THAKUR COLLEGE OF SCIENCE AND COMMERCE

M.COM ( B & F) PART II

INVESTMENT MANAGEMENT

MODULE 2
PORTFOLIO REVISION AND EVALUATION

MEANING OF PORTFOLIO REVISION

The art of changing the mix of securities in' a portfolio is called as portfolio revision. The
process of addition of more assets in an existing portfolio or changing the ratio of funds
invested in called as portfolio revision.
The sale and purchase of assets in an existing portfolio over a certain period of time to
maximize returns and minimize risk In called as Portfolio revision.
Portfolio revision involves changing the existing mix of securities. This may be affected either
by changing the securities currently included in the portfolio or by altering the proportion of
funds 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
purchases and sales of securities. The objective of portfolio revision is the same as the objective
of portfolio selection, je, maximising the return for a given level of risk or minimising the risk
for a given level of return. The ultimate aim of portfolio revision is maximisation of returns
and minimisation of risk.

NEED OF PORTFOLIO REVISION

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

CONSTRAINTS IN PORTFOLIO REVISION

Portfolio revision is the process of adjusting the existing portfolio in accordance with the
changes in financial markets and the investor's position so as to ensure maximum return from

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portfolio with the minimum of risk. Portfolio revision or adjustment necessitates purchase and
sale of securities. The practice of portfolio adjustment involving purchase and sale of securities
gives rise to certain problems which act as constraints in portfolio revision.
Some of these are:
(1) Transaction cost Buying and selling of securities involve transaction costs such as
commission and brokerage. Frequent buying and selling of securities for portfolio revision may
push up transaction costs thereby reducing the gains from portfolio revision. Hence, the
transaction costs involved in portfolio revision may act as a constraint to timely revision of
portfolio.
(2) Taxes: Tax is payable on the capital gains arising from sale of securities, Usually, long-term
capital gains are taxed any lower rate than short-term capital gains. To qualify as long-term
capital gain, a security must be held by an investor for a period of not less than 12 months
before sale. Frequent sales of Securities in the course of periodic portfolio revision or
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 portfolio revision.
(3) Statutory stipulations: The largest portfolios in every country are managed by investment
companies and mutual funds These institutional investors are normally governed by certain
statutory Stipulations regarding their investment activity. These stipulations often act as
constraints in timely portfolio revision.
(4) 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 carrying out portfolio revision itself
may act as a constraint to portfolio revision.

PORTFOLIO REVISION STRATEGIES

Two different strategies may be adopted for portfolio revision, namely an active revision
strategy and a passive revision strategy. The choice of the strategy would depend on the
investor's objectives, skill, resources and time.

(1) Active revision strategy:

Active revision strategy involves frequent and sometimes substantial adjustments to the
portfolio. Investors who undertake active revision strategy believe that security markets are not
continuously efficient. They believe that securities can be mispriced at times giving an
opportunity for earning excess returns through trading in them. Moreover, they believe that
different investors have divergent or heterogeneous expectations regarding the risk and return
of securities in the market. The practitioners of active revision strategy are confident of
developing better estimates of the true risk and return of securities than the rest of the market.
They hope to use their better estimates to generate excess returns. Thus, the objective of active
revision strategy is to beat the market.

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Active portfolio revision is essentially carrying out portfolio ☐ analysis and portfolio selection
all over again. It is based on an analysis of the fundamental factors affecting the economy,
industry and company as also the technical factors like demand and supply. Consequently, the
time, skill and resources required for implementing active revision strategy will be much
higher. The frequency of trading is likely to be much higher under active revision strategy
resulting in higher transaction costs.

(2) Passive revision strategy:

Passive revision strategy, in contrast, involves only minor and infrequent adjustment to the
portfolio over time. The practitioners of passive revision strategy believe in market efficiency
and homogeneity of expectation among investors. They find little Incentive for actively trading
and revising portfolios periodically.
Under passive revision strategy, adjustment to the portfolio is carried out according to certain
predetermined rules and procedures designated as formula plans. These formula plans help the
investor to adjust his portfolio according to changes i the securities market.

