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Unit 3 of 4 · MBA Sem 3

Unit 3: Portfolio management

Investment Analysis and Portfolio Management notes · PTU syllabus (MBA 911-18)

3 min read6 topics10 exam questions
On this page
  1. Unit summary
  2. Meaning and importance of portfolio management
  3. Approaches to portfolio management
  4. Portfolio analysis and construction
  5. Portfolio return and risk
  6. Portfolio evaluation
  7. Portfolio revision
  8. Key terms
  9. Quick revision
  10. Important questions

Unit summary

A portfolio, not a single security, determines an investor's risk and return. This unit covers the meaning, importance and approaches of portfolio management, portfolio analysis, and techniques of portfolio evaluation and revision.

After this unit you can

  • Explain the meaning, importance and approaches of portfolio management
  • Analyse portfolio return and risk
  • Evaluate portfolio performance with risk-adjusted measures
  • Explain portfolio revision techniques

PTU syllabus topics

  • Meaning
  • importance and approaches
  • portfolio analysis
  • evaluation and revision techniques
ProcessPortfolio management process
  1. 1

    Set objectives and constraints

    Return, risk, liquidity

  2. 2

    Asset allocation

  3. 3

    Security selection

  4. 4

    Construct the portfolio

  5. 5

    Monitor and revise

  6. 6

    Evaluate performance

    Sharpe, Treynor, Jensen

1

Topic 1

Meaning and importance of portfolio management

  • Portfolio: a combination of securities and other assets held by an investor.
  • Portfolio management: the art and science of selecting and managing a portfolio to meet the investor's objectives within constraints.
  • Importance: diversification reduces unsystematic risk, aligns investments with goals and risk tolerance, disciplines decisions, improves risk-adjusted returns.
  • Portfolio management services (PMS): SEBI-regulated professional management with minimum investment of ₹50 lakh; discretionary, non-discretionary and advisory.
2

Topic 2

Approaches to portfolio management

ClassificationApproaches
Portfolio approaches

  • Traditional approach

    Investor's needs — income, growth, safety — and security analysis

  • Modern approach (Markowitz)

    Risk–return optimisation using correlations

  • Active management

    Seek to beat a benchmark through selection and timing

  • Passive management

    Track an index at low cost

  • Strategic and tactical asset allocation

    Long-term mix and short-term tilts

ComparisonTraditional vs modern approach
Traditional
Modern

Basis

Investor needs and objectives

Mathematical risk–return trade-off

Risk

Judged qualitatively

Measured by variance and covariance

Diversification

Number of securities

Correlation among securities

Tool

Security analysis

Efficient frontier

3

Topic 3

Portfolio analysis and construction

  • Objectives: maximise return for a given risk, safety of principal, liquidity, regular income, capital growth, tax efficiency, marketability.
ProcessPortfolio management process
  1. 1

    Specify objectives and constraints

    Return, risk, horizon, liquidity, taxes, legal

  2. 2

    Asset allocation

    Strategic and tactical

  3. 3

    Security selection

  4. 4

    Portfolio construction

    Diversification, weights

  5. 5

    Monitoring and revision

  6. 6

    Performance evaluation

  • Construction issues: number of securities (diversification benefits level off after 15–25 stocks), correlations, transaction costs, taxes, liquidity, investor constraints; active vs passive management.
4

Topic 4

Portfolio return and risk

Harry Markowitz (1952) showed that portfolio risk depends on the covariance between securities, not just their individual risks.

Key formulasTwo-asset portfolio

  • Portfolio return

    Rp = wA RA + wB RB

  • Portfolio variance

    σp² = wA² σA² + wB² σB² + 2 wA wB ρAB σA σB

  • Minimum-variance weight of A

    wA = (σB² − ρ σA σB) ÷ (σA² + σB² − 2ρ σA σB)

Example

A: return 12%, σ 15%; B: return 18%, σ 25%; ρ = 0.2; equal weights. Rp = 15%. σp² = 0.25(225) + 0.25(625) + 2(0.25)(0.2)(15)(25) = 56.25 + 156.25 + 37.5 = 250 → σp ≈ 15.8% — less than the weighted average SD of 20%.

