PORTFOLIO PERFORMANCE EVALUATION

PORTFOLIO PERFORMANCE EVALUATION

Portfolio evaluation is the last step in the process of portfolio management. Portfolio evaluation is the stage where we examine to what extent the objective has been achieved. Through portfolio evaluation the investor tries to find out how well the portfolio has performed. The portfolio of securities held by an investor is the result of his investment decision. Portfolio evaluation is really a study of the impact of such decisions. Without portfolio evaluation portfolio management would be incomplete.

Meaning:

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 comprises 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 or investment period.

Performance evaluation addresses such issues as whether the performance was superior or inferior, whether the performance was due to skill or luck, etc.

While evaluating the performance of a portfolio the return earned on the portfolio has to be evaluated in the context of the risk associated with that portfolio. One approach would be to group portfolios into equivalent risk classes and then compare returns of portfolios within each risk category. An alternative approach would be to specifically adjust the return for the riskiness of the portfolio by developing risk adjusted return measure and use these for evaluating portfolios across differing risk levels.

Need for evaluation:

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 organization would like to evaluate the performance of each portfolio so as to compare the performance of different managers.

3.      Evaluation of mutual funds: investors and organizations desirous of placing their funds with 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.

Evaluation perspective:

Evaluation may be carried from different perspective or viewpoints such as---

1.      Transaction view: an investor may attempt to evaluate every transaction of purchase and sale of securities. Whenever, a security is bought and sold, the transaction is evaluated as regards its correctness and profitability.

2.      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.

3.      Portfolio view: 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.

Measures of portfolio evaluation:

1.      Sharpe’s measures: Sharpe’s performance index gives a single value to be used for the performance ranking of various funds or portfolios. Sharpe index measures the risk premium of the portfolio relative to the total amount of risk in the portfolio. This risk premium is the difference between the portfolio’s average rate of return and the riskless rate of return. The standard deviation of the portfolio indicates the risk. The index assigns the highest values to assets that have best risk-adjusted average rate of return.

  SI = (RISK PREMIUM - RISK FREE) / Standard Deviation of Portfolio

Treynor’s Performance index: To understand the Treynor index, an investor should know the concept of characteristic line. The relationship between a given market return and the fund’s return is given by the characteristic line. The fund’s performance is measured in relation to the market performance. The ideal fund’s return rises at a faster rate than the general market performance when the market is moving upwards and its rate of return declines slowly than the market return, in the decline. The ideal fund may place its fund in the treasury bills or short sell the stock during the decline and earn positive return.

With the help of charateristics line Treynor measures the performance of the fund. The slope of the line is estimated by:

Beta co efficient is treated as a measure of undiversifiable systematic risk.

T_n=Portfolio Average Return - Risk less Rate of Return

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                                              Beta Coefficient of the portfolio                                                                                                                      

1.      Jensen’s Performance Index:  the absolute risk adjusted return measure was developed by Micheal Jensen and commonly known as Jensen’s measure. It is mentioned as a measure of absolute performance because a definite standard is set and against that the performance is measured. The standard is based on the manager’s predictive ability. Successful prediction of security price would enable the manager to earn higher return than the ordinary investor expects to earn in given level of risk. The basic model of Jensen is given below:

R_p= intercept + Beta(Rm - Rf)

Jensen’s evaluation of portfolio performance involves two steps:

·         Using the equation the expected return should be calculated

·         With the help of β, Rm,Rp, he has to compare the actual return with the expected return. If the actual return is greater than the expected return, then the portfolio is considered to be functioning in a better manner.

Portfolio management strategies:

Portfolio Management Strategies refer to the approaches that are applied for the efficient portfolio management in order to generate the highest possible returns at lowest possible risks. There are two basic approaches for portfolio management including Active Portfolio Management Strategy and Passive Portfolio Management Strategy.

1.      Active Portfolio Management Strategy

The Active portfolio management relies on the fact that particular style of analysis or management can generate returns that can beat the market. It involves higher than average costs and it stresses on taking advantage of market inefficiencies. It is implemented by the advices of analysts and managers who analyze and evaluate market for the presence of inefficiencies.

The active management approach of the portfolio management involves the following styles of the stock selection.

§       Top-down Approach: In this approach, managers observe the market as a whole and decide about the industries and sectors that are expected to perform well in the ongoing economic cycle. After the decision is made on the sectors, the specific stocks are selected on the basis of companies that are expected to perform well in that particular sector.

§       Bottom-up: In this approach, the market conditions and expected trends are ignored and the evaluations of the companies are based on the strength of their product pipeline, financial statements, or any other criteria. It stresses the fact that strong companies perform well irrespective of the prevailing market or economic conditions.

2.      Passive Portfolio Management Strategy

Passive asset management relies on the fact that markets are efficient and it is not possible to beat the market returns regularly over time and best returns are obtained from the low cost investments kept for the long term.

The passive management approach of the portfolio management involves the following styles of the stock selection.

§       Efficient market theory: This theory relies on the fact that the information that affects the markets is immediately available and processed by all investors. Thus, such information is always considered in evaluation of the market prices. The portfolio managers who follows this theory, firmly believes that market averages cannot be beaten consistently.

§       Indexing: According to this theory, the index funds are used for taking the advantages of efficient market theory and for creating a portfolio that impersonate a specific index. The index funds can offer benefits over the actively managed funds because they have lower than average expense ratios and transaction costs. Apart from Active and Passive Portfolio Management Strategies, there are three more kinds of portfolios including Patient Portfolio, Aggressive Portfolio and Conservative Portfolio.

§       Patient Portfolio: This type of portfolio involves making investments in well-known stocks. The investors buy and hold stocks for longer periods. In this portfolio, the majority of the stocks represent companies that have classic growth and those expected to generate higher earnings on a regular basis irrespective of financial conditions.

§       Aggressive Portfolio: This type of portfolio involves making investments in “expensive stocks” that provide good returns and big rewards along with carrying big risks. This portfolio is a collection of stocks of companies of different sizes that are rapidly growing and expected to generate rapid annual earnings growth over the next few years.

§       Conservative Portfolio: This type of portfolio involves the collection of stocks after carefully observing the market returns, earnings growth and consistent dividend history.