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PORTFOLIO MANAGEMENT THEORY Question 1 Econometric approach is one of the most formal short-term forecasting approaches. This approach tries to describe the present economic condition as a function of certain policies and variables and the economic relationship attached to these variables. Explain the advantages and problems of using econometric models Answer 1 Advantages of using econometric Models Following are the main advantages of using models: Testing of hypothesis and idea of an economic indicator. Examples: Test to know how low interest rates stimulate growth and whether wages can be used as a predictor of inflation. Estimating sensitivities. Example: Would one percentage point rise in the US Consumer Price Index typically translate into I a-year bond yield? Developing internally consistent forecasts. Example: When researchers are using a judgmental approach, they may fail to see that something they are implying about income growth does not jibe with their assumption on employment growth. Running simulation of complex scenario. Example: A government economist may need to find out what happens if interest rates and government spending are both cut. Problems in the Use of Models The main problem in using the models is the lack of consistency of the data. Investment professionals should be aware of this before any decision is taken based on these models. Other problems that arise in these models are: Implausible Result: A number of variables used to isolate one may cause an implausible result. If any of the variables among them is working then the prediction might be quite unreliable. Statistical VS. Real World: The other problem is the difference in the statistical result and the result in the real world. Error in the Underlying Data: Past data used may be good predictors of some variable but in certain cases where variables are subject to huge revision they create problems when using models. Assumption: Assumption is the most vital problem in using models. It is not possible to predict every variable, so every model has some assumptions. So it is suggested to be careful while using assumptions. Structural Changes: Most of the models assume that past relationships have some, validity in predicting future relationships but this prediction may not be significant where fundamental structure changes due to rapidly changing economies. Simultaneity: Simultaneity is the term used to measure the influence of one variable on another when that second variable also influences the first one. These occurrences can create confusion in using statistical models.

Time Series Data: The time series data i.e., the data that frequently changes due to some economic factors like population growth, GDP growth sometimes- have a number of problems. These data may violate some assumptions due to their, trend properties. Question 2 Arbitrage pricing theory has wide applications in corporate finance and investment management. Explain how it can be used for active and passive strategies. Answer 2 APT and Active Management i. One of the important uses of multi-index model in active management of portfolios is making factor bets. If ones expectations are against the market expectations with respect to some factor, one can take a position so as to benefit by ones expectations. Suppose inflation expected by the market is 6 percent but you believe it to be 8 percent. By increasing your exposure to stocks/portfolios whose returns are positively related with inflation. One can increase your returns. By increasing the number of factors in the model, betting opportunities can be increased. ii. Another application of APT is in identifying mispriced securities. This is similar to the CAPM model. APT is used to estimate the required return on a stock based on the various return generating factors and sensitivity of the security to these factors. Along with the required rate of return, expected return on the stock is also estimated. If the required return is greater than the expected return, the security is overpriced and one can go short on the stock. On the other hand, if the required return is less than the expected return the security is underpriced and one can go long on this stock. This way APT can be used to identify the mispriced securities and adopt a suitable strategy. The advantage of APT over CAPM is that the required return can be more accurately estimated with the APT model. This is because, two securities having same sensitivity to the market index (beta) might have different sensitivities to other factors, which are important in determining the equilibrium return. iii. Finally, multi-index model can be used in long-short investment strategy or risk neutral investment strategy. This is nothing but the arbitrage mechanism illustrated above. If you are able to correctly identify underpriced and overpriced assets using the APT you can construct zero risk, zero investment portfolios with a positive net return. APT and Passive Management i. Index fund is a widely used strategy of passive management of a portfolio. Under this strategy, a portfolio of stocks is created such that performance of this portfolio closely reflects the performance of the underlying index. Such a portfolio can be created using the single-index model by finding a portfolio that has a beta of one with the index and that has minimum residual variance (risk) for a given portfolio size. Using a multi-index model rather than a single index model in construction of the index portfolio can help in better tracking the performance of the index. This is because there can be more than one source of return generation. By using multi-index model the portfolio can be matched with the index in terms of all important sources of return movements. That is, the correlation between the returns on the portfolio and the index can be improved, thereby capturing the performance of the index through our portfolio. If the source of return is only one factor, market factor, then multi-index model is to

