Portfolio Risk and Performance Analysis

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Portfolio Risk and
Performance Analysis

Essentials of Corporate Finance

Chapter 11

Materials Created by Glenn Snyder


San Francisco State University

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

2

Topics


Asset Management Firms


Active vs. Passive Portfolio Management


Roles of Risk and Performance


Setting Up the Portfolio


Diversification


Systematic and Unsystematic Risk


Stability and Portfolio Turnover


Risk and Performance Analysis


Risk Ratios


The Importance of Beta


Market Risk Premium


Sharpe and Treynor Ratios


Impact on Portfolio Management


Career Advice for a Risk and Performance Analyst

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

3

Asset Management Firms


An asset management firm is a company that
manages money, in the form of investments, for
their clients


Essentially, these firms manage their client’s assets


Asset management firms are typically…


Mutual Fund Companies


Pension Fund Companies


Hedge Fund Companies


Insurance Companies


Subsidiaries of Commercial Banks

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

4

Active vs. Passive Portfolio Management


Active Portfolio Management


The portfolio manager invests in securities of their choosing


The portfolio manager weights the securities as he or she
sees fit


Keeping the portfolio within the restrictions stated in the
prospectus



Passive Portfolio Management


Portfolio securities are made of all securities in the market
(based on the portfolio’s investment objective)


Portfolio securities are weighted based on each security’s
market capitalization

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

5

Roles of Risk and Performance


Asset management companies typically have a risk
and performance group that is independent of the
portfolio management teams



The role of the risk and performance group is


To calculate portfolio performance and compare it
applicable index or benchmark


To calculate risk metrics and analyze the portfolio to
determine if the return of the portfolio is adequate for the
amount of risk


To analyze the impact of active portfolio management

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

6

Setting Up the Portfolio


The portfolio manager will determine how to
structure the portfolio based on the restrictions and
guidelines in the portfolio’s prospectus


Portfolio Prospectus includes:


Fees


Investment Objectives


What type of securities it can hold


Market Cap


the size of the securities it can hold


The portfolio’s benchmark


the index it will be compared against


Limitations on


Ownership


Sector/Industry/Country weighting


Names of the portfolio managers

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

7

Diversification


Why Diversify?


Higher more consistent return


Lower risk



A diversified portfolio will hold a number of
securities


Diversification is not having all of your eggs in one
basket


Losses in some securities should be offset by
gains in others

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

8

Systematic and Unsystematic Risk


Systematic Risk


Market Risk


Risk inherent to the market


Risk that cannot be eliminated



Unsystematic (Company Specific) Risk


Risk inherent to the specific security


E.g. Microsoft Stock has risks beyond investing in the
stock market, such as anti
-
trust, competitors,
management succession, etc.


Diversifiable


Can be eliminated through
diversification

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

9

Systematic and Unsystematic Risk

Number of stocks in portfolio
10
20
30
40
50
Percent risk
20
40
60
80
Portfolio of
U.S. stocks
By diversifying the portfolio, the variance of the portfolio’s r
eturn relative to the variance of the market’s
return (beta) is reduced to the level of systematic risk
--
the risk of the market itself.
Systematic
risk
Total
risk
27%
1
Total Risk = Diversifiable Risk + Market Risk
(unsystematic) (
systematic)
=
Variance of portfolio return
Variance of market return
100
February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

10

Systematic and Unsystematic Risk


As more stocks are added, each new stock
has a smaller risk
-
reducing impact



s
p

falls very slowly after about 10 stocks are
included, and after 40 stocks, there is little, if
any, effect. The lower limit for
s
p

is about
27% =
s
M



s
M
= Market Risk


s
p

= Portfolio Risk


February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

11

Stability and Portfolio Turnover


Portfolio stability is important to many long
-
term investors



Portfolio Turnover is a ratio that calculates
the percentage of securities that changed in
the portfolio over the past year


If a portfolio has 100 securities and has a turnover
of 25%, then


75 securities remained constant in the portfolio


25 securities were bought/sold during the year

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

12

Risk and Performance Analysis


Risk and performance analysts calculate on a
monthly basis how a portfolio performs


Actual basis



actual returns of the portfolio and its
underlying securities


Relative Basis



portfolio returns compared against the
portfolio’s benchmark or market index


Peer Basis



many mutual funds are put into peer
universes and are ranked against competitive funds
invested in similar securities


Risk Basis



ratios that determine performance per unit of
risk and compared against


Risk free rate


Benchmark or Index


Peer portfolios

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

13

The Importance of Beta


Beta (
ß)


A measure of market risk, to which the returns on
a given stock move with the market


If beta = 1.0, average stock


If beta > 1.0, stock riskier than average


If beta < 1.0, stock less risky than average


Most stocks have betas in the range of 0.5 to 1.5

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

14

Market Risk Premium


Market Risk Premium (RP
M
)


The additional return over the risk
-
free rate
needed to compensate investors for assuming an
average amount of risk



RP
M
= (R
M



R
F
)


R
M

= market portfolio rate





with
ß = 1.0

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

15

Sharpe and Treynor Ratios


Sharpe Ratio



calculates the average
return over and above the risk
-
free rate
of return per unit of portfolio risk.



Sharpe Ratio = (R
i



R
f
) /
s
i


R
i
= Average return of the portfolio during period i

R
f
= Average return of the risk
-
free rate during period i

s
i
= standard deviation (risk) of the portfolio during period i

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

16

Sharpe and Treynor Ratios


Treynor Ratio



calculates the average
return over and above the risk
-
free rate of
return per unit of the world market portfolio
risk.



Treynor Ratio = (R
i



R
f
) /
b
i


R
i
= Average return of the portfolio during period i

R
f
= Average return of the risk
-
free rate during period i

b
i
= The systematic (market) risk of the world market portfolio during
period i

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

17

Sharpe and Treynor Ratios


Risk and performance analysts use Sharpe
and Treynor ratios to analyze the
effectiveness of the portfolio manager


If the Sharpe and Treynor ratios are below 1.0,
then the portfolio manager is taking too much risk
for the return the portfolio is generating

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

18

Impact on Portfolio Management


Risk and performance analysis impacts
portfolio management by:


Guiding the portfolio manager to


Take additional risk if the portfolio is underperforming its
peers and benchmark


Take less risk if the Sharpe and Treynor ratios are below
1.0


Increase diversification to reduce portfolio risk


Analyzing portfolio management strategies and
their effectiveness

February 26, 2007

Materials Created by Glenn Snyder


San Francisco State University

19

Career Advice for a Risk and Performance
Analyst


CFA (Chartered Financial Analyst)


The CFA is a 3 year certification that is required for most
risk and performance analysts and portfolio managers


Sharpen your technical skills


Highly math and science oriented


Understand portfolio management


Learn about portfolio management strategies, techniques,
and analysis


Many large asset management companies will have
a management training program


Highly Competitive


Hands on training