenses incurred in managing the portfolio of the client;

(e) details of risk foreseen by the portfolio manager and the risk relating to the

securities recommended by the portfolio manager for investment or disinvestment.

This report may also be available on the website with restricted access to each client.

The portfolio manager shall, in terms of the agreement with the client, also furnish to

the client documents and information relating only to the management of a portfolio.

The client has right to obtain details of his portfolio from the portfolio managers.

13. What is the disclosure mechanism of the portfolio managers to their clients?

The portfolio manager provides to the client the Disclosure Document at least two

days prior to entering into an agreement with the client.

The Disclosure Document contains the quantum and manner of payment of fees

payable by the client for each activity, portfolio risks, complete disclosures in respect

of transactions with related parties, the performance of the portfolio manager and the

audited financial statements of the portfolio manager for the immediately preceding

three years.

Please note that the disclosure document is neither approved nor disapproved by

SEBI nor does SEBI certify the accuracy or adequacy of the contents of the

Documents.

14. Does SEBI approve any of the services offered by portfolio managers?

No. SEBI does not approve any of the services offered by the Portfolio Manager. An

investor has to invest in the services based on the terms and conditions laid out in the


disclosure document and the agreement between the portfolio manager and the

investor.

15. Does SEBI approve the disclosure document of the portfolio manager?

The Disclosure Document is neither approved nor disapproved by SEBI. SEBI does

not certify the accuracy or adequacy of the contents of the Disclosure Document.

16. What are the rules governing services of a Portfolio Manager?

The services of a Portfolio Manager are governed by the agreement between the

portfolio manager and the investor. The agreement should cover the minimum details

as specified in the SEBI Portfolio Manager Regulations. However, additional

requirements can be specified by the Portfolio Manager in the agreement with the

client. Hence, an investor is advised to read the agreement carefully before signing it.

17. Is premature withdrawal of Funds/securities by an investor allowed?

The funds or securities can be withdrawn or taken back by the client before the

maturity of the contract. However, the terms of the premature withdrawal would be as

per the agreement between the client and the portfolio manager.

18. Can a Portfolio Manager impose a lock-in on the investor?

Portfolio managers cannot impose a lock-in on the investment of their clients.

However, a portfolio manager can charge exit fees from the client for early exit, as

laid down in the agreement.

19. Can a Portfolio Manager offer indicative or guaranteed returns?

Portfolio manager cannot offer/ promise indicative or guaranteed returns to clients.

20. On what basis is the performance of the portfolio manager calculated?

The performance of a discretionary portfolio manager is calculated using weighted

average method taking each individual category of investments for the immediately

preceding three years and in such cases performance indicator is also disclosed.

21. Where can an investor look out for information on portfolio managers?

Investors can log on to the website of SEBI www.sebi.gov.in for information on SEBI

regulations and circulars pertaining to portfolio managers. Addresses of the registered

portfolio managers are also available on the website.

http://203.199.12.51/acts/act122.html

http://203.199.12.51/pmd_mb.jsp?listCode=P

http://203.199.12.51/pmd_mb.jsp?listCode=P


22. How can the investors redress their complaints?

Investors would find in the Disclosure Document the name, address and telephone

number of the investor relation officer of the portfolio manager who attends to the

investor queries and complaints. The grievance redressal and dispute mechanism is

also mentioned in the Disclosure Document. Investors can approach SEBI for

redressal of their complaints. On receipt of complaints, SEBI takes up the matter with

the concerned portfolio manager and follows up with them.

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