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

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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

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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

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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

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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

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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

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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

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Systematic and Unsystematic Risk

Number of stocks in portfolio

10 20 30 40 50

Percent risk

20

40

60

80

Portfolio ofU.S. stocks

By diversifying the portfolio, the variance of the portfolio’s return relative to the variance of the market’s return (beta) is reduced to the level of systematic risk -- the risk of the market itself.

Systematicrisk

Totalrisk

27%

1

Total Risk = Diversifiable Risk + Market Risk(unsystematic) (systematic)

=Variance of portfolio returnVariance of market return

100

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Systematic and Unsystematic Risk As more stocks are added, each new stock

has a smaller risk-reducing impact

p falls very slowly after about 10 stocks are included, and after 40 stocks, there is little, if any, effect. The lower limit for p is about 27% = M

M = Market Risk p = Portfolio Risk

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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

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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

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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

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Market Risk Premium

Market Risk Premium (RPM) The additional return over the risk-free rate

needed to compensate investors for assuming an average amount of risk

RPM = (RM – RF) RM = market portfolio rate with ß = 1.0

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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 = (Ri – Rf) / i

Ri = Average return of the portfolio during period i

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

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

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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 = (Ri – Rf) / i

Ri = Average return of the portfolio during period i

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

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

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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

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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

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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