Page 332 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 13: Portfolio Performance Evaluation

13.3 Market Timing Notes

A portfolio manager’s performance has been seen so far in the context of stock selection for
superior performance. Managers can also generate superior performance from a portfolio by
planning the investment and disinvestment activities by shifting from stocks to bonds or bonds
to stocks based on good market timing sense. Positioning of a portfolio is to be adjusted by
correctly adjusting the direction of the market, either in the bull or bear phases. Managers with
a forecast of a declining market can position a portfolio either by shifting resources from stocks
to bonds, or restructure the component stocks in such a way that the beta of the equity portion
of the portfolio comes down.
One way of finding the performance of a portfolio in this regard is to simply look directly at the
way the fund return behaves, relative to the return of the market. This method calls for calculating
the returns of the portfolio and the market at different intervals and plot a scatter diagram to see
the direction of relationship between these two. If a portfolio is constructed by concentrating on
stock selection rather than keeping the market timing in mind, the average beta of the portfolio
stands fairly constant and if we plot such a portfolio’s returns and market returns, we observe a
linear relationship. On the other hand, if a manager was able to successfully assess the market
direction and reshuffle the portfolio accordingly, we would observe a situation of high portfolio
betas at times of rise in market and low portfolio beta at times of decline in the market.
Portfolio managers can also achieve superior performance by picking up high beta stocks during
a market upswing and moving out of equity, one could calculate the quarterly returns for a fund
and for the market index like Bombay Stock Exchange’s National Index of a 5-year period.

13.4 Benchmark Portfolios for Performance Evaluation

Benchmark portfolio is a tool for the meaningful evaluation of the performance of a portfolio
manager. The more the benchmark reflects the manager’s stated style, the more accurately the
performance due to a manager’s skills can be assessed. Specialized benchmarks are called “normal
portfolios.” They are specially constructed by mutual consent of the client and the manager to
reflect the client’s needs and the manager’s style. Some management firms develop a normal
portfolio, which they can use for all clients, and some develop it separately for each type of
client. When benchmarks are designed in advance, the portfolio manager knows what the
specific objectives are and tailors the portfolio accordingly. The benchmark should reflect the
appropriate investment universe in which the manager works. Without a yardstick for proper
comparison, it becomes difficult to distinguish between active management skills and random
results.
Rather than using a market index like the Bombay Stock Exchange’s Sensitive Index to the
Economic Times Index, a benchmark portfolio would use a portfolio with predominantly value-
oriented shares for a value manager, growth-oriented shares for a growth manager and small
capitalization shares for a small cap (size) manager. It is quite possible for an investment manager
to perform better than the benchmark, though the benchmark may itself under-perform in
relation to a market index. The process of constructing a benchmark portfolio involves:
1. Defining the universe of stock to be used for the benchmark portfolio, and
2. Defining the weightage of the stocks in the universe.

Performance attribution analysis, as mentioned earlier, is a means of evaluating an investment
manager’s performance, the return and the sources of return relative to a benchmark portfolio.
This analysis looks at an investment manager’s total ‘excess’ return, or ‘active management
return’ (AMR) relative to its benchmark over the given period.

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