2023
COMMERCE
(Discipline Specific Elective)
(For Honours and Non-Honours)
Paper: DSE-601 (Gr-I)
(Security Analysis and Portfolio Management)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
The figures in the margin indicate full marks for the questions
1. (a) State whether the following statements are True or False: 1x4=4
(1) A Treasury bill is a money market security.
Ans:- True.
(2) Unsystematic risks arise due to inflation.
Ans:- False.
(3) Personal income tax is assumed to be nil in Capital Asset Pricing Model.
Ans:- True.
(4) Jensen’s model is based on the Capital Asset Pricing Model.
Ans:- True.
(b) Fill in the blanks with an appropriate word(s): 1x4=4
(1) Portfolio is a combination of securities.
(2) The opportunistic building model is also known as Sectorial Analysis
(3) Systematic risk can be managed by the use of Diversification of different companies.
(4) A benchmark portfolio represents the Performance/Comparison evaluation standard.
2. Write short notes on (any four): 4x4=16.
(a) Investment Philosophy : Investment philosophy refers to a set of guiding principles or beliefs that dictate how an investor approaches investment decisions and portfolio management. It reflects the investor's attitude toward risk, return, and market dynamics. An investment philosophy typically encompasses factors such as investment goals, time horizon, risk tolerance, asset allocation strategy, and the role of active versus passive management. Different investors may adopt different investment philosophies based on their financial objectives, personal preferences, and market outlook. Common investment philosophies include value investing, growth investing, income investing, market timing, and buy-and-hold strategies.
(b) Intrinsic Value : Intrinsic value is the perceived or estimated true worth of an asset, security, or investment, independent of its market price. It represents the present value of the expected future cash flows generated by the asset, discounted at an appropriate rate of return. Intrinsic value serves as a fundamental basis for investment analysis and decision-making, particularly in value investing approaches. Investors seek to purchase assets trading below their intrinsic value, expecting the market price to eventually converge towards the intrinsic value over time. Intrinsic value analysis helps investors identify undervalued or overvalued assets and make informed investment choices.
(c) Portfolio Management Scheme : A Portfolio Management Scheme (PMS) is an investment management service offered by financial institutions or portfolio managers to high-net-worth individuals (HNIs) and institutional investors. Under a PMS, investors' funds are pooled together to create a portfolio of securities managed by professional portfolio managers or investment advisors. The portfolio managers make investment decisions on behalf of the investors based on the stated investment objectives, risk tolerance, and investment horizon. PMS offers personalised portfolio management tailored to the individual needs and preferences of investors, including discretionary and non-discretionary portfolio management services.
(d) Practical Application of Arbitrage : Arbitrage is a trading strategy that involves exploiting price differentials or inefficiencies in financial markets to earn risk-free profits. In practical terms, arbitrage opportunities arise when the same asset or security is priced differently in different markets or when the price of a derivative instrument deviates from its theoretical value. Traders or arbitrageurs capitalize on these price disparities by simultaneously buying and selling the same asset or related assets to lock in profits. Common examples of arbitrage include merger arbitrage, convertible arbitrage, statistical arbitrage, and cross-border arbitrage. Arbitrageurs play a vital role in promoting market efficiency by reducing price discrepancies and restoring equilibrium between markets.
(e) Risk and Return Measurement : Risk and return measurement are fundamental concepts in investment analysis and portfolio management. Risk refers to the uncertainty or variability of returns associated with an investment, while return represents the gain or loss on an investment over a specific period. Investors seek to maximize returns while minimizing risk, balancing the trade-off between risk and return based on their investment objectives and risk tolerance. Various quantitative metrics and measures are used to assess risk and return, including standard deviation, beta, Sharpe ratio, Treynor ratio, and information ratio. These metrics help investors evaluate the risk-adjusted performance of investments, compare investment opportunities, and construct diversified portfolios aligned with their risk-return preferences.