MEANING OF PORTFOLIO EVALUATION

Portfolio evaluation is the last step in the process of portfolio management. It is the stage when
we examine to what extent the objective has been achieved. It is basically the study of the
impact of investment decisions. Without portfolio evaluation, portfolio management would be
incomplete.
Portfolio evaluation 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 portfolios or on a benchmark portfolio.

Portfolio evaluation essentially comprises two functions:

(i) Performance measurement: Performance measurements an accounting function which
measures the return earned on a portfolio during the holding period or investment period.
(ii) Performance evaluation: Performance evaluation, on the other hand, addresses such
issues as whether the performance was superior or inferior, whether the performance was due
to skill or luck, etc.

NEED OF PORTFOLIO EVALUATION

Investment may be carried out by individuals on their own. The funds available with individual
investors may not be large enough to create a well-diversified portfolio of securities Moreover,
the time, skill and other resources at the disposal of individual investors may not be sufficient
to manage the portfolio professionally. Institutional investors such as mutual funds and

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investment companies are better equipped to create and manage well diversified portfolios in
a professional fashion. Hence, small investors may prefer to entrust their funds with mutual
funds of investment companies to avail the benefits of their professional services and thereby
achieve maximum return with minimum risk and effort.
Evaluation is an appraisal of performance. Whether the investment activity is carried out by
individual investors themselves or through mutual funds and investment companies, different
situations arise where evaluation of performance becomes imperative. These situations are
discussed below:
(1) Self-Evaluation: Where individual investors undertake the investment activity on their
own, the investment decisions are taken by them. They construct and manage their own
portfolio of securities. In such a situation, an investor would like to evaluate the performance
of his portfolio in order to identify the mistakes committed by him. This self-evaluation will
enable him to improve his skills and achieve better performance in future.
(2) Evaluation of portfolio managers: A mutual fund or investment company usually creates
different portfolios with different objectives aimed at different sets of investors. Each such
portfolio may be entrusted to different professional portfolio managers who are responsible for
the investment decisions regarding the portfolio entrusted to each of them. In such a situation,
the organisation would like to evaluate the performance of each portfolio so as to compare the
performance of different portfolio managers.
(3) Evaluation of mutual funds: In India, at present, there are many mutual funds as also
investment companies operating both in the public sector as well as in the private sector. These
compete with each other for mobilising the investment funds with individual investors and
other organisations by offering attractive returns, minimum risk, high safety and prompt
liquidity. Investors and organisations desirous of placing their funds with these mutual funds
would like to know the comparative performance of each so as to select the best mutual fund
or investment company. For this, evaluation of the performance of mutual funds and their
portfolios becomes necessary.
4) Evaluation Perspective: A portfolio comprises several individual securities. In the building
up of the portfolio several transactions of purchase and sale of securities take place. Thus,
several transactions in several securities are needed to create and revise a portfolio of securities.
Hence the evaluation may be carried out from different perspectives or viewpoints such a
transactions view, security view of portfolio view.
(5) Transaction view: An investor may attempt to evaluate every transaction of purchase and
sale of securities. Whenever a security is bought or sold, the transaction is evaluated as regards
its correctness and profitability.
(6) Security view: Each security included in the portfolio has been purchased at a particular
price. At the end of the holding period, the market price of the security may be higher or lower
than its cost price or purchase price. Further, during the holding period, interest or dividend
might have been received in respect of the security. Thus, it may be possible to evaluate the
profitability of holding each security separately. This is evaluation from the security viewpoint.
(7) Portfolio view: A portfolio is not a simple aggregation of a random group of securities. It
is a combination of carefully selected securities, combined in a specific way so as to reduce the

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risk of investment to the minimum. An investor may attempt to evaluate the performance of
the portfolio as a whole without examining the performance of individual securities within the
portfolio. This is evaluation from the portfolio view.

Though evaluation may be attempted at the transaction level, or the security level, such
evaluations would be Incomplete, inadequate and often misleading. Investment an activity
involving risk. Proper evaluation of the Investment activity must, therefore, consider return
along with risk involved. But risk is best defined at the portfolio level and not at the security
level or transaction level. Hens the best perspective for evaluation is the portfolio view.