better than the single index model. But it is safe to assume that returns are generated by more than one factor. ii. Another application where APT comes handy is construction of index-portfolios where some of the stocks in the index are deliberately kept out. Suppose, as a matter of policy a fund manager would like to avoid exposure to some sectors. If single index is used to construct the portfolio, sensitivity of the portfolio to other important factors may be missed and multi-index model can improve tracking an index. Same is the case when a fund manager, as a matter of policy, must include certain stocks in the portfolio. iii. Some times it may be desired by the fund manager to track the performance of the index and take position with respect to some additional risks, which are not captured in the index. This objective can be achieved only through a multi-index model. Take the case of a pension fund whose cash outflows are indexed to inflation. If inflation increases, cash outflow also increases. Manager of such a fund would like to have cash flows positively related to inflation. He might wish to hold a portfolio that has a zero or preferably positive sensitivity to inflation. He could form a portfolio that has more or less same response to all the factors affecting the index except the inflation and had a minimal residual risk. Question 3 The investor wants the asymmetric protection of his portfolio, so that its value will be guaranteed not to fall under a floor value when the market goes down while it will be free to appreciate when the market goes up. This approach of portfolio protection is portfolio insurance. Static portfolio insurance is a type of portfolio insurance. Discuss the practical problems with static portfolio insurance.

Answer 3 Practical Problems with Static Portfolio Insurance: Static portfolio insurance suffers from a series of major problems: The maximum maturity quoted is often much shorter than the desired horizon for the protection and is also rarely liquid enough. Suppose, there is no liquidity on the desired option beyond 6 months. After each 6-month period, a roll over can be effected but this practice is costly. The effective cost of the protection is only known when the last premium is paid and it depends largely on the moves of the underlying asset until maturity of the protection (this is called a path dependent insurance and this property is clearly undesirable); Sometimes only American options are available. American options can be more expensive than the European ones, but the investor cares only about the value of his/her portfolio at expiration and would be happier with European options; Options on the exchanges are standardized: only a few exercise prices and maturities are used. Moreover, the underlying asset used for the options may differ from the portfolio to be insured; Liquidity on the desired options may fall short; Option on the underlying asset may not exist. In Switzerland, for example, listed puts do not exist for all securities; In the case of a portfolio, the total risk is not the sum of the individual risks and it would be expensive and unnecessary to purchase puts for each individual risk; what is needed is in fact a put for the whole portfolio. For these reasons, other insurance strategies have been developed in a dynamic (rather than static) framework.

Question 4 Asset allocation should be dynamic and at the same time it should be integrated. Depending on the process of asset allocation, there can be various approaches of asset allocation. Discuss the popular approaches of asset allocation. Answer 4 The following are popular approaches of asset allocations: Popular Approach In the words of a layman, asset allocation can be looked at as a decision on how to divide the income between current spending and investment, and how to distribute the investment among the various possible avenues to attain the targeted goals. The methods in this approach generally try to capture a part of the wisdom that professionals get through years of study and practice into some rules of thumb. 100 Minus Your Age Method According to this method, the percentage of your total investment that can be invested in equities depends on your age and is based on the premise that you will live to be 100 years old. The method suggests that the proportion of investment to be placed in equities is 100 minus your age. The rest may be placed in bonds and other safe investments. Your Age 100 Minus Your Age % Investment in Equities % Investment in Bonds 30 70 70 30 40 60 60 40 50 50 50 50 60 40 40 60 Though life expectancy is increasing, the probability of a person living beyond 100 is still low. As the age increase, the ability to take risk normally declines. This method essentially addresses this issue. The person who uses this method reduces his allocation to equities as he/she grows old. This method, while based on the general perceptions about the desirable exposure to equities over the life of a person, suffers from some obvious defects. It does not take into account the life expectancy of a person, the factor of inflation, the wealth to be accumulated or the current financial needs. Over the years, this method results in increase in the current income and decrease in growth, which can be harmful for the financial condition of the person considering inflation and increasingly long life expectancies. Financial Objectives Method This method is based more on common sense than anything else. It simply says, plan your financial needs in future and invest enough money so that you will be able to realize them. It does not talk anything about how and where and when to invest. If your goals are short-term, invest in short-term liquid investments and if they are long term go for long-term investments. All that you have to know is what you want to achieve and how much you can save today for that. Cash Flow Needs Method This Method, as the name suggests, involves projecting the cash flows of the future and estimating the deficit if any. Investments will then be aimed at filling the deficit. The sources of income that a person may have, for example, may be wages and salary, pension payments, interest and dividend income on investments already made, rental income from properties, sale