3. (a) State the economic and financial meaning of investment. Discuss the factors that differentiate the investor from speculator and gambler. 7+7=14
Ans:- Economic and Financial Meaning of Investment :
1. Economic Meaning : In economics, investment refers to the expenditure of resources (such as money, time, or effort) in the creation, acquisition, or enhancement of physical or financial assets with the expectation of generating future income or returns. This expenditure is made with the aim of increasing productivity, expanding production capacity, or improving the efficiency of resource utilization. Economic investments contribute to long-term growth, development, and wealth creation in an economy by fostering capital formation, innovation, and technological advancement.
2. Financial Meaning : In finance, investment refers to the purchase or acquisition of financial assets such as stocks, bonds, real estate, commodities, or mutual funds with the expectation of earning a financial return in the form of capital appreciation, interest, dividends, or rental income. Financial investments involve allocating funds to different asset classes or investment vehicles based on their risk-return characteristics, time horizon, and investment objectives. The goal of financial investments is to preserve and grow wealth over time while managing risk and achieving financial goals such as retirement planning, wealth accumulation, or income generation.
Factors Differentiating Investor from Speculator and Gambler :
1. Objective :
- Investor: Investors typically have long-term objectives, such as wealth preservation, capital appreciation, or income generation. They focus on fundamental analysis, valuation, and the underlying fundamentals of investments.
- Speculator: Speculators aim to profit from short-term price fluctuations or market inefficiencies. They often engage in technical analysis, market timing, and momentum trading to capitalize on short-term trading opportunities.
- Gambler: Gamblers seek to make speculative bets or wagers based on luck or chance rather than on rational analysis or informed decision-making. They are motivated by the thrill of gambling and the possibility of winning big, often disregarding risk management principles.
2. Risk Tolerance :
- Investor: Investors tend to have a moderate to high risk tolerance and are willing to tolerate short-term fluctuations in the value of their investments in pursuit of long-term returns.
- Speculator: Speculators typically have a higher risk tolerance and may be more willing to take on leverage or engage in high-risk trading strategies to amplify potential gains (and losses).
- Gambler: Gamblers may have varying risk tolerances, but their risk-taking behavior is often driven by emotion, impulsivity, and the desire for immediate gratification rather than rational risk assessment.
3. Decision-Making Process :
- Investor: Investors base their investment decisions on thorough research, analysis, and consideration of factors such as valuation, financial performance, industry trends, and economic fundamentals.
- Speculator: Speculators rely on technical analysis, market sentiment, and short-term price movements to make trading decisions, often with less emphasis on fundamental analysis.
- Gambler: Gamblers make decisions based on intuition, luck, or superstition rather than on rational analysis or informed judgment. Their decisions are often driven by emotion and the desire for excitement or entertainment.
4. Time Horizon :
- Investor: Investors typically have a long-term investment horizon, ranging from several years to decades, allowing them to ride out market fluctuations and benefit from compounding returns.
- Speculator: Speculators have a short to medium-term time horizon, ranging from days to months, as they seek to capitalize on short-term market movements or trading opportunities.
- Gambler: Gamblers may have a short-term time horizon, focusing on immediate results or outcomes, such as the outcome of a single bet or gambling event.
In summary, while investors, speculators, and gamblers all engage in activities involving the allocation of resources or funds with the expectation of future returns, they differ significantly in their objectives, risk tolerance, decision-making processes, and time horizons. Investors focus on long-term wealth creation and fundamental analysis, speculators seek short-term profits from market movements, and gamblers pursue immediate gratification based on luck or chance.
Or
(b) What do you understand by company analysis? Explain the tools available for company analysis. 4+10=14
Ans:- Company analysis, also known as fundamental analysis, involves evaluating the financial performance, position, and prospects of a company to assess its investment potential. It aims to provide insights into the company's strengths, weaknesses, opportunities, and threats, helping investors make informed investment decisions. Company analysis typically involves examining various aspects of the company, including its financial statements, business operations, industry dynamics, management quality, and competitive positioning.
Following are tools available for company analysis:
1. Financial Statements Analysis :
- Financial statements, including the income statement, balance sheet, and cash flow statement, provide essential information about a company's financial performance, liquidity, solvency, and cash flow generation. Analysis of financial statements involves assessing key financial ratios, trends, and performance indicators to evaluate the company's profitability, efficiency, leverage, and liquidity.