MEASURING RETURNS
(SHARPE, TREYNOR AND JENSEN RATIOS)

Introduction:
In order to determine the risk-adjusted returns of investment portfolios, several eminent authors
have worked since 1960s to develop composite performance indices to evaluate a portfolio by
comparing alternative portfolios within a particular risk class. The most important and widely
used measures of performance are:

(1) The Treynor Measure

(2) The Sharpe Measure
(3) Jensen Measure

(1) The Treynor Measure:

Developed by Jack Treynor, this performance measure evaluates funds on the basis of Treynor's
Index. This Index is a ratio of return generated by the fund over and above risk free rate a) of
return (generally taken to be the return on securities backed by the government, as there is no
credit risk associated), during at given period and systematic risk associated with it (beta).
Symbolically, it can be represented as:
Treynor's Index (Ti) = (Ri - Rf)/Bi.
Where, Ri represents return on fund, Rf is risk free rate of return and Bi is beta of the fund.
All risk-averse investors would like to maximize this value. While a high and positive Treynor's
Index shows a superior risk- adjusted performance of a fund, a low and negative Treynor's
Index is an indication of unfavourable performance.

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(2) The Sharpe Measure:
In this measure, performance of a fund is evaluated on the basis of Sharpe Ratio, which is a
ratio of returns generated by the fund over and above risk free rate of return and the total risk
associated with it. According to Sharpe, it is the total risk of the fund that the investors are
concerned about. So, the measure evaluates funds on the basis of reward per unit of total risk.
Symbolically, it can be written as:
Sharpe Index (Si) = (Ri-Rf)/Si
While a high and positive Sharpe Ratio shows a superior risk adjusted performance of a fund,
a low and negative Sharpe Rath is an indication of unfavourable performance.

(3) Jenson Measure:

Jenson's measure proposes another risk adjusted performance measure. This measure was
developed by Michael Jenson and sometimes referred to as the Differential Return Method.
This measure involves evaluation of the returns that the fund has generated vs. the returns
actually expected out of the fund given the level of its systematic risk. The surplus between the
two returns is called Alpha, which measures the performance of a fund compared with the
actual returns over the period. Required return of a fund at a given level of risk (Bi) can be
calculated as
Rp = Rf + Bi (Rm - Rf)
Where, Rm is average market return during the given period After calculating it, alpha can be
obtained by subtracting required return from the actual return of the fund. Higher alpha
represents superior performance of the fund and vice versa. Limitation of this measure is that
it considers only systematic risk not the entire risk associated with the fund and an ordinary
investor cannot mitigate unsystematic risk, as his knowledge of market is primitive.

Practical problem on measuring return : (Sharpe, Treynor and Jensen):

Illustration 1:
Compare portfolio performance using Sharpe and Treynor measures for the following portfolio.
Average Return (%) Standard Deviation Beta
Portfolio X 14% 0.25 1.25
Portfolio Y 10% 0.15 1.10
Market Index 12% 0.25 1.20
The risk free rate of return is 8%.

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Illustration 2:
Following information given in respect of three mutual fund and market.
Mutual fund Average return Standard deviation % beta
P 12 % 18% 1.1
Q 10% 15% 0.9
R 13% 20% 1.2
Market index 11% 17% 1.0
The mean risk free rate 6%. Calculate Sharpe’s measure and Treynor’s measure and rank the
mutual funds.

Illustration 3:
The details of three portfolios are given below:
You are required to rank these portfolios according to Sharpe’s measures and Treynor’s
measures.
Portfolio Average return Standard deviation Beta
A 12% 0.25% 1.30
B 15% 0.30% 0.80
C 10% 0.20% 1.20
Market index 12% 0.25% 1.40
The risk-free rete of return is 8%
Illustration 4:
You are asked to analyse the two-portfolio having the following characteristic
portfolio Observed return Beta Standard deviation
X 0.16 1.4 0.04
Y 0.13 1.6 0.02
The risk free rate of return is 0.08 and the return on market portfolio is 0.15 with standard
deviation 0.04. compute the appropriate measure of performance of these portfolios and
comments on their respective performance. Use Sharpe’s measure and Treynor’s measure.
Illustration 5 :
Three mutual funds have reported the following rates of return and risk over the last five year.
Mutual fund Average return Standard deviation Beta
Sparrow Ltd. 14% 0.16 1.10
Heron Ltd. 12% 0.15 1.20
Vulture Ltd. 11% 0.16 0.85
Evaluate the portfolio performance using Sharpe and Treynor’s index which portfolio has
performed better. Assume risk free rate of return as 8%.
Illustration 6:

