Portfolio Management

1. Portfolio Management Parmeshwar Pant Head – Infrastructure & Project Financing Kumari Bank Limited parmeshwor@gmail.com; 9851067917

2. WHAT ? • Portfolio - an appropriate mix of or collection of investments held by an institution or a private individual. • Portfolio is a collection of investments assembled to meet one or more investment goals. • Portfolio Management - the art and science of making decisions about investment mix and policy, matching investments to objectives, asset allocation for individuals and institutions, and balancing risk vs. performance. • Dynamic – Static ??

3. WHY ? • Market is Constantly Evolving • Performance measurement • Improvement – learning loop • Discipline • Risk Diversification and control • Continuity;

4. PROCESS • Understanding investment objectives • Understanding Availability and Nature of funds • Developing an investment policy • Balancing risk and studying the portfolio performance from time to time • Taking decision on the investment strategy • Changing asset allocation from time to time-based on portfolio performance

5. OBJECTIVES • Better Capital Growth/Returns • Security of Principal Amount Invested • Inflation Hedge • Liquidity & Marketability • Risk Minimization • Consistent Returns • Regulatory Requirements

6. GLOBAL PORTFOLIOS • Financial Deposits • Fixed-income investments • Equity investments • Currencies & Commodities • Securitized Lending • Derivatives • Money Market Instruments • Overnight Money Market • Government Securities – T-Bills • Commercial Papers • Private/Venture Equity • Index Funds, Mutual Funds, Hedge Funds, ETF, REIT, and other kinds of funds • Real Asset and many more…

7. Investment Vs. Speculation • Identify investment opportunities and differentiate from speculative opportunities • Allocate your portfolio for both Investment and Speculation – Should be dynamic based on current market behavior or rather risk-return tradeoff • Market always changes, Greed and Fear • Construct Portfolio based on Fundamental and trade portfolio based on Technical indicators • Always be guided by Policy Objectives

8. HOW? • Identify available investment opportunities based on policy objectives • Fundamental Analysis on the available Investment opportunities • Analyze the various risk and impact on returns for • Market Risk • Interest Rate Risk • Other relevant Risks • Review the Portfolio performance regularly for dynamism and selection.

9. Contd…. • Long term price movements are determined by fundamentals; • Short term price movement are driven by changes in supply and demand, emotions, market sentiment, one off events etc; • Recommendation: • Select securities based on fundamental analysis, • Enter or exit the market based on technical indicators; • Diversify strategies: fundamental with technical overlay;

10. Asset Allocation • Strategic Asset Allocation (SAA) • The process that establish the weights of asset classes in total portfolio; • Conscious effort to gain exposure to the desired level of systematic risk; • Combining capital market expectations with the investors’ risk & return objectives and constraints • long term in nature • dynamic vs. static SAA • asset-only or asset liability management approach;

11. Asset Allocation – Contd… • Tactical Asset Allocation -TAA Form of active management, when the portfolio managers deviate from SAA in order to take advantage of any perceived short term opportunities in the market. • Deviation from SAA introduces the risk that portfolio could return less than the SAA portfolio (benchmark), so this risk should be rewarded by additional return (over the benchmark return) • How: Speculation, Trading, derivative overlay

12. Asset Selection • Security selection – SS • Deciding the structure of one asset class within the portfolio/ setting the so called “model portfolio” for each asset class / selecting form the investment universe the instruments/securities which will be included in the portfolio; Factors to consider • Liquidity; • Diversification vs. crowding effect; • Valuation; • Valuation (Simple to Complex) - Sources of research: brokerage houses vs. independent research vs. own research Valuation methods • Discounted cash flows (DCF) • Discounted dividend model (DDM); • Free cash flow to the firm (FCFF); • Free cash flow to the equity (FCFE;) • Peer comparison –based on price multiples • P/E; • P/B;

13. Optimization for portfolio • Asset class expected risk • Expected return • Weight Allowed deviations Equities 20%, 25%% ? +/- x% (Investing & Speculating) • Fixed income - 10%, 11% ? +/- y% • Money market - 3%, 8% ? +/- z% • TOTAL ? ? 100% • METHODOLOGY: • Inputs: Asset classes, Expected risk and return, Correlation matrix, Constraints (Short selling, nature of funds etc) • Process: Mean variance optimization; (alternatives: Black Litterman model, Monte Carlo simulation, etc;) • Output: Set of all possible portfolios (weights) with maximum return for any given risk level (or minimum risk for any given return level) = efficient frontier

14. Performance Measurement • Performance analysis • Performance measurement; • Performance attribution; • Definitions Absolute return vs. relative return • Inflation Adjusted Return • Alpha – the portfolio return in excess of the benchmark return, • Sources of alpha: • Tactical asset allocation; • Investment selection; • Market timing – trading;