  • Efficient frontier: the set of portfolios offering the highest return for each level of risk; rational investors choose a point on it based on their indifference curves.
  • Assumptions: investors are risk-averse, decisions based on mean and variance, single-period horizon.
5

Topic 5

Portfolio evaluation

Key formulasPerformance measures

  • Sharpe ratio

    (Rp − Rf) ÷ σp — reward per unit of total risk

  • Treynor ratio

    (Rp − Rf) ÷ βp — reward per unit of systematic risk

  • Jensen's alpha

    αp = Rp − [Rf + βp (Rm − Rf)]

FundReturnσβSharpeTreynor
A15%18%1.10.508.18
B13%12%0.80.588.75
Market12%14%1.00.436.00

Example

With Rf = 6%: Fund B ranks higher on both Sharpe and Treynor. Jensen's alpha for A = 15 − [6 + 1.1 × 6] = 2.4%; for B = 13 − [6 + 0.8 × 6] = 2.2% — both beat the market on a risk-adjusted basis.

  • Sharpe for undiversified portfolios (total risk matters); Treynor and Jensen for well-diversified portfolios.
  • Fama's decomposition: return due to selectivity and due to risk.
  • Information ratio: active return ÷ tracking error.
6

Topic 6

Portfolio revision

  • Portfolio revision: changing the mix of securities as conditions, objectives or relative values change.
  • Active revision (market timing, sector rotation) vs passive revision (rebalancing to a target allocation, indexing).
ClassificationFormula plans
Formula plans

  • Constant rupee value plan

    Keep a fixed rupee amount in equities; sell when it rises, buy when it falls

  • Constant ratio plan

    Keep a fixed ratio between equity and debt (e.g., 60:40)

  • Variable ratio plan

    Equity proportion falls as prices rise and rises as prices fall

  • Rupee cost averaging

    Invest a fixed amount at regular intervals (SIP)

  • Formula plans remove emotion and force "buy low, sell high", but may underperform in strong trends.

Global investing

  • Benefits: further diversification (low correlation between markets), access to global leaders and sectors, currency diversification.
  • Risks: exchange rate risk, political and regulatory risk, information gaps, higher costs, taxation.
  • Routes for Indian investors: RBI's Liberalised Remittance Scheme (US$ 2,50,000 a year), international mutual funds and fund-of-funds, ETFs, GIFT City IFSC platforms; TCS on remittances above ₹10 lakh.

Key terms

Portfolio management
Selecting and managing assets to meet objectives
PMS
SEBI-regulated portfolio management services
Passive management
Tracking an index at low cost
Sharpe ratio
Excess return per unit of total risk
Formula plan
Mechanical rule for portfolio revision

Quick revision

  • Portfolio management meaning, importance, PMS.
  • Traditional vs modern; active vs passive; asset allocation.
  • Portfolio process; construction issues.
  • Portfolio return and SD with correlation; diversification.
  • Evaluation: Sharpe, Treynor, Jensen; revision: active, passive, formula plans.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.Define portfolio management.
  2. Q2.Distinguish traditional and modern approaches.
  3. Q3.What is passive management?
  4. Q4.State the Sharpe ratio formula.
  5. Q5.What is Jensen's alpha?
  6. Q6.What is a constant ratio plan?

Long-answer questions

  1. Q1.Explain the meaning, importance and approaches of portfolio management.
  2. Q2.Explain how portfolio return and risk are computed and the role of correlation.
  3. Q3.Explain the Sharpe, Treynor and Jensen measures of portfolio evaluation.
  4. Q4.Discuss portfolio revision and formula plans.

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