2. Ratio Analysis :
- Ratio analysis involves calculating and interpreting financial ratios that measure different aspects of a company's financial performance, such as profitability, liquidity, solvency, and efficiency. Common financial ratios include profitability ratios (e.g., return on equity, profit margin), liquidity ratios (e.g., current ratio, quick ratio), leverage ratios (e.g., debt-to-equity ratio, interest coverage ratio), and efficiency ratios (e.g., inventory turnover, asset turnover).
3. DuPont Analysis :
- DuPont analysis decomposes return on equity (ROE) into its components, namely, net profit margin, asset turnover, and financial leverage. This tool helps identify the drivers of a company's ROE and assess the quality and sustainability of its profitability.
4. SWOT Analysis :
- SWOT analysis involves evaluating a company's strengths, weaknesses, opportunities, and threats. It helps identify internal strengths and weaknesses that affect the company's competitive advantage and external opportunities and threats arising from the industry and market environment.
5. Porter's Five Forces Analysis :
- Porter's Five Forces framework assesses the competitive intensity and attractiveness of an industry by analyzing five key forces: the threat of new entrants, the bargaining power of buyers, the bargaining power of suppliers, the threat of substitutes, and the competitive rivalry among existing firms. This analysis helps understand the industry's structure and competitive dynamics.
6. PESTEL Analysis :
- PESTEL analysis examines the external macroeconomic factors that impact a company's business environment, including political, economic, social, technological, environmental, and legal factors. It helps identify opportunities and risks arising from changes in the external environment.
7. Competitor Analysis :
- Competitor analysis involves assessing the strengths, weaknesses, strategies, and performance of competitors operating in the same industry. It helps understand the competitive landscape, benchmark the company's performance against competitors, and identify areas for differentiation and competitive advantage.
8. Management Analysis :
- Management analysis evaluates the quality, experience, and integrity of the company's management team. It examines factors such as management's track record, strategic vision, corporate governance practices, and alignment of interests with shareholders.
9. Qualitative Analysis :
- Qualitative analysis involves assessing non-financial factors that impact a company's performance and prospects, such as brand reputation, customer relationships, innovation capabilities, and regulatory compliance. It complements quantitative analysis by providing insights into intangible aspects of the business.
10. Scenario Analysis :
- Scenario analysis involves evaluating the potential impact of different scenarios or future events on a company's financial performance and valuation. It helps assess the sensitivity of the company's earnings, cash flows, and valuation to changes in key assumptions, risks, and market conditions.
These tools, when used individually or in combination, provide a comprehensive framework for analyzing companies and making informed investment decisions. They help investors understand the intrinsic value of a company, assess its competitive position, and evaluate its potential for long-term growth and value creation.
4. (a) Do you think that the effect of combining securities can bring about a balanced portfolio? Discuss. 14
Ans:- Yes, combining securities can indeed bring about a balanced portfolio. A balanced portfolio is one that is diversified across different asset classes, sectors, industries, and geographic regions, aiming to achieve a mix of return and risk that aligns with the investor's objectives, risk tolerance, and time horizon. By combining securities with different risk-return characteristics, correlations, and market exposures, investors can mitigate risks and enhance the overall stability and performance of their portfolio. Here are several reasons why combining securities can lead to a balanced portfolio:
1. Diversification : Combining securities from various asset classes, such as stocks, bonds, real estate, and commodities, diversifies the portfolio's risk exposure. Different asset classes have different risk-return profiles and may perform differently under various market conditions. Diversification helps reduce the portfolio's overall volatility and the impact of adverse events affecting any single asset or sector.
2. Risk Management : By spreading investments across multiple securities, investors can manage specific risks associated with individual assets or sectors. For example, combining high-risk, high-reward investments with more conservative, income-generating assets can balance the portfolio's risk exposure and provide downside protection during market downturns.
3. Return Enhancement : Combining securities with potentially higher returns and lower correlations can enhance the portfolio's overall return potential. Allocating capital to assets with different return drivers and market cycles allows investors to capture opportunities for growth while mitigating the impact of underperforming investments.
