7 Pages   |   1,636 Words
[Portfolio Risk and Return]
A Case Study Analysis  

Table of Contents
Executive Summary: 3
Modern Portfolio Analysis: 4
Sharpe “simplified” Approach: 5
Corporate Governance: 5
Recommendations: 6
Conclusion: 7

Executive Summary:

“RD&I” is one of the largest investment counselling firms in the country with over $30 billion under management. The firm’s principle source of income is the fees paid by the clients for portfolio management services. This annual fee is a small percentage with respect to the market value of the client’s portfolio. The company’s stated objective for equity portfolio is to achieve a 14-16% annual rate of return with a limited standard error of deviation around 5-6%.
There are three committees: Investment Policy Committee (IPC) that develops economic forecasts; Equity Selection Committee (ESC) that uses IPC recommendation to analyse companies; and Securities List Review Committee (SLRC) that monitors the recommendations made by IPC and ESC. The SLRC can make amendments to the portfolios based on current developments. The committee receives computer reports, automatically generated for any client’s portfolio that shows significant deviation from the specified risk-return objective.

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Henry Stones is a new employee at “RD&I” as a portfolio manager and has previously been working at a bank as a trust officer. Upon his arrival, his impression is of both excitement and dismay. He is excited and impressed with respect to the performance of portfolios, and his dismay is relative to operational procedures that allow portfolio managers a high degree of flexibility stemming from lack of formal guidelines and procedures dealing with formulating and revising a client’s portfolio.
The various methodologies adopted by the portfolio managers varied in terms of their approach; some used a more traditional approach where they emphasized on diversification in different industries so as to eliminate the non-systematic risk. The more modern approaches were inclined towards betas of individual securities and the resulting betas of the portfolio. These approaches basically attempt to maximize returns and minimize risk, but the addition of elements such as risk-free securities can have varied impact on the returns of a portfolio.
Thus, Henry is determined to decide between Markowitz variance covariance technique and Sharpe “simplified” procedure.

Modern Portfolio Analysis:

“RD&I”  portfolio with only two stocks IBM and GPU depict a decreasing return as the weightage of IBM stock is dropped to zero; the reason is rather logical because the expected return of IBM stock is greater but as quantity of the stock is decreased, it adversely impacts the portfolio returns. This is the reaction on analysis towards Markowitz Modern portfolio theory.
An efficient portfolio offers the highest expected return for a specified risk. This risk level is calculated by variance or standard deviation of return. Furthermore, risk tolerance concept basically uses standard deviation to find a portfolio that will enhance returns for the standard deviation of return in line with risk tolerance.
In order to find the efficient portfolio, there is need to first find the portfolio with minimum variance for each given level of expected returns. To do this we create 11 portfolios, with 0.1 increments in weights, in the opposite direction, in each stock. There is need to calculate the expected returns based on the formula Rp= ∑ XiRi, where X represent the weights and R represent returns on individual stocks. The maximum return that was calculated was around 10% whilst, the lowest was around 4%. GPU stock has an extremely high beta which depicts its excessive riskiness as compared to the market. It might be a better idea for Henry to decrease or eliminate GPU stock from the portfolio and combine IBM stock with a certain risk-free asset that would allow more flexibility and lower cost lending at that specific rate.
With respect to the graph in sheet 2 (Q2) of excel file, the relative bulge depicts the diversification benefit of having invested in two different stocks, the peak of the bulge at 5.80% onwards to 10% is an attractive area considering portfolio construction; this is primarily due to the reason that from this point onwards as the risk increases, so does the returns. However, it must be noted that 5.8% return might as well be the optimal return with respect to variance of 1.54%.
As stated previously, the traditional portfolio theory that was being utilized by certain portfolio managers with respect to diversification across assets that are not perfectly correlated results in the portfolios risk to be lower than the weighted sum of the variances of the individual securities in the portfolio. So with respect to the theory, once you get to 30 or so securities in a portfolio, the standard deviation remains constant. The remaining risk is systematic or non-diversifiable risk. The reason to discuss this traditional theory is to emphasise that conventional portfolio theories has a certain level of strategic importance that if incorporated in our portfolio can increase our portfolio performance.

