Portfolio Management and Investment Analysis Student Manual PDF

PORTFOLIO MANAGEMENT AND INVESTMENT ANALYSIS  Course Outline Module Contents Module 1 Portfolio Management Module 2 Portfolio Risk and Returns Module 3 Portfolio Performance Measurement Module 4 Risk Measurement Module 5 Asset Classes...

PORTFOLIO MANAGEMENT AND INVESTMENT ANALYSIS  Course Outline Module Contents Module 1 Portfolio Management Module 2 Portfolio Risk and Returns Module 3 Portfolio Performance Measurement Module 4 Risk Measurement Module 5 Asset Classes 2 MODULE 1 PORTFOLIO MANAGEMENT The portfolio is a collection of investment instruments like shares, mutual funds, bonds, FDs and other cash equivalents, etc. Portfolio management is the art of selecting the right investment tools in the right proportion to generate optimum returns with a balance of risk from the investment made. In other words, a portfolio is a group of assets. The portfolio gives an opportunity t*o diversify risk. Diversification of risk does not mean that there will be an elimination of risk. With every asset, there is an attachment of two types of risk: diversifiable/unique/unexplained/unsystematic risk and undiversifiable/ market risk / explained /systematic risk. Even an optimum portfolio cannot eliminate market risk, but can only reduce or eliminate the diversifiable risk. As soon as risk reduces, the variability of return reduces. Portfolio Management Process Portfolio Management process is an on-going way of managing a client’s portfolio of assets. There are various components and sub-components of the process that ensure a portfolio is tailored to meet the client’s investment objectives well within his constraints. Portfolio managers need to chart out specific strategies for portfolio management to maintain the risk-return trade-off. The portfolio management process has the following steps and the sub-components: 3 Steps Subcomponents Identification of Objectives and Constraints Investment Policy Statement Capital Market Expectations Planning Asset Allocation Strategy 1. Strategic Asset Allocation 2. Tactical Asset Allocation Portfolio Selection Execution Portfolio Implementation Monitoring and Rebalancing Feedback Performance Evaluation Planning This is the most crucial step as it lays down the foundation of the entire process. It comprises of these tasks: 1. Identification of Objectives and Constraints: The identification of client’s investment objectives and any constraints is the foremost task in the planning stage. Any desired outcomes that the client has regarding return and risk are the investment objectives. Any limitations on the investments decisions or choices are the constraints. Both are specified at this stage. 2. Investment Policy Statement: Once the objectives and constraints are identified, the next task is to draft an investment policy statement. 3. Capital Market Expectations: The third step in the planning stage is to form expectations regarding capital markets. Risk and return of various asset classes are forecasted over the long term to choose portfolios that either maximizes the 4  expected return for certain levels of risk or minimize the portfolio risk for certain levels of expected return 4. Asset Allocation Strategy: This is the last task in the planning stage. a. Strategic Asset Allocation: The investment policy statement and the capital market expectations are combined to determine the long-term weights of the target asset classes, also known as strategic asset allocation. b. Tactical Asset Allocation: Any short-term change in the portfolio strategy as a result of the change in circumstances of the investor or the market expectations is tactical asset allocation. If the changes become permanent and the policy statement is updated to reflect the changes, there is a chance that the temporary tactical allocation becomes the new strategic portfolio allocation. Asset Allocation - Asset allocation means spreading your investments across various asset classes. Broadly speaking, that means a mix of stocks, bonds, and cash or money market securities. Within these three classes there are subclasses: Large-cap stocks: Shares issued by companies with a market capitalization above $10 billion. Mid-cap stocks: Shares issued by companies with a market capitalization between $2 billion and $10 billion. Small-cap stocks: Companies with a market capitalization of less than $2 billion. These equities tend to have a higher risk due to their lower liquidity. International securities: Any security issued by a foreign company and listed on a foreign exchange. Emerging markets: Securities issued by companies in developing nations. These investments offer a high potential return and a high risk due to their potential for country risk and their lower liquidity. 5  Fixed-income securities: Highly rated corporate or government bonds that pay the holder a set amount of interest, periodically or at maturity, and return the principal at the end of the period, these securities are less volatile and less risky than stocks. Money market: Investments in short-term debt, typically a year or less. Treasury bills (T-bills) are the most common money market investment. Execution - Once the planning stage is completed, execution of the planned portfolio is the next step. This consists of these decisions: 1. Portfolio Selection: The expectation of the capital markets is combined with decided investment allocation strategy to choose specific assets for the investor’s portfolio. Generally, the portfolio managers use the portfolio optimization technique while deciding the portfolio composition. 2. Portfolio Implementation: Once the portfolio composition is finalized, the portfolio is executed. Portfolio executions are equally important as high transaction costs can reduce the performance of the portfolio. Transaction costs include both explicit costs like taxes, fees, commissions, etc. and implicit costs like bid-ask spread, opportunity costs, market price impacts, etc. Hence, the execution of the portfolio needs to be appropriately timed and well-managed. Feedback - Any changes required due to the feedback are analyzed carefully to make sure that they are as per the long-run considerations. The feedback stage has the following two sub-components: 1. Monitoring and Rebalancing: The portfolio manager needs to monitor and evaluate risk exposures of the portfolio and compares it with the strategic asset allocation. This is required to ensure that investment objectives and constraints are being achieved. The manager monitors the investor’s circumstances, economic fundamentals and market conditions. Portfolio rebalancing should also consider taxes and transaction costs. 