Portfolio Risk and Performance AnalysisEssentials of Corporate FinanceChapter 11Materials Created by Glenn Snyder San Francisco State University

TopicsAsset Management FirmsActive vs. Passive Portfolio ManagementRoles of Risk and PerformanceSetting Up the PortfolioDiversificationSystematic and Unsystematic RiskStability and Portfolio TurnoverRisk and Performance AnalysisRisk RatiosThe Importance of BetaMarket Risk PremiumSharpe and Treynor RatiosImpact on Portfolio ManagementCareer Advice for a Risk and Performance Analyst

Asset Management FirmsAn asset management firm is a company that manages money, in the form of investments, for their clientsEssentially, these firms manage their clients assetsAsset management firms are typicallyMutual Fund CompaniesPension Fund CompaniesHedge Fund CompaniesInsurance CompaniesSubsidiaries of Commercial Banks

Active vs. Passive Portfolio ManagementActive Portfolio ManagementThe portfolio manager invests in securities of their choosingThe portfolio manager weights the securities as he or she sees fitKeeping the portfolio within the restrictions stated in the prospectus

Passive Portfolio ManagementPortfolio securities are made of all securities in the market (based on the portfolios investment objective)Portfolio securities are weighted based on each securitys market capitalization

Roles of Risk and PerformanceAsset 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 isTo calculate portfolio performance and compare it applicable index or benchmarkTo calculate risk metrics and analyze the portfolio to determine if the return of the portfolio is adequate for the amount of riskTo analyze the impact of active portfolio management

Setting Up the PortfolioThe portfolio manager will determine how to structure the portfolio based on the restrictions and guidelines in the portfolios prospectusPortfolio Prospectus includes:FeesInvestment ObjectivesWhat type of securities it can holdMarket Cap the size of the securities it can holdThe portfolios benchmark the index it will be compared againstLimitations onOwnershipSector/Industry/Country weightingNames of the portfolio managers

DiversificationWhy Diversify?Higher more consistent returnLower risk

A diversified portfolio will hold a number of securitiesDiversification is not having all of your eggs in one basketLosses in some securities should be offset by gains in others

Systematic and Unsystematic RiskSystematic RiskMarket Risk Risk inherent to the marketRisk that cannot be eliminated

Unsystematic (Company Specific) RiskRisk inherent to the specific securityE.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

Systematic and Unsystematic Risk

Systematic and Unsystematic RiskAs more stocks are added, each new stock has a smaller risk-reducing impact

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

sM = Market Risk sp = Portfolio Risk

Stability and Portfolio TurnoverPortfolio 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 yearIf a portfolio has 100 securities and has a turnover of 25%, then 75 securities remained constant in the portfolio25 securities were bought/sold during the year

Risk and Performance AnalysisRisk and performance analysts calculate on a monthly basis how a portfolio performsActual basis actual returns of the portfolio and its underlying securitiesRelative Basis portfolio returns compared against the portfolios benchmark or market indexPeer Basis many mutual funds are put into peer universes and are ranked against competitive funds invested in similar securitiesRisk Basis ratios that determine performance per unit of risk and compared againstRisk free rateBenchmark or IndexPeer portfolios

The Importance of BetaBeta ()A measure of market risk, to which the returns on a given stock move with the marketIf beta = 1.0, average stockIf beta > 1.0, stock riskier than averageIf beta < 1.0, stock less risky than averageMost stocks have betas in the range of 0.5 to 1.5

Market Risk PremiumMarket 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 = 1.0

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

Sharpe Ratio = (Ri Rf) / si

Ri = Average return of the portfolio during period iRf = Average return of the risk-free rate during period isi = standard deviation (risk) of the portfolio during period i

Sharpe and Treynor RatiosTreynor 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) / bi

Ri = Average return of the portfolio during period iRf = Average return of the risk-free rate during period ibi = The systematic (market) risk of the world market portfolio during period i

Sharpe and Treynor RatiosRisk and performance analysts use Sharpe and Treynor ratios to analyze the effectiveness of the portfolio managerIf 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

Impact on Portfolio ManagementRisk and performance analysis impacts portfolio management by:Guiding the portfolio manager toTake additional risk if the portfolio is underperforming its peers and benchmarkTake less risk if the Sharpe and Treynor ratios are below 1.0Increase diversification to reduce portfolio riskAnalyzing portfolio management strategies and their effectiveness

Career Advice for a Risk and Performance AnalystCFA (Chartered Financial Analyst)The CFA is a 3 year certification that is required for most risk and performance analysts and portfolio managersSharpen your technical skillsHighly math and science orientedUnderstand portfolio managementLearn about portfolio management strategies, techniques, and analysisMany large asset management companies will have a management training programHighly CompetitiveHands on training