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The detail of three portfolio are given below. Compare these portfolio on performance using
Sharpe’s and Treynor’s measure.
Portfolio Average return Standard deviation Beta
A 16% 0.25 1.00
B 12% 0.30 1.25
C 11% 0.25 1.30
Market index 13% 0.35 1.15
The risk free rate of return is 10%.
Illustration 7:
The actual results of the portfolio’s and the market index during the last three year are given
below.
portfolio Average return Beta
A 15% 1.2
B 16% 1.5
C 12% 0.8
Market index 13% 1.0
The risk free rate of return is 9%. You are required to rank these portfolio’s according to
Jensen’s measure of measure of portfolio return.
Illustration 8:
Portfolio Average return Beta
X 12% 0.67
Y 16% 0.85
Z 20% 0.90
Market index 10% 1.0
Risk free rate of return is 8%.
Calculate Jensen’s measure and rank the securities X, Y and Z.
Illustration 9:
Compare the following portfolio according to Jensen’s measure of portfolio evaluation and
rank them.
Portfolio Return on portfolio beta Risk free rate of
return
1 15% 1.5 7%
2 12% 0.9 7%
3 10% 1.2 7%
Market index 12% 1.0 7%

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Illustration 10:
Calculate Jensen measure and rank them.
Particular Average return beta Rf
X 10% 0.67 5%
Y 12% 0.90 5%
Z 15% 1.25 5%
Market index 10% 1.00 5%

Illustration 11:
Following are the details of three portfolio:
Portfolio Average return Standard deviation Beta
A 13% 0.25 1.25
B 12% 0.25 0.75
C 11% 0.20 1.00
Market index 11% 0.25 1.10
The risk-free rate is 8%. You are required to compare these portfolios on performance using
the Sharpe’s ,Treynor’s and Jensen’s measure and rank them.

Illustration 12:
Mr. Moti wants to invest his money in a mutual fund, for this he has collected information
about three mutual fund.
Mutual fund Average return Standard deviation Beta
A 25% 12% 1.27
B 27% 15% 1.30
C 23% 9% 1.15
Market index 20% 13% 1.00
Recommend which portfolio should be selected using Sharpe. Treynor and Jensen’s measure
of portfolio evaluation. Assume risk free rate to be 7.5%.
Illustration 13:
Based on the following data decide whether the portfolio has outperformed the market in term
of Treynor’s, Sharpe and Jensen benchmark evaluation measure:
particular portfolio Market
Average return 7% 10%
Beta 0.4 1.0
Standard deviation 3 8
Risk free rate 6% 6%

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Illustration 14:
From the following calculate.
(a) Sharpe’s ratio
(b) Treynor’s ratio
(c) Jensen’s ratio
Year Mutual Mutual Return on Return on Standard
fund return fund beta market govt. deviation
index securities
1 6.85 1.32 14.31 4.35 0.8
2 1.20 1.27 18.95 3.85 0.9
3 21.00 1.25 14.50 6.15 1.2
4 10.18 1.10 9.25 7.50 1.4
5 17.65 0.95 20.00 6.00 1.5

Illustration 15:
Evaluate performance of following portfolio and market using the following data and comment
on the same:
Portfolio SD(%) Beta Return (%)
Dev Ltd. 20 1.25 35
Gandharva Ltd. 18 1.10 30
Asura Ltd. 19 1.15 32
Market 15 1.00 25
Risk free rate of return is 8%.
Illustration 16:
The details of three portfolio are given below:
Portfolio Return on portfolio Beta Standard deviation
(%)
Sony 18 1.2 28
Mony 12 0.8 32
Tony 16 1.1 36
Market index 14 1.0 22
Compare these portfolios on performance using Sharpe and Treynor measures. Risk free return
is 8%.
Illustration 18:
The details of three portfolio are given below:
Portfolio Average return on Beta Standard deviation
portfolio (%) (%)
Fund – 1 18 1.4 30
Fund – 2 12 0.9 35
Fund – 3 16 1.1 40
Market index 14 1.0 25
Compare these portfolios using Sharpe and Treynor measures. Risk free return is 8%.
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