15. Example • Strategic Asset Allocation – 100% Equities • Tactical Asset Allocation – 85% Equities & 15% Cash • Benchmark Return – 20% • Cash Return – 0% • Equity Investment Return – 35% • Portfolio Return – 85% X 35% + 15% X 0% = 29.75% • Alpha – 29.75% - 20% = 9.75% • Inflation – 15% • Inflation Adjusted Return – 29.75%-15% = 14.25%

16. Rebalancing • Constant mix strategy - Why? • Divergent price movements; • Cash inflows or outflows; • Changes in asset allocation (SAA or TAA) • Changes in stock selection; • To maintain the desired risk exposure to systematic risk factors; • How? • Calendar rebalancing; • Percentage of portfolio rebalancing;

17. Contd… • Some investments can be very successful. • £10,000 invested in September 2001 in Lastminute.com would have been worth £134,143 in August 2003 • $10,000 invested in August 1998 in Cephalon would have been worth $107,096 in September 2003 (and $180,000 in 2007) • Losses in value can be even more spectacular • $10,000 invested in September 2000 in Palm Inc. would have been reduced to $91 by April 2003 • A holding in July 2000 of £15 million in Exeter Equity Growth Fund would have been worth £72,463 in August 2003 (the share price fell from 103.50 to 0.50)

18. Contd… • The essentially feature of asset prices is unpredictable variability • Even when averaged into an index this variability is apparent • Portfolio management is about coping with the variability • Investment analysis is about underlying longer-term trends

19. RISK RETURN TRADE-OFF • High Correlation • Define your appetite for Risk • Quantifiable to the extent possible – Calculative Risk Taking • Diversification of Risk MEASURES: • Standard Deviations, Covariance, Beta, Regression Forecasting, VAR, Monte Carlo Simulations,

20. Risk Return Trade-Off • The greater the risk of a security, the higher is expected return • Return is the compensation that has to be paid to induce investors to accept risk • Success in investing is about balancing risk and return to achieve an optimal combination • The risk always remains because of unpredictable variability in the returns on assets • Risk of estimation/projection being wrong always persists

21. Risks • The risk inherent in holding a asset is the variability, or the uncertainty, of its return • Factors that affect risk are • Maturity - Underlying factors have more chance to change over a longer horizon • Maturity value of the security may be eroded by inflation or currency fluctuations • Increased chance of the issuer defaulting the longer is the time horizon • Market fundamentals keeps on changing which affects asset value and returns • In times of volatility actual risks are overstated – Overplay of Fear and Greed • Creditworthiness • Priority • Liquidity • Economic cycle • Business Cycle • Technology

22. Components of Risk • Diversifiable (Unsystematic) Risk – Results from uncontrollable or random events that are firm-specific – Can be eliminated through diversification – Examples: labor strikes, lawsuits. • Non-diversifiable (Systematic) Risk – Attributable to forces that affect all similar investments – Cannot be eliminated through diversification – Examples: war, inflation, political events.

23. Snapshot - PM 1. Set investment policy a. Objectives b. Amount c. Choice of assets 2. Conduct security analysis a. Examine securities (identify those which are mispriced?) b. Use ● Technical analysis – the examination of past prices for trends ● Fundamental analysis – true value based on future expected returns 3. Portfolio Construction a. Identify assets b. Choose extent of diversification 4. Portfolio Evaluation a. Assess the performance of portfolio 5. Portfolio Revision

24. FI’s portfolio management • Management of Assets and Liabilities • Assets – Investment, Loans & Advances • Liabilities – Deposits and Borrowings Guidance: • Cost & Returns • Liquidity & Volatility • Duration (Maturities of Portfolio) • Sector-al Limits (Security Based, Exposure Based) • Geo-graphical Limits • Regulatory Requirements (Sector Specific, Obligor, SLR, CRR, NLA) • Diversification of Risks (Market Risk, Interest Rate Risk, Liquidity Risk, Credit Risk, other Risks)

25. Combined Efforts of ALCO and CRM • Formulating Policy Documents: • Deposit Management Policy • Investment & Liquidity Management Policy • Credit Policy • Contingency Action Policy • Policy document states and defines bank’s policies, rules and philosophy for exposures for better risk management and quality. • Principle and rationale considered while formulating policy is to protect the interest of its stakeholders Aggregating limits by Customer, Sector and correlated credits – SOL - Concentration risk, Products, Nature of Security

26. Thumb Rule D O N O T P U T A L L Y O U R E G G S I N O N E B A S K E T

27. Discussion • EPF Context…. • Case Study – Understanding Company’s Growth Potential and Estimating Future Earnings Potential

28. EXAMPLE:Stock Investment Portfolioguided by capital asset pricing model (CAPM)

29. Number of units of systematic risk (b) Market Risk Premium or the price per unit risk The CAPM Formalized or,

30. Example: STOCK INVESTMENTBeta: A Popular Measure of Risk • A measure of un-diversifiable risk • Indicates how the price of a security responds to market forces • Compares historical return of an investment to the market return • The beta for the market is 1.0 • Assets may have positive or negative betas. Nearly all are positive. • Assets with betas greater than 1.0 are more risky than the overall market. • Assets with betas less than 1.0 are less risky than the overall market.