proceeds of properties, inheritance of property, sale of used vehicle, etc. The outflows expected in future should then be reduced from the inflows. If there is a surplus, then you may go for conservative or safe investments. In case three is a deficit, investments will have to be made aggressive and the degree of aggressiveness depends on the amount of deficit and the amount now available for . Risk Tolerance Method This method ignores the financials and focuses on the psychology of the individual. According to this method, a risk-averse person should invest all or most of the money available in low risk investments and a risk-lover may invest in high risk instruments. 100% Common Stocks for Long Run This strategy involves placing all the long-term investments entirely in equity stocks. This method generally gets into popularity when stock markets are on a high and falls in popularity along with the markets. There is no other basis, scientific or otherwise, for it. Question 5 The portfolio manager needs to be alert and sensitive to the changes in the requirements of the client. In this regard, discuss the important factors affecting the client that make it necessary to change the portfolio composition. (need for portfolio revision) Answer 5 CHANGE IN WEALTH According to the utility theory, the risk taking ability of the investor increases with increase in wealth. It says that people can afford to take more risk as they grow rich and benefit from its rewards. But, in practice, while they can afford, they may not be willing. As people get rich, they become more concerned about losing the newly acquired riches than getting richer. So, they may become conservative and more risk-averse. The fund manager should observe the changes in the attitude of the investor towards risk and try to understand them in a proper perspective. If the investor turns to be conservative after making huge gains, the portfolio manager should modify the portfolio accordingly. CHANGE IN THE TIME HORIZON As time passes, some events may take place that may have an impact on the time horizon of the investor. Births, deaths, marriages and divorces - all have their own impact on the investment horizon. There are, of course, many other important events in a person's life that may force a change in the investment horizon. The happening or non happening of the events will naturally have its effect. For example, a person may have planned for an early retirement,-considering his delicate health. But, after turning 55 years of age, if his health improves, he may not take retirement. He may extend the investment horizon, as he does not need annuities until he retires. CHANGES IN LIQUIDITY NEEDS Investors very often ask the portfolio manager to keep enough scope in the portfolio to get some cash as and when they want. This forces the portfolio manager to increase the weight of liquid investments in the asset mix. Due to this, the amount available for investment in fixed income and/or growth securities that actually help in achieving the goal of the investor, gets reduced. That is, the money taken out today from the portfolio means that the

amount and the return that would have been earned on it are no longer available to achieve the investor's goal. CHANGES IN TAXES It is said that there are only two things certain in this world - death and taxes. The only uncertainties regarding them relate to thedate, time, place and mode. With taxes you have the additional aspect of the amount or rate. So, portfolio managers have to constantly look out for changes in the tax structure and make suitable changes in the portfolio composition. The rate of tax under long-term capital gains is usually lower than the rate applicable to income. If there is a change in the minimum holding period for long-term capital gains, it may lead to revision. The specifics of tax planning depend on the nature of income of the investor, and the nature of other investments. BULL AND THE BEAR MARKETS The fluctuations in the stock markets often provide opportunities for the investors in both positive as well as negative aspects. Say, when everything is going well, the markets also perform well, but during downtrends in the economies, the stock prices fall. Let us consider the period one where stock return is more than bond in contrast to the period two where the bond has better return than the stock. This provides the opportunity to buy stock at period one and sell the stock in period two to shift to the bond market. The above facts also apply to individual securities. It remains at the hands of the investors to protect themselves against discomforts that arise in the markets. This is possible only when the investors have proper knowledge and discipline in the investment process. The disciplined investment decisions provide value by providing the objective basis to confidently pursue uncomfortable investments. THE CENTRAL BANK POLICY It is to be always kept in mind that the central bank and the other banks enjoy a greater power in influencing liquidity in the capital markets. The stock market's demand for funds arises basically out of the money supply' growth and the underlying policy that determines it. The monetary and liquidity constraints finally influence a toll on the stock markets. Further, the monetary policy 'also has an immediate effect on the money markets, though it has less effect on long-term bond yields. INFLATION RATE CHANGES Inflation has its unique way of affecting the stock markets. As per the studies of Fama, unexpected changes in the rate of inflation may have its effect on pricing of stocks in either direction. When the inflation rate increases beyond expectations, the bond investors face a reduced real yield on the bonds. The nominal yield then rises so as to counteract the loss, and the bond prices fall. The unexpected changes in the inflation rate are also significant to the stock market returns. It is to be noted here, that the simple measures of inflation, such as Consumer Price Index (CPI), are not that reliable predictors of future returns on stocks and bonds. Alternatively the rates of changes in producer prices, which actually result in CPI inflation provides a better measure, and signals for future returns.