6  2. Performance Evaluation: The investment performance of the portfolio must be evaluated regularly to measure the achievement of objectives and the skill of the portfolio manager. Both absolute returns and relative returns can be used as a measure of performance while analysing the performance of the portfolio. Investment Policy Statement A formal written document created to govern investment decision making after taking into account the client’s objectives and constraints. This statement is formulated in the planning stage of the process as mentioned above. Role: Investment policy statement has the following roles to play: Endorse long-term discipline in all the portfolio decisions. Easily implemented by both current as well as future investment advisors. Protect against short-term portfolio reallocation in case the changing markets or the performance of the portfolio causes overconfidence or panic. Elements: An investment policy statement has several of these elements: A complete client description providing enough background so that any investment advisor can understand the client’s situation. A purpose with respect to investment objectives, policies, goals, portfolio limitations and restrictions. Identification of responsibilities and duties of all the parties involved. A formal statement depicting objectives and constraints. A schedule for reviewing the performance of the portfolio and the policy statement. Ranges of asset allocation and guidelines regarding rigidity and flexibility when devising or modifying the asset allocation. Instructions for adjustments in the portfolio and rebalancing. 7  Types of investment Strategies Strategic asset allocation is a part of the asset allocation in the planning stage. The following are the approaches used to execute the strategic asset allocation: 1) Passive Investment: These strategies comprise of portfolios that do not respond to any changes in expectations. Buy and hold and indexing are examples of such passive strategies. 2) Active Investment: These strategies respond much more to changing expectations. They aim to benefit from the differences between the beliefs of a portfolio manager concerning the valuations and those of the marketplace. Making investments according to a particular style of investment and generating alpha are examples of such active investments. 3) Hybrids: These include enhanced index, risk-controlled active and semi-active strategies, which are hybrids of active and passive strategies. Index tilting is one example of a hybrid strategy, where the portfolio manager tries to match the risk attributes of a benchmark portfolio, but at the same time deviates from the same benchmark portfolio allocations to earn superior returns Investment Constraints Liquidity Constraints Will you be able to convert the investment to needed liquidity or cash at the suitable time or anytime you wish to, can the liquidity deteriorate over time, what events can impact on liquidity Tax Constraints These constraints depend on when, how and if returns of different types are taxed. Income generated from your investments is it taxable. The tax environment needs to be kept in mind while drafting the policy statement. Time Constraints 8 These constraints are related to the time periods over which returns are expected from the portfolio to meet specific needs in future. You may have to pay for college education for your children or need the money after your retirement. Such constraints are important to determine the proportion of investments in long term and short-term asset classes. Generally, if you have a longer time horizon have the ability to take more risk in their portfolios and require less liquidity. Index Investing Indexes are also often used as benchmarks against which to measure the performance of mutual funds and exchange-traded funds (ETFs). For instance, many mutual funds compare their returns to the return in the S&P 500 Index to give investors a sense of how much more or less the managers are earning on their money than they would make in an index fund. "Indexing" is a form of passive fund management. Instead of a fund portfolio manager actively stock picking and market timing—that is, choosing securities to invest in and strategizing when to buy and sell them—the fund manager builds a portfolio wherein the holdings mirror the securities of a particular index. The idea is that by mimicking the profile of the index—the stock market as a whole, or a broad segment of it—the fund will match its performance as well. Since you cannot invest directly in an index, index funds are created to track their performance. These funds incorporate securities that closely mimic those found in an index, thereby allowing an investor to bet on its performance, for a fee. An example of a popular index fund is the Vanguard 4 S&P 500 ETF (VOO), which closely mirrors the S&P 500 Index. When putting together mutual funds and ETFs, fund sponsors attempt to create portfolios mirroring the components of a certain index. This allows an 9  investor to buy a security likely to rise and fall in tandem with the stock market as a whole or with a segment of the market. Index Examples The S&P 500 Index is one of the world's best-known indexes and one of the most commonly used benchmarks for the stock market. It includes 80% of the total stocks traded in the United States. Conversely, the Dow Jones Industrial Average is also well known, but represents stock values from just 30 of the nation's publicly traded companies. Other prominent indexes include the Nasdaq 100 Index, Wilshire 5000 Total Market Index, MSCI EAFE Index, and the Bloomberg Barclays US Aggregate Bond Index. Risk Tolerance Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand in their financial planning. Risk tolerance is an important component in investing. You should have a realistic understanding of your ability and willingness to stomach large swings in the value of your investments; if you take on too much risk, you might panic and sell at the wrong time. Risk tolerance is a measure of how much of a loss an investor is willing to endure within their portfolio. Factors that affect risk tolerance include, age, investment goals, income, comfort level, personal history Risk Tolerance Types Aggressive Risk Tolerance Aggressive investors tend to be market-savvy, they reach for maximum returns with maximum risk. 10  Moderate Risk Tolerance Moderate investors accept some risk to the principal but adopt a balanced approach usually combines large-company mutual funds with less volatile bonds and riskless securities, moderate investors often pursue a 50/50 structure Conservative risk Tolerance Accept little to no volatility in their investment portfolios, are unwilling to allow any type of risk to their principal. They are risk averse, opt for bank certificates of deposit, money markets, T-bills. Investment Pattern Analysis Conservative Risk Profile Primary Goal In capital protection Requires Stable growth