31. Interpreting Beta • Higher stock betas should result in higher expected returns due to greater risk • If the market is expected to increase 10%, a Asset with a beta of 1.50 is expected to increase 15%. • If the market went down 8%, then a Asset with a beta of 0.50 should only decrease by about 4% • Beta values for specific stocks can be obtained from various Merchant Banks or even market research institutions or can also be constructed using software's like Excel, SPSS etc.

32. Using the CAPM to derive a required Rate • Three inputs are required: (i) An estimate of the risk free interest rate. • The current yield on short term treasury bills is one proxy. • Practitioners tend to favor the current yield on longer-term treasury bonds. • Remember to adjust the market risk premium accordingly. (ii) An estimate of the market risk premium, E(Rm) - Rf. • Expectations are not observable. • Generally use a historically estimated value. (iii) An estimate of beta. Is the project or a surrogate for it traded in financial markets? If so, gather data and run an OLS regression. If not, you enter a very fuzzy area.

33. Valuation • Suppose you are considering investing in a new project in the same industry of Boatful Corp. • The market rate of return is 15%, and the risk-free rate is 5%. • The beta of Boatful's stock is 1.3 against market. • The capital structure of Boatful: 80% of equity, 20% of bond. • Compute the beta of Boatful's operations

34. Contd – Required Return • Beta of New Project would be same as the Beta o Boatful’s corp. • Applying the CAPM Required Return would be for the proposed investment. REQUIRED RETURN

35. Value of Stock • Financial Projection shows that the company has an expected dividend of NPR 6 next year, and that it will grow annually at a rate of 4% for ever, the value of a share is (Using Dividend Discount Model)

36. Asset pricing • Future cash flows of the asset can be discounted using the expected return calculated from CAPM to establish the price of the asset. • If observed price > CAPM valuation  overvalued (paying too much for that amount of risk) • If observed price < CAPM valuation  undervalued • Choose the best stocks based on overvalued or undervalued technique to build a stock portfolio accordingly, remember to diversify.

37. Fundamental Strategies • Top-Down versus Bottom-Up Approaches • Top-Down • Broad country and asset class allocations • Sector allocation decisions • Individual securities selection • Bottom-Up • Emphasizes the selection of securities without any initial market or sector analysis • Form a portfolio of equities that can be purchased at a substantial discount to what his or her valuation model indicates they are worth

38. Fundamental Strategies • Three Generic Themes • Time the equity market by shifting funds into and out of stocks, bonds, and T-bills depending on broad market forecasts • Shift funds among different equity sectors and industries (e.g., financial stocks, technology stocks) or among investment styles (e.g., value, growth large capitalization, small capitalization). This is basically the sector rotation strategy • Do stock picking and look at individual issues in an attempt to find undervalued stocks

39. Fundamental Strategies: • The 130/30 Strategy • Long positions up to 130% of the portfolio’s original capital and short positions up to 30% • Use of the short positions creates the leverage needed, increasing both risk and expected returns compared to the fund’s benchmark • Enable managers to make full use of their fundamental research to buy stocks they identify as undervalued as well as short those that are overvalued

40. Technical Strategies • Contrarian Investment Strategy • The belief that the best time to buy (sell) a stock is when the majority of other investors are the most bearish (bullish) about it • The overreaction hypothesis • Price Momentum Strategy • Focus on the trend of past prices alone and makes purchase and sale decisions accordingly • Assume that recent trends in past prices will continue • Elliot Wave, Fibonacci

41. Determining the Expected Rate of Return for a Risky Asset Assume: RFR = 6% (0.06) RM = 12% (0.12) Implied market risk premium = 6% (0.06) E(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2% E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0% E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9% E(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4% E(RE) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%

42. Price, Dividend, and Rate of Return Estimates

43. Comparison of Required Rate of Return to Estimated Rate of Return

44. Practice Problem #1 • A particular asset has a beta of 1.2 and an expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, the stock is: A. appropriately priced B. underpriced C. overpriced

45. Practice Problem #2 Last year… • Firm A: return: 10%, beta: 0.8 • Firm B: return: 11%, beta: 1.0 • Firm C: return: 12%, beta: 1.2 • Given that the risk-free rate was 3% and market return was 11%, which firm had the best performance?

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