CHANGING RETURN PROSPECTS It is assumed that other things being equal, the changes in prices accompany changes in the return prospects. With each negative fluctuation in the bond's price, its yield rises but its total

return falls. For the equities, as price changes take place regularly, so do the return prospects. These changes eventually lead to the adjustments in the investor's portfolio. Bonds are both the most quantifiable as well as the least quantifiable of asset classes, for bonds which are downgraded by raters provide a better return prospect. A simple measure such as the slope of the bond market yield curve serves as an indicator of bond performance relative to cash equivalents. THE TRANSACTION COST BARRIER For all good reasons, transaction costs provide a jolt to the portfolio managers. These costs can never be recovered and their cumulative erosion value can at times be harmful. The very task of portfolio revision does not come free. Apart from the negative effect from the fees earned by brokers, the traders themselves can influence the security prices. The portfolio manager is expected to understand the trading costs and then to control or avoid them. It is to be mentioned here that transaction costs consist of morethan just commissions. Market changes are observed, before and after the trade and even during the day. This may be another inadequate measure. The actual cost of transacting is the difference between the realized price and the price that must have existed in the absence of the order. Added to these, there can be trades that one seeks to carryout, but fails to execute, which provides another tariff, an opportunity cost. Several research studies have tried to find the true transaction cost. But they could not realize their goals, because traders possess many skills and devising ways to win whatever game the portfolio managers try to impose on them. Trading costs are of the nature of an iceberg. The commissions rise above the surface, visible to the man. The part below the water reflects market impact of trades and those costs of the traders that were never incurred. TRANSACTION MANAGEMENT The modern portfolio theory aided with affordable computing power and new investment vehicles provides encouraging facts ontrading costs. It tries to argue with the fact that trading costs are difficult to overcome. These innovations in finance made the program trade a credible alternative to traditional trade executions. If anyone trades without any basis, with the broker initiating a transaction without having seen the actual list of securities being traded, then the broker's bid may be overstating the actual value of the trade cost. Thus, a broker would be able to make some profits also. TRADING'S POSITIVE SIDE It is worthwhile to mention here that the traders provide liquidity to the markets, which is one of the prominent features of capital markets. Further, the commissions indirectly help in funding investment research, which adds to the efficiency that makes investment management a rewarding occupation. Added to this, rebalancing is a necessary aspect of portfolio management, so it should be done on a cost effective basis. Question 6 Discuss the factors considered in Risk Attribute Model developed by Solomon Brothers. Answer 6 In the RAM model of Solomon Brothers, the following six macroeconomic factors are used: Economic growth: The monthly change in industrial production is used, which is measured concurrently with stock returns.