Sharpe “simplified” Approach:

Markowitz theory requires N + N(N - 1)/2 unique estimated inputs to calculate total risk of portfolio (VARp), and these inputs are: N variances of N stocks in your portfolio and N(N - 1)/2  unique co-variances between returns of pairs of stocks. Thus, the theory required a large number of estimated items; therefore computational requirements are daunting.  Sharpe has simplified these technical input requirements for estimating total risk of the portfolio. Sharpe proposed that ROR of any security (Ri) is sensitive to ROR of the overall stock market (Rm) in a linear fashion as represented by its function.
With reference to sheet 2 (Q2) of spreadsheet, the returns shown were rather linear as stated above as the weightage of GPU stock increased the returns increased simultaneously up to 11.12%. The reason behind this is the negative alpha of GPU which depicted the returns intercept. On the other hand, the risk increased on average as the quantity of GPU stock was raised. Even graphically with reference to sheet 2 (Q2) of spreadsheet, the frontier is above that of Markowitz efficient frontier, which theoretically is impossible if we consider the portfolio at 5.8% return to be the market portfolio. However, the most desirable portfolio for each individual investor is at the point where that investors (highest) indifference curve is tangent to the efficient frontier.

Corporate Governance:

The case states that several individuals serve on all three committees which is to be beneficial because it increases interaction. However, it also might bring in problems specific to areas of conflict and the like. It is important to understand that for the protection of long term interests of shareholders, majority of the board shall comprise of independent members and also the board must meet regularly outside the presence of the management.


It is important to note, “RD&I” is operating at a vast level of professional expertise and hence it is very important to follow a set of standards and regulations. This would primarily create a step by step approach and streamline all processes. Active portfolio management must be practised to increase competition within the three regions of its operations.
The suggested method to follow would be to utilize Markowitz efficient frontier to determine the right combination of risky and risk-free asset that can give Henry the return at market portfolio (tangency portfolio). It must also utilize other multifactor models such as macroeconomic factor models, whereby the stated factors are the variables that impact the expected future cash flows of the specified companies or the interest rates that are used to discount those cash flows to the current period.
Markowitz portfolio theory must be used by Henry to formulate and update portfolios. It is important because it gives us a detailed level of information with the help of expected return for each asset present in the portfolio, variance for the subsequent assets, and correlation between all the above stated pair of assets. Markowitz theory is important because it extends into the capital market theory as well and is utilized extensively by numerous portfolio managers.
Sharpe’s measure (reward-to-variability ratio) is a tool that can be utilized for measuring performance of portfolios managed by “RD&I”. So basically, mean variance portfolio theory emphasises on the objective of maximizing Sharpe measure under the influence of portfolio managers, which results in increasing the slope of Capital Allocation Line. A good portfolio manager is identified by the steepness of CAL slope compared to a passively held market-index portfolio.
Consistent active management process must be observed to achieve greater returns for a specified level of risk. For this purpose, it is important to monitor economic conditions, relative asset mix and circumstances. To identify these active returns (portfolio return minus benchmark return) information ratio may be used.


Conclusively, according to the spread sheet analysis, the Markowitz Frontier is a better mechanism of formulating portfolios. The bulged peak at 5.8% is decidedly the best option, unless the above mentioned recommendations are incorporated. The incorporation of a risk-free asset may effectively improve portfolio performance.
Furthermore, diversification will improve the bulge and simultaneously the portfolio performance. As previously mentioned active portfolio management must be observed, but when the average risky portfolio is created by utilizing optimal weights of the active and passive portfolio, the resulting performance in terms of the square of Sharpe’s measure is enhanced. The weight of each specific security to the general improvement in the performance of the active portfolio is measured by the subsequent extent of mispricing and non-systematic risk.
The corporate governance issues must be resolved to promote fluent regulatory framework. Standards and regulations must be enforced, and compliance must be assured to streamline active portfolio management.
With respect to a portfolio perspective, individual assets (investments) shall be analysed in the context of their risk addition to a portfolio, not with respect to how much risk they carry individually. Hence, all three steps of portfolio management: planning, execution, and feedback must be performed strategically.

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