4. Income Generation : Combining income-generating securities, such as dividend-paying stocks, bonds, and real estate investment trusts (REITs), can provide a steady stream of cash flow to the portfolio. This income component helps balance the portfolio's return profile and provides stability, especially during periods of market volatility.
5. Asset Allocation : Combining securities enables investors to implement a strategic asset allocation strategy tailored to their investment goals and risk preferences. Asset allocation involves determining the optimal mix of asset classes based on factors such as time horizon, risk tolerance, and financial objectives. A balanced portfolio allocates resources across different asset classes according to their expected returns, volatilities, and correlations.
6. Portfolio Rebalancing : Combining securities allows investors to periodically rebalance their portfolios to maintain the desired asset allocation. Rebalancing involves buying or selling assets to restore the portfolio's target weights, ensuring that it remains aligned with the investor's risk-return profile. This disciplined approach helps prevent the portfolio from becoming overly concentrated in certain assets or sectors.
In summary, combining securities in a well-diversified and strategically allocated portfolio can indeed bring about balance by mitigating risks, enhancing returns, generating income, and aligning with the investor's objectives. A balanced portfolio aims to achieve a harmonious blend of growth, stability, and income while managing risk effectively across various market conditions.
Or
(b) Define Markowitz diversification theory. Explain the statistical method used by Markowitz to reduce risk. 4+10=14
Ans:- Markowitz Diversification Theory :
Markowitz Diversification Theory, also known as Modern Portfolio Theory (MPT), is a framework developed by economist Harry Markowitz in the 1950s. It provides a mathematical approach to portfolio construction and asset allocation, aiming to maximize expected return for a given level of risk or minimize risk for a given level of return. The theory highlights the importance of diversification in reducing portfolio risk by combining assets with different risk-return profiles.
Statistical Method Used by Markowitz to Reduce Risk :
The statistical method used by Markowitz to reduce risk in portfolio construction is based on two key concepts: expected return and risk.
1. Expected Return :
- Markowitz used expected return to quantify the average return that an investor can expect from a portfolio over a specific period. Expected return is calculated as the weighted average of the returns of individual assets in the portfolio, with each asset's weight determined by its allocation or proportion in the portfolio. By combining assets with different expected returns, investors can achieve a targeted level of return for their portfolio.
2. Risk :
- Markowitz defined risk as the variability or uncertainty of returns associated with an investment. He used variance or standard deviation as measures of risk to quantify the extent of fluctuation in portfolio returns. A portfolio with lower variance or standard deviation is considered less risky because it experiences smaller fluctuations in returns over time. Markowitz emphasized that investors should seek to minimize portfolio risk by diversifying across assets with low or negative correlations, as this helps offset the impact of adverse events affecting any single asset or sector.
3. Efficient Frontier :
- Markowitz introduced the concept of the efficient frontier, which represents the set of optimal portfolios that achieve the highest expected return for a given level of risk or the lowest risk for a given level of return. The efficient frontier is derived from the combination of assets with different risk-return profiles, allowing investors to select the most suitable portfolio based on their risk preferences and return objectives. Portfolios lying on the efficient frontier are considered efficient because they offer the highest return potential for a given level of risk or the lowest risk for a given level of return.
4. Portfolio Optimization :
- Markowitz developed a mathematical optimization model to identify the optimal portfolio allocation that maximizes expected return while minimizing risk. The optimization process involves constructing the efficient frontier by systematically varying the allocation weights of different assets and selecting the portfolio with the desired risk-return trade-off. Markowitz's portfolio optimization model helps investors construct well-diversified portfolios that balance risk and return according to their investment objectives and risk tolerance.
In summary, Markowitz's statistical method for reducing risk in portfolio construction involves quantifying expected return and risk, diversifying across assets with different risk-return profiles, and optimizing portfolio allocation to achieve the highest return for a given level of risk or the lowest risk for a given level of return. By following these principles, investors can build portfolios that are efficient, well-diversified, and aligned with their risk-return preferences.