and/or high level of income Access to Investment within 3 years Conservative investing - is an investment strategy that prioritizes the preservation of capital over growth or market returns.... In a conservative investing strategy more than half of a portfolio will generally be held in debt securities and cash equivalents rather than equities or other risky assets. Conservative investors have risk tolerances ranging from low to moderate. As such, a conservative investment portfolio will have a larger proportion of low-risk, fixed-income investments and a smaller smattering of high-quality stocks or funds. A conservative strategy necessitates investment in the safest short-term instruments, such as Treasury bills and certificates of deposit. Although a conservative investing strategy may protect against inflation, it may not earn significant returns over time when compared to more aggressive strategies. Investors are 11 often encouraged to turn to conservative investing as they near retirement age regardless of individual risk tolerance. A capital preservation strategy incorporates safe, short-term instruments, such as Treasury bills (T-bills) and certificates of deposit (CDs). A capital preservation strategy could be appropriate for an older investor looking to maximize her current financial assets without significant risks. Conservative investing strategies generally have lower returns than more aggressive strategies, such as a growth portfolio. For example, a capital growth strategy seeks to maximize capital appreciation or the increase in a portfolio’s value over the long term. Such a portfolio could invest in high-risk small-cap stocks, such as new technology companies, junk or below-investment-grade bonds, international equities in emerging markets, and derivatives. In general, a capital growth portfolio will contain approximately 65-70% equities, 20-25% fixed-income securities, and the remainder in cash or money market securities. Although growth-oriented strategies seek high returns by definition, the mixture still somewhat protects the investor against severe loss Aggressive Risk Profile An aggressive investment strategy typically refers to a style of portfolio management that attempts to maximize returns by taking a relatively higher degree of risk. Strategies for achieving higher than average returns typically emphasize capital appreciation as a primary investment objective, rather than income or safety of principal. Such a strategy would therefore have an asset allocation with a substantial weighting in stocks and possibly little or no allocation to bonds or cash. Aggressive investment strategies are typically thought to be suitable for young adults with smaller portfolio sizes. Because a lengthy investmentorizon enables them to ride out market fluctuations, and losses early in one's career have less impact than later, 12 The aggressiveness of an investment strategy depends on the relative weight of high- reward, high-risk asset classes, such as equities and commodities, within the portfolio. For example, Portfolio A which has an asset allocation of 75% equities, 15% fixed income, and 10% commodities would be considered quite aggressive, since 85% of the portfolio is weighted to equities and commodities. However, it would still be less aggressive than Portfolio B, which has an asset allocation of 85% equities and 15% commodities. An aggressive strategy needs more active management than a conservative “buy-and- hold” strategy, since it is likely to be much more volatile and could require frequent adjustments, depending on market conditions. More rebalancing would also be required to bring portfolio allocations back to their target levels. Volatility of the assets could lead allocations to deviate significantly from their original weights. This extra work also drives higher fees as the portfolio manager may require more staff to manage all such positions. Moderate Risk Profile A Moderate investor values reducing risks and enhancing returns equally. This investor is willing to accept modest risks to seek higher long-term returns. A Moderate investor may endure a short-term loss of principal and lower degree of liquidity in exchange for long- term appreciation. balanced approach with intermediate-term time horizons of five to 10 years. Combining large-company mutual funds with less volatile bonds and riskless securities, moderate investors often pursue a 50/50 structure. 13 MODULE 2 PORTFOLIO RISKS AND RETURNS Sources of Risk Financial Risk Financial risk is the possibility of losing money on an investment or as all risks defined from events in the financial markets that affect all participants. They arise from the effect of market forces on Financial assets and liabilities. It includes Credit risk, Markets risk (Interest rate, exchange rate, inflation), Liquidity Risk Non-Financial Risk Non-financial risks (NFR) are all of the risks which are not covered by traditional financial risk management. The risks result in Financial losses but are not due to effect in the Financial market examples include Model Risk, Operational Risk (fraud, misconduct, failure of internal controls or audit systems, natural disasters), Accounting risk (changes in GAAP/IFRS and comparability issues, managed earnings, etc.). Regulatory risk Portfolio Risks Portfolio risks can be reduced through diversification. However, diversification reduces only a particular type of risk. From this point of view, a particular asset or a portfolio of assets possesses two types of risks namely: ▪ Unsystematic risk and ▪ Systematic risk Unsystematic/Diversifiable/Business Risk/Total Risk Appraised with: Standard Deviation, Variance etc Systematic/Undiversifiable/ Market risk Appraised with: Beta, Coefficient of Variation etc. 14  Other Appraisal Techniques: Sensitivity Analysis Simulation Decision Tree Linear Programming Uunsystematic risk Unsystematic risk arises from the unique uncertainties of individual securities, These uncertainties are diversifiable if a large number of securities are combined to form well – diversified portfolios. Uncertainties of individual securities in a portfolio cancel out each other. Thus, unsystematic risk can be totally reduced through diversification. It is calculated using standard deviation which is the degree of variability of the company’s returns Examples Include ✓ The company’s workers declare strike actions ✓ The R & D expert leaves the company ✓ The company losses a big contract in a bid ✓ A formidable competitor enters the market ✓ The company has a bad management team ✓ The company is unable to obtain adequate quantity of raw material ✓ The company’s location is not advantageous 15 Give more examples Systematic Risk This is also known as non – diversifiable, non – specific, general and market- imposed risk. Systematic risk arises on account