Portfolio Risk and Performance Analysis Essentials of Corporate Finance Chapter 11 Materials Created by Glenn Snyder – San Francisco State University

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 2 Topics Asset Management Firms  Active vs. Passive Portfolio Management  Roles of Risk and Performance Setting Up the Portfolio  Diversification Systematic and Unsystematic Risk Stability and Portfolio Turnover Risk and Performance Analysis  Risk Ratios The Importance of Beta  Market Risk Premium Sharpe and Treynor Ratios  Impact on Portfolio Management Career Advice for a Risk and Performance Analyst

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 3 Asset Management Firms An asset management firm is a company that manages money, in the form of investments, for their clients  Essentially, these firms manage their client’s assets Asset management firms are typically…  Mutual Fund Companies  Pension Fund Companies  Hedge Fund Companies  Insurance Companies  Subsidiaries of Commercial Banks

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 4 Active vs. Passive Portfolio Management Active Portfolio Management  The portfolio manager invests in securities of their choosing  The portfolio manager weights the securities as he or she sees fit Keeping the portfolio within the restrictions stated in the prospectus Passive Portfolio Management  Portfolio securities are made of all securities in the market (based on the portfolio’s investment objective)  Portfolio securities are weighted based on each security’s market capitalization

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 5 Roles of Risk and Performance Asset management companies typically have a risk and performance group that is independent of the portfolio management teams The role of the risk and performance group is  To calculate portfolio performance and compare it applicable index or benchmark  To calculate risk metrics and analyze the portfolio to determine if the return of the portfolio is adequate for the amount of risk  To analyze the impact of active portfolio management

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 6 Setting Up the Portfolio The portfolio manager will determine how to structure the portfolio based on the restrictions and guidelines in the portfolio’s prospectus  Portfolio Prospectus includes: Fees Investment Objectives  What type of securities it can hold  Market Cap – the size of the securities it can hold  The portfolio’s benchmark – the index it will be compared against Limitations on  Ownership  Sector/Industry/Country weighting Names of the portfolio managers

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 7 Diversification Why Diversify?  Higher more consistent return  Lower risk A diversified portfolio will hold a number of securities  Diversification is not having all of your eggs in one basket  Losses in some securities should be offset by gains in others

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 8 Systematic and Unsystematic Risk Systematic Risk  Market Risk – Risk inherent to the market  Risk that cannot be eliminated Unsystematic (Company Specific) Risk  Risk inherent to the specific security E.g. Microsoft Stock has risks beyond investing in the stock market, such as anti-trust, competitors, management succession, etc.  Diversifiable – Can be eliminated through diversification

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 9 Systematic and Unsystematic Risk

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 10 Systematic and Unsystematic Risk As more stocks are added, each new stock has a smaller risk-reducing impact  p falls very slowly after about 10 stocks are included, and after 40 stocks, there is little, if any, effect. The lower limit for  p is about 27% =  M   M = Market Risk  p = Portfolio Risk

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 11 Stability and Portfolio Turnover Portfolio stability is important to many long- term investors Portfolio Turnover is a ratio that calculates the percentage of securities that changed in the portfolio over the past year  If a portfolio has 100 securities and has a turnover of 25%, then 75 securities remained constant in the portfolio 25 securities were bought/sold during the year

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 12 Risk and Performance Analysis Risk and performance analysts calculate on a monthly basis how a portfolio performs  Actual basis – actual returns of the portfolio and its underlying securities  Relative Basis – portfolio returns compared against the portfolio’s benchmark or market index  Peer Basis – many mutual funds are put into peer universes and are ranked against competitive funds invested in similar securities  Risk Basis – ratios that determine performance per unit of risk and compared against Risk free rate Benchmark or Index Peer portfolios

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 13 The Importance of Beta Beta (ß)  A measure of market risk, to which the returns on a given stock move with the market  If beta = 1.0, average stock  If beta > 1.0, stock riskier than average  If beta < 1.0, stock less risky than average  Most stocks have betas in the range of 0.5 to 1.5

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 14 Market Risk Premium Market Risk Premium (RP M )  The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk  RP M = (R M – R F ) R M = market portfolio rate with ß = 1.0

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 15 Sharpe and Treynor Ratios Sharpe Ratio – calculates the average return over and above the risk-free rate of return per unit of portfolio risk.  Sharpe Ratio = (R i – R f ) / s i R i = Average return of the portfolio during period i R f = Average return of the risk-free rate during period i s i = standard deviation (risk) of the portfolio during period i

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 16 Sharpe and Treynor Ratios Treynor Ratio – calculates the average return over and above the risk-free rate of return per unit of the world market portfolio risk.  Treynor Ratio = (R i – R f ) /  i R i = Average return of the portfolio during period i R f = Average return of the risk-free rate during period i b i = The systematic (market) risk of the world market portfolio during period i

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 17 Sharpe and Treynor Ratios Risk and performance analysts use Sharpe and Treynor ratios to analyze the effectiveness of the portfolio manager  If the Sharpe and Treynor ratios are below 1.0, then the portfolio manager is taking too much risk for the return the portfolio is generating

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 18 Impact on Portfolio Management Risk and performance analysis impacts portfolio management by:  Guiding the portfolio manager to Take additional risk if the portfolio is underperforming its peers and benchmark Take less risk if the Sharpe and Treynor ratios are below 1.0 Increase diversification to reduce portfolio risk  Analyzing portfolio management strategies and their effectiveness

February 26, 2007 Materials Created by Glenn Snyder – San Francisco State University 19 Career Advice for a Risk and Performance Analyst CFA (Chartered Financial Analyst)  The CFA is a 3 year certification that is required for most risk and performance analysts and portfolio managers Sharpen your technical skills  Highly math and science oriented Understand portfolio management  Learn about portfolio management strategies, techniques, and analysis Many large asset management companies will have a management training program  Highly Competitive  Hands on training