Portfolio Analysis

Portfolio Analysis is one of the areas of investment management that enable market participants to analyze and assess the performance of a portfolio (equities, bonds, alternative investments, etc.), intending to measure performance on a relative and absolute basis along with its associated risks.

Some of the top ratios used are as follows -

1) Holding Period Return

It calculates the overall return during the investment holding period.

Holding Period Return ={(Ending Value–Beginning Value)+Dividends Received}/Beginning Value

2) Arithmetic Mean

It calculates the average returns of the overall portfolio.

Arithmetic Mean = (R1 + R2 + R3 +……+ Rn) / n

R = Returns of Individual Assets

3) Sharpe Ratio

It calculates the excess return over and above the risk-free return per unit of portfolio risk.

Sharpe Ratio Formula = (Expected Return – Risk-Free rate of return) / Standard Deviation (Volatility)

4) Alpha

It calculates the difference between the actual portfolio returns and the expected returns.

Alpha of portfolio = Actual rate of return of portfolio – Expected Rate of Return on Portfolio

5) Tracking Error

It calculates the standard deviation of the excess return concerning the benchmark rate of return.

Tracking Error Formula = Rp-Ri

• Rp = Return from the portfolio
• Ri = Return from the index

Tracking Error = Standard Deviation of (P - B)

• P = Portfolio returns
• B = Benchmark returns

6) Information Ratio

It calculates the success of the active investment manager strategy by calculating excess returns and dividing it by tracking error.

Information ratio Formula = (Rp – Rb) / Tracking error

Rp = Return of Portfolio, Rb = Return on Benchmark

7) Sortino Ratio

It calculates the excess return over and above the risk-free return per unit of negative asset returns.

Sortino Ratio Formula = (Rp – Rf) / σd

Rp = Return of Portfolio, Rf = Risk-Free Rate, σd = standard deviation of negative asset returns

Let's understand this concept in more detail with the help of a few examples by making use of these popular tools as discussed.

Example #1

Ryan invested in a portfolio of stocks, as discussed below. Based on the information, calculate the holding period return of the portfolio:

Holding Period Return={(Ending Value–Beginning Value)+Dividends Received}/Beginning Value

Below is the use holding period return formula.

Example #2

• Venus investment is trying to undertake a portfolio analysis of one of its funds, namely growth 500, using certain performance measures. The fund has an information ratio of 0.2 and an operational risk of 9%. The funds are benchmarked against the S&P 500 and have a Sharpe ratio of 0.4 with a standard deviation of 12%.
• Venus investment has decided to create a new portfolio by combining the growth 500 and the benchmark S&P 500. The criteria are to ensure a Sharpe ratio of 0.35 or more as part of the analysis. Venus has decided to undertake the portfolio analysis of the newly created portfolio using the following risk measure:

Sharpe Ratio

Optimal Active Risk of the New Portfolio = (Information Ratio/Sharpe Ratio)*Standard Deviation of Benchmark S&P 500

Accordingly Sharpe Ratio of the New Portfolio = (Information Ratio ^2 + Sharpe Ratio ^2)

Thus the Sharpe ratio is less than 0.35, and Venus can not invest in the said fund.

Example #3

Raven investments are trying to analyze the portfolio performance of two of its fund managers, Mr. A and Mr. B.

Raven investment is undertaking the portfolio analysis using the information ratio of the two fund managers with a higher information ratio acting as a measure of superior performance.

The following details enumerated below are used to measure the information ratio for portfolio analysis purposes:

With a higher information ratio, fund manager B has delivered superior performance.

#1 - Understanding Investor Expectation and Market Characteristics

The first step before portfolio analysis is to sync the investor expectation and the market in which such Assets will be invested. Proper sync of the expectations of the investor vis-à-vis the risk and return and the market factors helps a long way in meeting the portfolio objective. With a higher information ratio, fund manager B has delivered superior performance.

#2 - Defining an Asset Allocation and Deployment Strategy

This is a scientific process with subjective biases. It is imperative to define what type of assets the portfolio will invest, what tools will be used in analyzing the portfolio, which type of benchmark the portfolio will be compared with, the frequency of such performance measurement, and so on.

#3 - Evaluating Performance and Making Changes if Required

After a stated period as defined in the previous step, portfolio performance will be analyzed and evaluated to determine whether the portfolio attained stated objectives and the remedial actions, if any, required. Also, any changes in the investor objectives are incorporated to ensure portfolio analysis is up to date and keeps the investor expectation in check.

• It helps investors to assess the performance periodically and make changes to their Investment strategies if such analysis warrants.
• This helps in comparing the portfolio against a benchmark for return perspective and understanding the risk undertaken to earn such return, enabling investors to derive the risk-adjusted return.
• It helps realign the investment strategies with the changing investment objective of the investor.
• It helps in separating underperformance and outperformance, and accordingly, investments can be allocated.

Portfolio analysis is an indispensable part of investment management and should be undertaken periodically to identify and improvise any deviation observed against the investment objective. Another important objective it intends to achieve is to identify the real risk undertaken to achieve the desired return and whether the risk is commensurate with the return achieved by the investor. In short, it is a complex task and requires professional expertise and guidance to make it impactful.