of the economy – wide uncertainties and tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification. It is also known as Market risk. Investors are exposed to market risk even when they hold well – diversified portfolios of securities. Examples Include The government changes the interest rate policy The inflation rate increases The CBN promulgates a restrictive credit policy The corporate tax rate is increased The government withdraws tax on dividend payments by companies. The government resorts to massive deficit financing The government eliminates/reduces the Capital gains tax rate. Systematic/ Undiversifiable/ Market Risk This is the risk that cannot be reduced by diversification It’s a risk faced or that affects all assets - a very wide variety of assets Its calculated using beta which is the degree of correlation of a particular asset returns to the market returns. The index of markets such as NSE, Nasdaq is used as a proxy for the market returns The systematic risk and the unsystematic risk are different and distinct from the risk free. Risk free refers to those financial instruments that are regarded as not being exposed to any variability in their returns irrespective of the events in the environment. e. g. Treasury bills. 16  The rate of return on the T-bills is referred to as Risk free rate. The rate you can earn in the absence of any risk Measuring Unsystematic risk The news that Diamond bank has failed capital adequacy ratio affect Diamond bank equity prices not the whole market. News that First Bank Non-Performing Loans (NPL) ratio has ballooned affect First Bank Equity specifically and didn’t affect the whole market. The way to reduce unsystematic risk is through diversification: The process of investing in different assets that are not affected by the same unsystematic risk. i.e. assets whose returns are not positively correlated. Formula for Standard Deviation ( α) = ∑ (Y- My)^2/N Y = Returns on the security My = Mean of the returns N= No of periods Calculating Unsystematic Risk: To calculate the unsystematic risk of an assets we calculate the standard deviation Measuring Unsystematic risk Find below the returns of Greatness Nigeria Plc equity for a period of time. Use the below information to calculate the 1. Expected Returns and 2. Standard Deviation of the asset (Standard deviation/ Total Risk/ Unsystematic risk) 17 Step 1: calculate the expected returns for this company: The expected returns is the mean of the actual returns i.e Total of returns / No of periods 2+3+10+7+12+13 /6 = 7.83% Step 2: Calculate the deviation for each of the year Step 3: Square the annual deviation 18 Step 4: Calculate the variance Variance = Total squared variance/ No of periods = 0.01068334/ 6 = 0.001780557 Variance is a measure of the variability of figures in a data set, the higher the variance the greater the dispersion or their variability from the mean of the data. If two investments have the same expected return, but one has a lower variance, the one with the lower variance is the less risky choice. Step 5: Calculate standard deviation Standard Deviation is equal to square root of Variance Standard deviation = _/Variance Sqrt (0.001780557) = 0.042196643 = 4.22% If two investments have the same expected return, but one has a lower Standard Deviation, the one with the lower standard deviation is the less risky choice. Interpretation The expected return for Greatness Nigeria Plc is 7.83% However, the standard deviation shows that the returns is plus or minus 4.22% on 7.83% So, the returns hover between (7.83+4.22) & (7.83-4.22) = 12.05% - 3.61% Measuring Systematic risk An economic recession that leads to reduction in purchasing power and demand for products will affect virtually all assets to a various degree A sharp increase in interest rate will affect all assets to various degrees. Hence risks like these two, Demand risk and interest rate risk are undiversifiable/Systematic risks. The degree of a company systematic risk is its beta 19 Formula for beta (β) = ∑ (X – Mx) (Y- My∑ (X – Mx) ^2 Y= returns of Financial asset My= Mean of returns on Financial asset X= Returns of Market Mx = Mean of returns on market Beta measures how a financial asset responds to changes in the market performance Exercise If the Nigeria Stock Exchange has the following returns, use the information to calculate the beta of Greatness Nig Plc Equity Actual returns % Period (N) (Y) 2011 5 2012 7 2013 4 2014 7 2015 15 2016 14 Step 1: Calculate the Mean of returns for the market i.e NSE = 52/6 = 8.67% Step 2: Calculate the deviation of NSE and import the deviation of Greatness from above Step 3: Calculate the product of the deviation of Greatness and NSE and calculate the square of the deviation of the Market 20  Beta (β) = 0.00746667/ 0.01093333 = 0.68292683 So, the beta of Greatness is 0.68, which means that the company moves at 68% of the market. Hence, if the market moves by 100 points, Greatness moves by 68 Points. If the returns of the market are 10% Good fortune will return 6.8% Coefficient of Variation (C.V) This measure the relationship between risk and return using Expected return and standard deviation as the measure of Returns and risk respectively: C.V = Standard Deviation/ Expected returns The higher the ratio the less attractive, the higher the risk (standard deviation) versus the returns, the less attractive the investments is. If two investments are being compared, the one with the lower Coefficient of variation is a better choice for a rational investor than the higher one Correlation Co-efficient: This measures the degree of correlation between the returns of two assets. COR (A,B) = Cov (A.B) Std dev A X Std Dev B 21  Measures the degree of correlation between the returns of two assets or a security and the market. Correlation coefficient can range between -1 to 1. If it is positive it means the returns move in the same direction if its negative it means the returns move in opposite direction If it is 1 (one), it means the degree of movement is exactly the same. If one moves upwards 10% the second also moves upwards by the same degree If it is negative, it means when one moves upwards the other will move southwards. In portfolio development the trend is to put together assets with negative correlation so that you can diversify the unsystematic risk. Result Interpretation Positive Returns move in the same direction Negative Returns move in opposite direction Perfect positive correlation, move in the same direction by the same rate 1 Perfect negative correlation moves in the opposite direction by the same rate -1 >1 Error in computation < -1 Error in Computation 0 No linear relationship between their returns 22 Covariance Covariance speaks of the relationship between the returns o tow Financial assets When two stocks move together, they have a positive