What is the Portfolio Analysis?

Tools Used in Portfolio Analysis

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 ReturnHolding Period ReturnHolding period return refers to total returns over the period for which an investment was held, usually expressed in percentage of initial investment, and for comparing returns from various investments held for different periods of time.read more ={(Ending Value–Beginning Value)+Dividends Received}/Beginning Value

2) Arithmetic Mean

It calculates the average returns of the overall portfolio.

Arithmetic MeanArithmetic MeanArithmetic mean denotes the average of all the observations of a data series. It is the aggregate of all the values in a data set divided by the total count of the observations.read more = (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 FormulaSharpe Ratio FormulaThe Sharpe ratio formula calculates the excess return over the risk-free return per unit of the portfolio’s volatility. The risk-free rate of return gets subtracted from the expected portfolio return and is divided by the standard deviation of the portfolio. Sharpe ratio = (Rp – Rf)/ σpread more = (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 portfolioAlpha Of PortfolioThe term alpha refers to an index that is used in a variety of financial models, including the capital asset pricing model, to determine the maximum possible return from a low-risk investment. Alpha of portfolio = Actual rate of return of portfolio – Risk-free rate of return – β * (Market return – Risk-free rate of return)read more = 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 FormulaTracking Error FormulaTracking Error Formula is used in order to measure the divergence arising between the price behavior of portfolio and price behavior of the respective benchmark and according to the formula Tracking Error calculation is done by calculating the standard deviation of the difference in return of the portfolio and the benchmark over the period of time.read more = Rp-Rb

Rp = Return of Portfolio, Rb = Return on Benchmark

6) Information Ratio

It calculates the success of the active investment managerInvestment ManagerAn investment manager manages the investments of others using several strategies to generate a higher return for them and grow their assets. They are sometimes also referred to as portfolio managers, asset managers, or wealth managers. They may also be considered financial advisors in some cases, but they are typically less involved in the sales aspect.read more strategy by calculating excess returns and dividing it by tracking error.

Information ratio FormulaInformation Ratio FormulaInformation ratio” (IR) is measured by comparing the excess returns generated by the investment portfolio to the volatility of those excess returns. Mathematically, the information ratio formula is represented as = (Rp – Rb) / Tracking error read more = (Rp – Rb) / Tracking error

7) Sortino Ratio

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

Sortino Ratio FormulaSortino Ratio FormulaThe Sortino ratio is a statistical tool used to evaluate the return on investment for a given level of bad risk. It is calculated by subtracting the risk-free rate of return from the expected return and dividing the result by the negative portfolio’s standard deviation (downside deviation).read more = (Rp – Rf) / σd

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

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Examples of Portfolio Analysis

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:

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 managersFund ManagersA fund manager refers to an investment professional responsible for fund investment strategy formulation and implementation. They collect and invest the money from various investors and create a good variety of managed funds catering to the diverse preferences exhibited by the investors. read more 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.

Steps to Portfolio Analysis

#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.

Advantages

  • 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.

Conclusion

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.

This has been a guide to what Portfolio Analysis is and its meaning. Here we discuss its tools along with examples, advantages, and steps. You can learn more about portfolio management from the following articles –

  • Portfolio InvestmentPortfolio ManagerPortfolio DiversificationPortfolio Rebalancing