5. (a) What are the basic assumptions of Capital Asset Pricing Model? How would you evaluate a security with the help of Capital Asset Pricing Model? 7+7=14
Ans:- The Capital Asset Pricing Model (CAPM) is a financial theory that describes the relationship between systematic risk and expected return for assets, particularly stocks. To evaluate a security using the CAPM, one must understand its basic assumptions and then apply the model to estimate its expected return.
Basic Assumptions of CAPM :
1. Efficient Markets : CAPM assumes that financial markets are efficient, meaning that security prices reflect all available information and that investors cannot consistently outperform the market through active trading or stock selection.
2. Single Period : CAPM focuses on a single-period analysis, where investors make investment decisions based on expected returns and risks over a specific period, typically one year.
3. Homogeneous Expectations : CAPM assumes that investors have homogeneous expectations regarding future returns, meaning they all use the same information and hold similar views about the prospects of different securities.
4. Perfectly Divisible Securities : CAPM assumes that investors can buy and sell securities in any quantity, without any transaction costs, and that securities are perfectly divisible, allowing investors to hold fractional shares.
5. Risk-Free Rate : CAPM assumes the existence of a risk-free rate of return, representing the return on an investment with zero risk, such as government bonds. Investors can borrow or lend at the risk-free rate, allowing them to adjust their portfolio's risk-return profile.
6. Linear Relationship : CAPM assumes a linear relationship between the expected return of a security and its systematic risk, as measured by its beta coefficient.
Evaluating a Security using CAPM :
To evaluate a security using the CAPM, follow these steps:
1. Estimate the Risk-Free Rate : Determine the risk-free rate, typically using the yield on government bonds with a maturity matching the investment horizon.
2. Calculate the Market Risk Premium : Calculate the market risk premium, which represents the excess return that investors expect from investing in the overall market compared to the risk-free rate. It is calculated as the expected market return minus the risk-free rate.
3. Estimate the Security's Beta : Calculate the beta coefficient of the security, which measures its sensitivity to systematic risk or market movements. Beta represents the slope of the security's regression line against the market portfolio.
4. Calculate the Expected Return : Use the CAPM formula to calculate the expected return of the security:
Rt – R = a + b (Rm – R)
Where, Rt = Portfolio Return
R = Risk less return
a = Intercept the graph that measures the forecasting ability of the portfolio manager.
b = Beta coefficient, a measure of systematic risk
Rm = Return of the market portfolio
5. Interpret the Result : Compare the calculated expected return with the security's actual return or with alternative investment opportunities. If the calculated expected return is higher than the security's actual return, the security may be undervalued, suggesting a potential buying opportunity. Conversely, if the calculated expected return is lower than the security's actual return, the security may be overvalued, indicating a potential selling opportunity.
By following these steps and applying the CAPM formula, investors can assess the expected return of a security based on its systematic risk and the prevailing market conditions, helping them make informed investment decisions and construct well-diversified portfolios.
Or
(b) What are the basic assumptions behind the Arbitrage Pricing Theory (APT)? Distinguish between Capital Asset Pricing Model and Arbitrage Pricing Theory. 7+7=14
Ans :- Basic Assumptions behind Arbitrage Pricing Theory (APT) :
Arbitrage Pricing Theory (APT) is an alternative asset pricing model developed by Stephen Ross in the 1970s. It is based on the idea that the expected return of an asset can be modeled as a linear function of several systematic risk factors. The basic assumptions behind APT include:
1. No Arbitrage Opportunities : APT assumes that there are no arbitrage opportunities available in the market. In other words, investors cannot consistently earn riskless profits by exploiting price differentials between assets.
2. Multiple Systematic Risk Factors : APT assumes that the returns of assets are influenced by multiple systematic risk factors or sources of risk, such as changes in interest rates, inflation, economic growth, and industry-specific factors.
3. Linear Relationship : APT assumes a linear relationship between the expected return of an asset and its exposure to systematic risk factors. The expected return of an asset is expressed as a linear combination of its sensitivity to each risk factor, weighted by the risk premium associated with that factor.
4. Factor Sensitivity : APT assumes that each asset's sensitivity to systematic risk factors, known as factor sensitivities or factor loadings, determines its expected return. Assets with higher sensitivities to risk factors are expected to have higher expected returns to compensate investors for bearing more risk.