covariance: If Stock A returns moves higher whenever Stocks B returns moves higher and this same relation subsists when the returns of both stock decreases, i.e. when return in Stock A reduces and Stock B also reduces. This is Positive covariance When they move in opposite direction the have negative covariance: If Stock A returns moves higher whenever Stocks B returns moves lower and this same relation subsists when the returns decreases, i.e when return in Stock A reduces and Stock B increases and Vice versa. This is Negative covariance Covariance measure the directional relationship between returns on two assets, it does not show the strength or degree of this relationship. Correlation coefficient however shows the strength of this relationship by putting figure to the relationship Capital Asset Pricing Model (CAPM) The capital asset pricing model was the work of financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book "Portfolio Theory and Capital Markets." His model starts with the idea that individual investment contains two types of risk: ▪ Systematic Risk – ▪ Unsystematic Risk – Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock market can't eliminate that risk. 23 Therefore, when calculating a deserved return, systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk. Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relationship between risk and expected return Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk. CAPM's starting point is the risk-free rate – typically a 10-year government bond yield (rf). To this is added a premium that equity investors demand to compensate them for the extra risk they accept (Erm-Erf). This equity market premium consists of the expected return from the market (Erm)as a whole less the risk-free rate of return (Erf). The equity risk premium (βi) is multiplied by a coefficient that Sharpe called "beta.“ 24  Assumptions 1) There is a single risk-free rate of return 2) An accurate statistical estimate can be made of the beta factor of a company’s shares. 3) Single period investment horizon 4) Perfect market (no personal taxes) 5) Homogeneous expectations of investors 6) Investors hold well diversified portfolios 7) Inflation and its effect on dividends and capital gains can be ignored 8) Returns are measured as both dividends and capital gains 9) Efficient market (free flow of information Limitations Inability to define the exact market composition. ▪ CAPM is a single period model ▪ CAPM is a single factor model ▪ CAPM assumes full diversification ▪ Distinction between lending and borrowing is not considered by CAPM. ▪ According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility – that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jump up and down. ▪ If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%. ▪ Beta is found by statistical analysis of individual, daily share price returns, in comparison with the market's daily returns over precisely the same period. 25 ▪ Beta, compared with the equity risk premium, shows the amount of compensation equity investors need for taking on additional risk. If the stock's beta is 2.0, the risk- free rate is 3%, and the market rate of return is 7%, the market's excess return is 4% (7% - 3%). ▪ Accordingly, the stock's excess return is 8% (2 X 4%, multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%, the stock's excess return plus the risk-free rate). ▪ What this shows is that a riskier investment should earn a premium over the risk- free rate – the amount over the risk-free rate is calculated by the equity market premium multiplied by its beta. ▪ In other words, it's possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a stock is consistent with its likely return – that is, whether or not the investment is a bargain or too expensive. 26 MODULE 3 PORTFOLIO PERFORMANCE MEASUREMENT Portfolio Performance Measurement ▪ Portfolio Analysis is the process of reviewing or assessing the elements of the entire portfolio of securities or products in a business. The review is done for careful analysis of risk and return. ▪ Portfolio Analysis conducted at regular intervals helps the investor to make changes in the portfolio allocation and change them according to the changing market and different circumstances. ▪ The analysis also helps in proper resource/asset allocation to different elements in the portfolio Measurement of Portfolio Performance ▪ Treynor Ratio 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&P 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 27  Manager B 14% 1.03 Manager C 15% 1.20 Treynor Ratio Now, we 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 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 28 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. 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 Ratio 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 of return is also known as alpha. 29 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 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% = 1.5% Alpha E = 15%- 10.5% = 4.5% Alpha F = 15%- 11% = 4.0% 30 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. The Jensen measure requires the use of a different risk-free rate of return for each time interval considered. 31 MODULE 4 RISK MANAGEMENT Risk management is the identification, evaluation, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability or impact of unfortunate events or to maximize the realization of opportunities In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions. Essentially, risk management occurs when an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment. Risk Management Framework A risk management framework (RMF) is the structured process used to identify potential threats to an organization and to define the strategy for eliminating or minimizing the impact of these risks, as well as the mechanisms to effectively monitor and evaluate this strategy. There are at least five crucial components that must be considered when creating a risk management framework. They include: 1. Risk identification; 2. Risk measurement and assessment; 3. Risk mitigation 4. Risk reporting and monitoring 5. Risk governance. 