Page 325 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes has gone up to 110 by July, the intermediate cash flow of 2,20,000 is converted into 2,000 units
increasing the total units to 10,000. At the end of the year, the NAV further raised to 132 per
unit. The NAV of 132 at the end of the year compared with 100 at the beginning of the year
obviously results in a return of 32% for the year. This is called Unit Value Rate of Return.

Portfolio Performance and Risk Adjusted Methods

Modern Portfolio Theory provides a variety of measures to measure the return on a portfolio as
well as the risk. When a portfolio carries a degree of risk, the return from it should be evaluated
in terms of risk. More specifically, it is better to evaluate the performance of fund in terms of
return per unit of risk. In case of a well-diversified portfolio the standard deviation could be
used as a measure of risk, but in case of individual assets and not-so-well diversified portfolios,
the relevant measure of risk could be the systematic risk. We have already seen in earlier units
the measurement aspects of portfolio risk and the systematic risk.

In case of a well-diversified portfolio the standard deviation could be used as a measure of risk,
but in case of individual assets and not-so-well diversified portfolios the relevant measure of
risk could be the systematic risk. We have already seen in earlier units the measurement aspects
of portfolio risk and the systematic risks.
There are three popular measures to estimate the return per unit of risk from a portfolio. They
are
1. Sharpe’s Ratio
2. Treynor’s Measure
3. Jensen’s Differential Returns

Risk-adjusted Returns

The performance of a fund should be assessed in terms of return per unit of risk. The funds that
provide the highest return per unit of risk would be considered the best performer. For well-
diversified portfolios in all asset categories, the standard deviation is the relevant measure of
risk. When evaluating individual stocks and not so well diversified portfolios, the relevant
measure of risk is the systematic or market risk, which can be assessed using the beta co-efficient
( ). Beta signifies the relationship between covariance (stock, market) and variance of market.
Two well-known measures of risk-adjusted return are:
Sharpe’s Ratio

A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance.
It is calculated by subtracting the risk-free rate – such as that of the 10-year US Treasury bond –
from the rate of return for a portfolio and dividing the result by the standard deviation of the
portfolio returns.
Sharpe’s measure is called the “Reward-to-Variability” Ratio. The returns from a portfolio are
initially adjusted for risk-free returns. These excess returns attributable as reward for investing
in risky assets are validated in terms of return per unit of risk. Sharpe’s ratio is as follows:
E[R] R
Or S = f

r p r f
=
p

320 LOVELY PROFESSIONAL UNIVERSITY