Differences between Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) :
1. Underlying Theory :
- CAPM is based on the idea that the expected return of an asset is determined solely by its sensitivity to market risk, as measured by its beta coefficient. It assumes a single systematic risk factor, namely, the market portfolio.
- APT, on the other hand, allows for multiple systematic risk factors to influence asset returns. It does not rely on the market portfolio as the only source of risk but considers a broader set of factors affecting asset prices.
2. Number of Factors :
- CAPM considers only one systematic risk factor, the market portfolio's return. It assumes that all other sources of risk are diversifiable and therefore do not affect expected returns.
- APT allows for multiple systematic risk factors, which can include macroeconomic variables, industry-specific factors, and other sources of systematic risk. The number and nature of these factors are not specified by the theory but are determined empirically.
3. Assumptions :
- CAPM relies on strong assumptions, such as the existence of a risk-free rate, efficient markets, and homogeneous expectations among investors.
- APT relaxes some of the assumptions of CAPM, such as the requirement for a risk-free rate and the assumption of a single systematic risk factor. It allows for more flexibility in modeling asset returns based on empirically observable factors.
4. Ease of Application :
- CAPM is relatively simple to apply and interpret, as it provides a straightforward formula for estimating expected returns based on an asset's beta coefficient and the risk premium of the market portfolio.
- APT is more complex and requires identifying and estimating the relevant systematic risk factors affecting asset returns. It involves empirical testing and factor analysis to determine the appropriate set of factors and their risk premiums.
In summary, while both CAPM and APT are asset pricing models used to estimate expected returns, they differ in their underlying theories, assumptions, and approach to modeling systematic risk. CAPM focuses on a single systematic risk factor (market risk), while APT allows for multiple factors influencing asset returns, providing a more flexible framework for asset pricing.
6. (a) Define portfolio performance evaluation. Discuss Jensen’s Differential Return Model in detail. 4+10=14
Ans:- Portfolio Performance Evaluation : Portfolio performance evaluation refers to the process of assessing the performance of an investment portfolio relative to its stated objectives, benchmarks, or peer groups. It involves analyzing the returns generated by the portfolio over a specific period, considering factors such as risk, volatility, and investment style. Portfolio performance evaluation aims to provide insights into the effectiveness of portfolio management decisions, identify strengths and weaknesses, and inform future investment strategies. Common methods used for portfolio performance evaluation include benchmark comparison, risk-adjusted return analysis, and attribution analysis.
Jensen Model
Jensen's model proposes another risk adjusted performance measure. This measure was developed by Michael Jensen and is sometimes referred to as the Differential Return Method. This measure involves evaluation of the returns that the fund has generated vs. the returns actually expected out of the fund given the level of its systematic risk. The surplus between the two returns is called Alpha, which measures the performance of a fund compared with the actual returns over the period. Required return of a fund at a given level of risk (b) can be calculated as:
Rt – R = a + b (Rm – R)
Where, Rt = Portfolio Return
R = Risk less return
a = Intercept the graph that measures the forecasting ability of the portfolio manager.
b = Beta coefficient, a measure of systematic risk
Rm = Return of the market portfolio
Thus, Jensen’s equation involves two steps:
(i) First he calculates what the return of a given portfolio should be on the basis of b, Rm and R.
(ii) He compares the actual realised return of the portfolio with the calculated or predicted return. Greater the excess of realised return over the calculated return, better is the performance of the portfolio.
Limitation of this model is that it considers only systematic risk not the entire risk associated with the fund and an ordinary investor cannot mitigate unsystematic risk, as his knowledge of market is primitive.
Graphic representation of Jensen’s model is a given in the following figure:
The figure shows three lines showing negative, neutral and positive values. The negative line shows that the management of the performed portfolio is inferior. The positive line shows that superior quality of management of funds. The neutral value shows that the performance of the fund is similar to the performance of the market portfolio.