32 Risk Identification The first step is to define the risk universe. i.e a list of all possible risks e.g. IT risk, operational risk, legal risk, political risk, strategic risk, and credit risk Core ve Non-core risk After listing all possible risks, the company can then select the risks to which it is exposed and categorize them into core and non-core risks. Core risks are those that the company must take in order to drive performance and long-term growth. Non-core are not essential, can be minimized or eliminated completely. Risk Measurement: Provides information on quantum of either a specific risk exposure or an aggregate risk exposure and the probability of a loss occurring due to those exposures. E.g. market risk can be measured using observed market prices, operational risk is considered both an art and a science. Risk measures include value-at-risk (VaR), earnings-at-risk (EaR), and economic capital. Risk Mitigation Having categorized and measured its risks, a company can then decide on which risks to eliminate or minimize, and how much of its core risks to retain. Risk mitigation can be achieved through an outright sale of assets or liabilities, buying insurance, hedging with derivatives, or diversification Risk Reporting and Monitoring Regular reports on specific and aggregate risk measures to ensure risk levels remain at an optimal level. Frequency of reports will be a function of the operations and sent to risk personnel who have that authority to adjust risk exposures. Risk Governance It is the process that ensures all company employees perform their duties in accordance with the risk management framework. Risk governance involves defining the roles of all employees, segregating duties, and assigning authority to individuals, committees, and 33 the board for approval of core risks, risk limits, exceptions to limits, and risk reports, and also for general oversight. Modern Portfolio Theory (MPT) Modern Portfolio Theory (MPT) is a theory of how Risk Averse investors ensure there is an optimization of the risk and returns in portfolio development, to ensure that for any level of risk, the returns are maximized or for any level of returns the least risk is assumed In traditional Portfolio Management, asset managers are focused on the risk return relationship of individual assets In MPT - Investors are focused on how assets affect the portfolio overall risk and return. Asset purchase is based on its impact on the overall risk and return on the portfolio rather than the risk return of the asset itself Efficient Frontier It’s the graphical and visual representation of the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. With historical information on the risk and returns of various asset, using the MPT quantitative models’ various portfolios with risk and returns are created. These portfolios are plotted on a graph E(Rp) = Returns Qp = Risk 34 Efficient Vs Inefficient Frontier The Portfolios that lie on the efficient portfolio line are the efficient portfolio, they represent the lowest risk for a given level of return. Inefficient portfolios are those portfolios inside or to the right of the Efficient frontier line, for every portfolio inside the line for a given risk there is another portfolio along the efficient frontier line that offers a higher return. Inefficient portfolio is one that delivers an expected return that is too low for the amount of risk taken on. Conversely, an inefficient portfolio also refers to one that requires too much risk for a given expected return. In general, an inefficient portfolio has a poor risk-to-reward ratio. 35 Global Minimum Variance The global minimum variance portfolio lies to the far left of the efficient frontier and is made up of a portfolio of risky assets that produces the minimum risk for an investor. It is the portfolio that provides you with the lowest possible portfolio volatility, for a number of underlying assets. Optimal Vs Efficient Portfolio The efficient frontier represents the efficient portfolio, out of these portfolios which is most attractive to an investor. It’s the point at which the investors Indifference curve cuts the efficient frontier The indifference curve shows all the Portfolio investments that gives the investor the same level of utility (Satisfaction). But not all of them are Efficient portfolios. The one that is efficient is the one he will choose 36 Portfolio Construction In Portfolio Construction the aim is risk reduction via diversification. If we have two Assets X and Y constructed in to a portfolio 50% apiece Asset X: Risk = 30%, Returns = 10% Asset Y: Risk = 60% Returns = 25% Returns on the Portfolio is the weighted returns 0.5(25%) + 0.5(25%) = 17.5% Depending on the correlation coefficient between the two assets the risk will vary as below Correlation between assets is the secret to reducing risk, investors choose assets with low correlation to reduce risk in portfolio, while maintaining returns Capital Allocation Line (CAL) All along we have dealt only with risky assets. CAL introduces the risk-free asset into the mix. capital allocation line (CAL), is a line created on a graph of that show optimal combination of risk-free and risky assets. With a mix of risk free and risky assets, using MPT quantitative model, portfolios are created and when graphed, the most efficient portfolios are on the CAL Line (you can say CAL line is the efficient front in a risk free and risky asset portfolio construct) 37 Capital Market Line (CML) The CML is a special type of CAL, however the risky asset is this case is the Market portfolio. A market portfolio is a theoretical bundle of investments that includes every type of asset available in the investment universe, each asset weighted in proportion to its total presence in the market. The expected return of a market portfolio is the expected return of the market as a whole. Investors usually use proxies as Market portfolio because there is no portfolio that fits that description in real life: Dow jones, s&p 500 are examples Capital market line (CML) is a graph that reflects the expected return of a portfolio consisting of all possible proportions between the market portfolio and a risk-free asset. The market portfolio is completely diversified, carries only systematic risk. The slope of the CML is the Sharpe ratio of the market portfolio. A stock picking rule of thumb is to buy assets whose Sharpe ratio will be above the CML and sell those whose Sharpe ratio will be below the CML line shows all optimal combinations between the Risk- free asset and the Market 38 Investors are to choose any portfolio on this line to maximize the risk return combination, all portfolios on this line show the same Sharpe ratio. If you analyze any portfolio or asset that shows Sharpe ratio above this line, its undervalued so buy, if its below its overvalued, so sell 39 Module 5 Asset Classes An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Asset classes are made up of instruments which often behave similarly to one another in the marketplace. Historically, the three mains asset classes have been 1. equities (stocks), 2. fixed income (bonds), and 3. cash equivalent or money market instruments. 