Business cycle: The factor representing the stage of the business cycle is taken as the difference between the yield on top rated corporate bonds of a 20-year maturity and the 20-year Treasury bonds. The spread between the two falls during economic booms and rises during economic recessions. Long-term interest rates: The change in the ten-year Treasury yields is taken. This represents the change in relative attractiveness of the financial assets and may cause investors to change the portfolio mix. Short-term interest rates: The change in the 1-month Treasury bill rate is taken. Inflation shock: The difference between the expected inflation and the actual inflation is taken. The expected inflation is estimated based on another model developed by the proponents of this model. Value of the currency: The change in value of the domestic currency is taken, as measured by a trade-weighted basket of currencies. Apart from these six main factors, there is another factor considered. It is a residual factor, called `residual market beta by the proponents of this model. The factor is intended to capture the other macroeconomic factors remaining after considering the above six. Identification of the factors The first step for estimating the parameters for the RAM model of Solomon Brothers is to run multiple regression for each stock of the universe being considered. The dependent variable for the regression is the stock return and the independent variables are the above six factors, the residual market beta and other market factors. The statistical significance of each of the factors is studied. Then, for all the stocks in the universe being considered, the factors are standardized. Standardization involves finding the average and the standard deviation of each of the factors, then calculating the difference between the values of the factors obtained from the regression and the average, and finally dividing the difference with the standard deviation. From the standardized values thus obtained, value lesser than 5 and greater than +5 are rejected. This results in values that are too wide away from the mean being rejected. The standardized multiple regression coefficient of a stock is then taken as the sensitivity of that stock to that macroeconomic factor. If the value of the regression coefficient of a stock for one of the factors is zero, it means that the stock has average sensitivity to that factor. Deviations from zero indicate higher sensitivity to that factor. For example, let us say that a stock has a positive value for change in the value of the domestic currency. It means that, all other things remaining constant, the stock will provide better returns than the market if the value of the domestic currency increases. Similarly, a negative value indicates that, all other things remaining the same, the stock will under perform the market. Question 7 Asset allocation is one of the crucial steps in the process of portfolio building. Discuss the different types of asset allocation. Answer 7 The process of asset allocation described above is referred to as integrated asset allocation. The name is justified, considering that all the major aspects of asset allocation have been included in the analysis, in a systematic manner. If you recall the process explained once again, you will realize that the process involves not only integrating all the aspects, but also review of the

allocation. Thus, the process is dynamic as well as integrated. Sometimes it may be desirable to skip some of the steps in the allocation process. Depending on the steps that are skipped, asset allocation can be of three types strategic asset allocation, tactical asset allocation and insured asset allocation. Strategic Asset Allocation Strategic asset allocation is also referred to as long run asset allocation or policy asset allocation. Strategic asset allocation is generally undertaken periodically. In this type of asset allocation, relatively few and broad categories of assets are considered. For example, one may consider the mix of stocks and bonds in various proportions starting from say, 10% in bonds and 90% in stocks to 10% in stocks and 90% in bonds. Using these proportions, the likely range of outcomes from the investment are estimated. The asset mix thus chosen by the investor is taken as the long run or the policy asset mix. Generally, the asset mix is held constant. Such a strategy is referred to as constant asset mix strategy. This should not be confused with a buy-and-hold strategy. In a constant mix strategy, transactions are necessary to ensure that the mix remains constant. In strategic asset allocation, long run predictions regarding the capital markets are used. These are assumed to be constant during the period of analysis (planning horizon). Thus, in the asset allocation process, we no longer have the step relating to prediction of future on an ongoing basis as, once predicted, the conditions are taken to be constant. Similarly, the risk tolerance of the investor is also assumed to remain constant during this period. Tactical Asset Allocation Tactical asset allocation is performed routinely, as part of active asset management. It is aimed at benefitting from short run underpricing and overpricing of assets. Tactical asset allocation may involve switching funds between equities, bonds and cash. Within equities and bonds, investments may also be switched from one category of equities to another and one category of bonds to another. In this type of asset allocation, it is assumed that the risk tolerance of the investor is constant. Tactical asset allocation decisions are often contrarian. They are made with a view to benefit from a steep fall or rise in the market. The basic assumption in this type of asset allocation is that markets overreact to information. Implicit in this is the belief of the investors that make tactical allocation that their predictions regarding the movements of the market are not only different from the other investors, but are also superior. In tactical asset allocation, as already explained, changes in the risk tolerance of the investor are ignored. But, it does not mean that the risk characteristics of the investments are also ignored. They are not. Insured Asset Allocation Insured asset allocation is aimed at achieving the objectives of the investor without depending on market timing, unlike tactical asset allocation. Insured asset allocation is very similar to tactical asset allocation in that it is applied routinely as part of active asset management. This type of asset allocation is based on the assumption that the risk tolerance of the investors is highly sensitive to the changes in their net worth. A minimum value of the net worth or asset value (as the case may be, based on the goal), is called the floor. If the value of the assets or net worth crosses the floor, the allocation to risky assets is increased. Above the floor, higher the value, higher the allocation to risky assets. Similarly, lower the value, lower the allocation to risky assets. That is, the asset mix is made conservative. At any rate, it is ensured that the floor value is achieved. This type of asset allocation does not, as can now be seen, focus on the desirability of investing in more risky assets based on their risk-return characteristics. It is based on the implicit assumption that risk-return characteristics of the asset classes remain constant.

