Unit 5: Active Portfolio Management

Active Portfolio Management

Active Portfolio Management is when a portfolio manager actively buys and sells securities to beat the market or achieve higher returns than a benchmark index (like Nifty 50, Sensex).

The goal is to "outperform the market" by making smart investment decisions.

Key Features:

Feature	Description
High involvement	Manager regularly analyzes and changes investments
Objective	Beat the market or benchmark returns
Tools used	Research, forecasting, technical & fundamental analysis
Examples	Actively managed mutual funds, hedge funds

Portfolio Management & Performance Evaluation

This process involves reviewing how well a portfolio has performed over a specific time. The key focus is:

• Returns earned

• Risk taken

• Comparison with market index or risk-free rate

Performance Evaluation of Existing Portfolio

We use certain ratios and metrics to evaluate whether the portfolio has done well. Let’s look at one of the most popular ones:

Sharpe Ratio

Sharpe Ratio measures how much excess return (above risk-free rate) a portfolio earns per unit of risk taken.

Higher the Sharpe Ratio → better the risk-adjusted performance.

Formula:

$$\text{Sharpe Ratio}=\frac{R_p-R_f}{{\sigma }_{\mathrm{p}}}$$

Where:

• $R_p$ = Portfolio return

• $R_f$ = Risk-free return (like government bond yield)

• $\sigma_p$ = Standard deviation (volatility/risk of the portfolio)

📌 Example:

• Portfolio return = 15%

• Risk-free rate = 5%

• Standard deviation = 10%

$$\text{Sharpe Ratio}=\frac{15-5}{10}=1.0$$

Interpretation: A Sharpe Ratio of 1.0 means you’re earning 1% excess return for every 1% of risk taken.

Sharpe Ratio Value	Performance Rating
< 1.0	Poor
= 1.0	Acceptable
1.5 – 2.0	Good
> 2.0	Excellent

Other Ratios You May Include (Optional for Full Evaluation):

Metric	Formula & Meaning
Treynor Ratio	$\frac{R_p - R_f}{\beta}$ – excess return per unit of systematic risk
Jensen’s Alpha	$\alpha = R_p - [R_f + \beta(R_m - R_f)]$ how much more return than expected
Information Ratio	Measures excess return over benchmark vs its volatility

Summary Table

Topic	Explanation in Simple Words
Active Portfolio Management	Actively buying/selling stocks to beat the market
Performance Evaluation	Checking if the portfolio earned good return for the risk taken
Sharpe Ratio	Return per unit of total risk
High Sharpe Ratio	Means better performance (more reward for same risk)

Treynor and Jensen Measures

These are risk-adjusted performance evaluation tools used in portfolio management to check how efficiently a portfolio or mutual fund performed relative to risk.

Treynor Ratio (Systematic Risk Measure)

Measures return per unit of market (systematic) risk, using Beta.

Formula:

$$\text{Treynor Ratio}=\frac{R_p-R_f}{{\beta }_{\mathrm{p<span\; class="vlist-s"></span>}}}$$

Where:

• $R_p$ = Portfolio return

• $R_f$ = Risk-free rate (e.g., Govt. bond rate)

• $\beta_p$ = Beta of the portfolio (sensitivity to market)

Higher Treynor Ratio = Better performance for market risk taken

Example:

• Portfolio return = 14%

• Risk-free rate = 5%

• Beta = 1.2

$$\text{Treynor Ratio} = \frac{14 - 5}{1.2} = \frac{9}{1.2} = 7.5$$

Jensen’s Alpha (Abnormal Return Measure)

Measures how much extra return a portfolio generated compared to expected return using CAPM.

Formula:

$$\alpha =R_p-[R_f+\beta (R_m-R_f)]$$

Where:

• $R_p$ = Portfolio return

• $R_m$ = Market return

• $R_f$ = Risk-free rate

• $\beta$ = Portfolio beta

Positive Alpha = Portfolio outperformed
Negative Alpha = Portfolio underperformed

Example:

• $R_p$ = 16%, $R_f$ = 6%, $R_m$ = 14%, $\beta$ = 1.1

$$\alpha =16-[6+1.1(14-6)]=16-[6+8.8]=16-14.8=\ast \ast +1.2$$

🟢 This portfolio gave 1.2% extra return beyond what was expected.

Finding Alternatives and Revision of Portfolio

This is a process of rebalancing and improving a portfolio by replacing underperforming assets with better alternatives.

Steps:

1. Review current portfolio performance.

2. Identify weak or risky assets (e.g., declining sectors).

3. Search for alternatives (new sectors, better mutual funds, stocks).

4. Reallocate funds based on updated goals, risk tolerance, or market outlook.

Example:

• Selling low-performing PSU bank stocks

• Buying fast-growing tech or pharma stocks

• Moving from debt funds to hybrid funds if risk appetite increases

Portfolio Management and the Mutual Fund Industry

Mutual Fund: An investment vehicle that pools money from many investors to invest in diversified assets (stocks, bonds, etc.) — professionally managed.

Role in Portfolio Management:

Function	Description
Diversification	Lowers risk by investing in various assets
Professional management	Experts handle investments
Liquidity	Easy to buy/sell mutual fund units
Variety of choices	Equity, Debt, Hybrid, ELSS, Index funds
Tracking and Reporting	NAV updates, risk ratios, fund fact sheets provided regularly

Types of Mutual Funds in Portfolio:

• Equity Funds – For capital growth

• Debt Funds – For safety and stable returns

• Hybrid Funds – Mix of equity and debt

• Index Funds – Passive investing with low cost

• ELSS – Tax-saving + long-term growth

Summary Table

Concept	Meaning
Treynor Ratio	Return per unit of market risk (Beta)
Jensen’s Alpha	Extra return above market expected return
Finding Alternatives	Replacing poor-performing assets with better options
Revision of Portfolio	Rebalancing to suit new goals or market conditions
Mutual Fund Industry Role	Provides diversified, managed investment options for portfolios

Tags: INVESTMENT ANALYSIS & PORTFOLIO MANAGEMENT

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