4. Currently, most investment professionals include real estate, commodities, futures, other financial derivatives, and even cryptocurrencies to the asset class mix. Equity Equity represents ownership, when you purchase shares in a company, you're purchasing ownership in that company. As part-owner, you have rights to a portion of a company's profits, and these are usually paid out to investors in the form of a dividend There are two major equity types Ordinary Shares Preference Shares Shares are created via issue of shares by companies Issue of Shares is the process in which companies allot new shares to shareholders. Shareholders can be either individuals or corporates The process of creating new shares is known as Allocation or allotment. 40 Generally, the issue of shares is of two kinds - common shares and preference shares. While the former allows for voting rights to the shareholders, the latter does not permit the holders of any rights. However, the dividend is passed on to both in case of a profit. Ordinary share Ordinary shareholders, who are sometimes referred to as residual owners or residual claimants, are the true owners of the firm. As residual owners, ordinary shareholders receive what is left—the residual—after all other claims on the firm’s income and assets have been satisfied. Because of this uncertain position, ordinary shareholders expect to be compensated with adequate dividends and ultimately, capital gains. Represent claims against the firm’s profits and also against proceeds from the sale of its assets Usually irredeemable but may be repurchased Bear the greatest risk among the securities holders As dividends are appropriation of profit, they are not mandatory. Shareholders cannot even increase at their general meeting the rate of dividend proposed by the directors Risk of capital loss is high but potential for return is limitless Pays variable dividend depending on company’s performance and dividend policy Preference shares Represent ownership shares in a business firm and are claims against the firm’s profits and against proceeds from the sale of its assets However, they are entitled to only a fixed rate of return and also get priority (over the ordinary shareholders) in the payment of dividend and in the repayment of principal upon the liquidation of the company 41 Non-payment of dividend per se is not sufficient ground for the institution of winding up proceedings Bears risk greater than Bills holders but less than ordinary shareholders The dividend is expressed as a percentage of its par value. Therefore, unlike ordinary share a preference share’s par value may have real significance. If a firm fails to pay a preference share dividend, the dividend is said to be in arrears. Fixed Income Fixed income A fixed-income security is an investment that provides a return in the form of fixed periodic interest payments and the eventual return of principal at maturity. Unlike variable-income securities, where payments change based on some underlying measure—such as short-term interest rates—the payments of a fixed-income security are known in advance. Bonds Debentures Certificates of deposits (Fixed Deposits) Fixed income debt Whenever you purchase an institution's bonds, you're essentially lending them money— which is why they represent debt. In return, the institution pays interest on the loan in the form of periodic payments to bondholders throughout the life of the bond, and the principal is returned at the end of the term 42 Bonds A bond is simply a type of loan taken out by companies and governments. Investors lend a company or government money when they buy its bonds. In exchange, the company or government pays an interest "coupon" at predetermined intervals (usually annually or semiannually) and returns the principal on the maturity date, ending the loan. TYPES OF BONDS: Federal Government Bond State Bonds Corporate Bonds ATURE OF BONDS: ▪ Premium ▪ Par ▪ Discount Par value: – Face amount; paid at maturity. – Assume N1,000. – Coupon interest rate: – Stated annual interest rate. – Generally fixed. Coupon Payment: – The dollar amount of interest paid each period. – Payments are generally every six months Maturity: years until bond must be repaid. – Original maturity 43  – Remaining term Issue date: – date when bond was issued. Default risk: – Risk that issuer will not make interest or principal payments, in Full and On Time Bond indenture a complex and lengthy legal document stating the conditions under which a bond is issued. Debentures A debenture is a type of bond or other debt instrument that is unsecured by collateral. Since debentures have no collateral backing, they must rely on the creditworthiness and reputation of the issuer for support. Both corporations and governments frequently issue debentures to raise capital or funds. Similar to most bonds, debentures may pay periodic interest payments called coupon payments. Like other types of bonds, debentures are documented in an indenture. An indenture is a legal and binding contract between bond issuers and bondholders. The contract specifies features of a debt offering, such as the maturity date, the timing of interest or coupon payments, the method of interest calculation, and other features. Corporations and governments can issue debentures. Certificate of Deposit ▪ Instrument evidencing a time deposit made with a bank at a fixed interest rate and period of time. ▪ Fixed CDs are quoted on an interest-bearing basis. Interest payment is annualized and paid at maturity ▪ CDs may be negotiable or non-negotiable. Negotiable CDs (NCDs) allow the depositor to sell the CD in the open market prior to the maturity date. 44  ▪ Interest income is subject to withholding tax deductions (currently 10%) ▪ Variable Rate CDs: The coupon established on a variable rate CD at issue and on subsequent roll dates is set at some amount (12.5 to 30 basis points depending on the maturity and name of the issuer) above the average rates that banks are paying on new CDs ▪ Discount CDs: These are CDs issued at a discount instead of interest-bearing CDs issued by banks. Bonds and Risk Interest Rate Risk: Interest rates and bond prices carry an inverse relationship; as interest rates fall, the price of bonds trading in the marketplace generally rises. Conversely, when interest rates rise, the price of bonds tends to fall. Reinvestment Risk: The risk of having to reinvest proceeds at a lower rate than the funds were previously earning. Credit/Default Risk: Investors must consider the possibility of default and factor this risk into their investment decision. Rating Downgrades: A company's ability to operate and repay its debt (and individual debt) issues is frequently evaluated by major ratings institutions such as Standard & Poor's or Moody's. Ratings range from 'AAA' for high credit quality investments to 'D' for bonds in default. Liquidity Risk: While there is almost always a ready market for government bonds, corporate bonds are sometimes entirely different animals. There is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few Money Market Instruments The money market refers to trading