Question 8 If one wants to save to build capital for his or her retirement, he/she might want to limit his/her analysis to long-term bond funds in the hope of earning the relatively higher returns from such investment. Explain the factors that an investor should keep in mind while selecting a bond fund. Answer 8 Management And Performance Good management is certainly crucial for stock funds, but some people do not think so. Good bond managers can produce incrementally superior results and will keep their funds at the top of the pack. Thus, it is important to know who the manager is, how long that individual has been at the helm, and what philosophy he or she follows. The past performance can be evaluated in terms of variation of returns, which can be measured by standard deviation. By studying the past volatility of a portfolio's total returns one can gain a pretty good feel for its likely future course. Standard deviations can be used to make comparisons with other bond portfolios. Fund Costs They are especially important for bond fund investors because fixed-income portfolios generally produce lower long run returns than stock products. The information on fund costs can be obtained from the quarterly or annual reports of the fund. Compare the fees and expenses of several funds having same investment philosophy, examine the portfolio's expense ratio over the past several years and choose that fu_d having the least cost. Portfolio Turnover As with stock funds, higher turnover translates into increased transaction costs, which are shouldered by fund investors. In the case of treasury and high-grade corporate bond products, transaction expenses will tend to be relatively low, even with an actively traded portfolio. But, if the fund holds positions in lower quality debt, high turnover can be a problem. Fund Size Generally, it is believed that bigger bond funds are better because they benefit from economies of scale and should have lower expense ratios. In addition, their managers may be able to make better deals since they trade in larger block of funds. This analysis makes sense for highly quality fixed-income portfolios. But smaller or medium sized fund may be suitable when investing in less liquid junkbond securities. The reason being that these portfolios may be able to maneuver more easily. They could take meaningful positions in smaller junk issues without having to worry about affecting prices as such. Bond Fund Yields A funds yield or, more precisely its net income distribution rate is similar to the current yield on a stock or bond. It is based on the interest on interest or dividends paid, expressed as a percent of the net asset value. Capital gains are not included, since they are fare more irregular and unpredictable than income. One can get a good feel for the past range of a funds yield by looking at several years worth of information. Since the yields show the kind of return one can expect, it is most important to people looking for a monthly cash flow. These individuals should remember that a mutual funds yield fluctuat. PORTFOLIO CHARACTERISTICS Portfolio Composition

Every prospectus mentions the investment objective and the type of securities that will form the portfolio composition of a particular fund. Investors should ensure that the target bond portfolio is being run in accordance with its investment policy, as outlined in the prospectus. To do this, examine the funds holdings as listed in the annual and quarterly reports. The portfolio composition should be looked in general terms, without trying to analyze each issues investment potential. Quality Rating Besides the portfolio composition, one should also look at the quality of securities constituting a portfolio of the fund. The quality can be determined by looking at the credit rating of individual securities and especially those forming the bulk of the portfolio. In India, credit rating is generally done by CARE, ICRA and CRISIL. The credit rating of the securities should not be less than A. Since each drop in quality entails a commensurate increase in yield, gaining extra yield is relatively easy, but only by assuming higher credit risk. Many bond funds are reaching out for yield, in part to offset their higher expenses. However, when fund expenses and any sales charges are taken into account, purchasing the lower quality portfolio does not always translate into higher income to the investor. Average Maturity This is an important indicator of volatility. Funds with the longest maturities have the greatest interest rate risk. They will fall the farthest if rates move upward. Investors should be careful of long maturities during periods of low interest rates. While investigating maturities, it should be found out if the manager hedges with futures or options. This can help lessen the funds exposure to interest rate risk. Thus, if an investor expects the interest rate to move upwards, he/ she should go for that bond fund whose portfolio consists of securities of short maturities. The situation will reverse if the investor expects the interest rate to move downwards. Question 9 Risk-adjusted performance measures are always criticized for their inability to analyze properly the performance of portfolios. Discuss briefly some important criticism leveled against these measures. Answer 9 Risk-Adjusted Performance Measures: Some Issues Let us conclude our discussion on performance measures with a discussion on the criticism leveled against the use ofthese measures. Use of Market Surrogate All measures other than Sharpes measure require the identification ofa market portfolio. Empirical studies conducted in the US market have also revealed that when commonly used NYSE based surrogates are involved suchas the Dow-Jones Industrial Average, the S&P 500 or any index comparable to the NYSE composite, the performance ranking of the common (equity) stock portfolios are quite different. Hence the performance is highly dependent on theselection of