A comparison between the three models shows that the intercept of the line is Sharpe and Treynor models is always at the origin, whereas Jensen’s model it may be at the origin (a = 0), above the origin (a > 0) and even be below the origin indicating a negative value (a < 0). The risk adjusted measures have been criticized for using a market surrogate instead of the true market portfolio. These measures have been unable to statistically distinguish luck or change from skill except over very long period of time. Moreover, these models rely heavily on the validity of CAPM. If in estimating the measures the analyst assumes the wrong from of the CAPM in the market place, he will get based measure of performance, usually in favour of low risk portfolios.
Or
(b) (1) Discuss the components of performance as provided by E. Fama. 7
Ans:- Eugene Fama, a prominent economist and Nobel laureate, contributed significantly to the field of finance, particularly in the study of asset pricing and market efficiency. While Fama's work covers various aspects of finance, including efficient market hypothesis and asset pricing models, he also discussed the components of performance, particularly in the context of evaluating investment managers. Here are the key components of performance as provided by Eugene Fama:
1. Market Timing Ability :
- Market timing ability refers to an investment manager's skill in predicting market movements and adjusting portfolio allocations accordingly. Managers who possess market timing ability can anticipate changes in market conditions, such as bull and bear markets, and adjust their portfolio exposures to capitalize on opportunities or mitigate risks. Fama recognized that successful market timing could significantly impact portfolio performance.
2. Security Selection Ability :
- Security selection ability refers to an investment manager's skill in identifying mispriced or undervalued securities within a given market or asset class. Managers who excel in security selection can conduct thorough fundamental analysis, identify attractive investment opportunities, and build portfolios that outperform their benchmarks or peers. Fama emphasized the importance of security selection in generating alpha, or excess returns, for investors.
3. Costs and Fees :
- Fama highlighted the impact of costs and fees on investment performance. Transaction costs, management fees, and other expenses associated with portfolio management can erode investment returns over time. Therefore, Fama emphasized the importance of minimizing costs and fees to enhance portfolio performance. Investment managers who effectively manage costs and fees can deliver better net returns to their clients.
4. Passive versus Active Management :
- Fama discussed the debate between passive and active management in the context of portfolio performance. Passive management involves replicating the performance of a market index or benchmark through low-cost index funds or exchange-traded funds (ETFs). Active management, on the other hand, involves actively selecting securities and making portfolio decisions to outperform the market. Fama's research contributed to the understanding of the trade-offs between passive and active management and their implications for portfolio performance.
5. Risk Management :
- Fama recognized the importance of risk management in achieving long-term investment objectives. Effective risk management involves identifying, assessing, and mitigating risks that may impact portfolio performance. This includes diversification, asset allocation, and risk monitoring strategies aimed at managing volatility, downside risk, and other sources of portfolio risk. Fama emphasized that risk management should be an integral part of the investment process to achieve consistent and sustainable performance.
Overall, Eugene Fama's contributions to understanding the components of performance have helped shape modern portfolio management practices and investment strategies. By recognizing the importance of market timing ability, security selection, cost management, passive versus active management, and risk management, investors and investment managers can better evaluate and enhance portfolio performance over time.
(2) X gives the following information:
Calculate the return on portfolio A, B, C and D according to the Jensen’s Performance Index. 7
Sol. Calculation of Jensen’s Alpha for all portfolios A, B, C, and D using the formula:
α=RP−(Rf+β×(RM−Rf)
Assuming the expected market return ( RM ) is 10%
Portfolio A:
αA=15%−(5%+1.2×(10%−5%))
αA=15%−(5%+1.2×5%)
αA=15%−(5%+6%)
αA=15%−11%
αA=4%
Portfolio B:
αB=12%−(5%+0.8×(10%−5%))
αB=12%−(5%+0.8×5%)
αB=12%−(5%+4%)
αB=12%−9%
αB=3%
Portfolio C:
αC=15%−(5%+1.5×(10%−5%))
αC=15%−(5%+1.5×5%)
αC=15%−(5%+7.5%)
αC=15%−12.5%
αC=2.5%
Portfolio D:
αD=12%−(5%+1.0×(10%−5%))
αD=12%−(5%+1.0×5%)
αD=12%−(5%+5%)
αD=12%−10%
αD=2%
N.B:- These calculations are based on the assumption that the expected market return ( RM ) is 10%.
-00000-