in very short-term debt investments. At the wholesale level, it involves large-volume trades between institutions and traders. At the retail level, 45 it includes money market mutual funds bought by individual investors and money market accounts opened by bank customers. In all of these cases, the money market is characterized by a high degree of safety and relatively low rates of return. The money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. It enables governments, banks, and other large institutions to sell short-term securities to fund their short-term cash flow needs. Money markets also allow individual investors to invest small amounts of money in a low-risk setting. Some of the instruments traded in the money market include Treasury bills, certificates of deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage- backed securities and asset-backed securities. TREASURY BILLS Short-term debt obligations of the central government Gilt – edged securities, T/Bills are discountable instruments. Carry zero default risk Still carry inflation or interest rate risk Are discount or zero-coupon instruments i.e only the discounted value is paid at inception Original tenors are 91, 180 & 360 days Issued on weekly basis or frequently as required, by auction Re-discountable Banker’s Acceptance ▪ Short term, zero coupon, commercial bill of exchange drawn on reputable companies and accepted by the bank. 46 ▪ BAs are time drafts i.e. orders to pay a certain sum of money to the holder on a specified future date. Drawn to finance commercial trade transactions of readily marketable commodities ▪ Accepted by a bank that assumes responsibility to make payment on draft at maturity. Accepting bank may discount the bill which may be rediscounted or held till maturity date ▪ Tenors/maturities are usually 1-6 months ▪ Major investors in banks’ BA portfolios are mutual funds, pension funds, large institutional investors and individuals Repurchase Agreement ▪ Repurchase agreements (Repos) are contracts involving the simultaneous sale and future repurchase of the securities ▪ The sale & repurchase prices, amount and value dates are stated in the agreement. Difference between purchase and sale prices is the interest rate on the borrowing ▪ On buyback date, the original seller passes the original buyer interest on the implicit loan created by the transaction ▪ A repo is essentially a collateralized loan. It is done to create temporary liquidity. They do not affect security positions ▪ Reverse repo transactions are used for short term liquidity management with T- bills as underlying transaction (collateral) ▪ Reverse repo is the opposite of repo; a repo is a borrowing whilst a reverse repo is a placement Commercial Paper ▪ Short term unsecured promissory note issued in the open market ▪ Issuers are usually companies with high credit ratings 47  ▪ Zero coupon instrument: investors pay issuers net of discount period at market discount rate ▪ Tenors between 30-270 days; tenors beyond 270 days require SEC approval. Issuer promises to pay buyer a fixed amount at a future date but pledges no asset, only his liquidity and established earning power to guarantee payment ▪ Issues may be guaranteed by banks ▪ CP discount rate is usually higher than T-bills and BAs reflecting a higher risk factor Mutual Funds A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. A mutual fund's portfolio is structured and maintained to match the investment objectives stated in its prospectus. The value of the mutual fund company depends on the performance of the securities it decides to buy. So, when you buy a unit or share of a mutual fund, you are buying the performance of its portfolio or, more precisely, a part of the portfolio's value Unlike stock, mutual fund shares do not give its holders any voting rights. A share of a mutual fund represents investments in many different stocks (or other securities) instead of just one holding. That's why the price of a mutual fund share is referred to as the net asset value (NAV) per share, sometimes expressed as NAVPS. A fund's NAV is derived by dividing the total value of the securities in the portfolio by the total amount of shares outstanding. Mutual fund shares can typically be purchased or redeemed as needed at the fund's current NAV, which—unlike a stock price—doesn't fluctuate during market hours, but it is 48 settled at the end of each trading day. Ergo, the price of a mutual fund is also updated when the NAVPS is settled. 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 in the market. Derivatives A derivative is a contract between two or more parties whose value is based on an agreed- upon underlying financial asset (like a security) or set of assets (like an index). Common underlying instruments include bonds, commodities, currencies, interest rates, market indexes, and stocks. The term derivative refers to a type of financial contract whose value is dependent on an underlying asset, group of assets, or benchmark. A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC). These contracts can be used to trade any number of assets and carry their own risks. Prices for derivatives derive from fluctuations in the underlying asset. These financial securities are commonly used to access certain markets and may be traded to hedge against risk. The types include Futures Forwards Options Swaps Futures A futures contract, or simply futures, is an agreement between two parties for the purchase and delivery of an asset at an agreed-upon price at a future date. Futures are standardized contracts that trade on an exchange. Traders use a futures contract to hedge 49 their risk or speculate on the price of an underlying asset. The parties involved are obligated to fulfill a commitment to buy or sell the underlying asset. Forwards Forward contracts or forwards are similar to futures, but they do not trade on an exchange. These contracts only trade over-the-counter. When a forward contract is created, the buyer and seller may customize the terms, size, and settlement process. As OTC products, forward contracts carry a greater degree of counterparty risk for both parties. Swaps Swaps are another common type of derivative, often used to exchange one kind of cash flow with another. For example, a trader might use an interest rate swap to switch from a variable interest rate loan to a fixed interest rate loan, or vice versa. Options An options contract is similar to a futures contract in that it is an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price. The key difference between options and futures is that with an option, the buyer is not obliged to exercise their agreement to buy or sell. It is an opportunity only, not an obligation, as futures are. As with futures, options may be used to hedge or speculate on the price of the underlying asset. 50