market portfolio. Limitation in Using Market Index as a Benchmark Portfolio It has been argued that a market index should not be used as a benchmark portfolio because it is nearly impossible foran investor to construct a portfolio whose returns replicate these on the index. This is because of the transaction costsinvolved in initially forming the portfolio, in restructuring the portfolio when stocks are replaced in the index; and inpurchasing more shares of the stocks comprising the index when the cash dividends are received. Hence, the return on the index overstate the returns of that a passive investor can earn. Skill or Luck Obviously, an investor would like to know whether an apparently successful investment manager was skilled or justlucky. Unfortunately a very long time interval is needed to distinguish skill from luck on the part of the investmentmanager. Validity of CAPM The measure of portfolio performance (Jensens measure and Treynors measure) are based on the CAPM, which maynot be the correct asset pricing model. Put differently, if assets are priced according to some other model, say the APTmodel, use of the beta based performance measure will be inappropriate. It must be noted that the Sharpes measure(reward-to-variability ratio) is immune to this criticism because it uses standard deviation as a measure of risk anddoes not rely on the validity or on the identification of a market portfolio. Question 10 One of the important steps in portfolio management process is to evaluate the performance of portfolios during the time horizon concerned. Performance evaluation of a portfolio is in other words, the evaluation of performance of portfolio manager. Manager universe comparisons are a part of evaluating the performance of a portfolio manager? How do you make manager universe comparisons? Answer 10 Manager Universe Comparisons The obvious way of evaluating a portfolio manager's performance is to compare it with other portfolio managers. Portfolios can be classified as style universes with broad strategy guidelines. While making manager universe comparisons, several problems should be addressed. Identifying a suitable universe is the first problem. The analyst should first decide about the fact that the available universe matches the selected universe, provided the basic goal of comparison is to assess the expertise of the investment manager. Bond managers practice a large number of techniques which creates a big problem, because the managers facethe fundamental problem of how to narrowly define the styles. Since no two managers are similar, a separate style can be formed for every manager making it very difficult to compare their styles. This suggests that styles should be outlined along with broad policy framework. A universe is suitable for comparison with a given manager only when the

selection of that manager implies a good alternative for the investors. While evaluating the new strategies such as dedication, immunization and other combinations, this concern becomes more important. The target returns fixed to these strategies are generally stated in absolute terms and are customized to suit specific investors with specified liability stream. The comparison process will be very difficult if the comparison portfolios are not customized properly for the same liability stream. For example, comparison of the dedicated portfolio with immunized portfolio will not be appropriate for a traditional style universe. The second problem, which may be thought of as an extension of the first problem, relates to the difficulty attached in exactly categorizing managers into styles. Universe manager developers are those persons who select and help investment managers in successfully understanding the investment management process for both domestic and international investment. They can demand comprehensive information about investment process, objectives, constraints, and philosophy. This clearly suggests that some subjective resolution should be made in positioning a manager within a universe. The amount of time that is available for performance with the manager is another problem. Superior or inferior kind of performance for a fixed period can be attributed to good or bad luck of the investment manager rather than his superior or inferior skills. If this is the case, one should not expect this to continue for longer periods of time and hence actual performance over a long phase may not always be accessible. The absence of long performing years states that new performers may not have a long record of actual performance. In addition to this, the old performers may sometimes undergo a change in personnel or investment outlook. In spite of these difficulties attached to such manager universe comparison, it is very likelythat an investor will ask how his manager's performance differs from that of others. A constant superior performance over a long period of time enhances the investor's confidence that excess returns are a result of good skill rather than sheer luck. However, a consistent inferior performance for a given period of time should not be attributed to bad skills, unless a detailed study upholds that conclusion.