MODERN ACADEMY FOR

COMPUTER SCIENCE AND

MANAGEMENT TECHNOLOGY IN
MAADI

Principles of
Finance

prepared by :
Dr. waleed zakaria
 CHAPTER THREE

PORTFOLIO PERFORMANCE
 LEARNING OBJECTIVES

• Portfolio performance management.

• Explain Classification of financial markets.

• Capital market V Money market.

What Is a Portfolio?
• A portfolio is a collection of financial investments like stocks, bonds,
commodities, cash, and cash equivalents, as well as their fund
counterparts.

• Stocks and bonds are generally considered a portfolio's core building

blocks, though you may grow a portfolio with many different types of
assets—including real estate, gold, paintings, and other art collectibles.

• Diversification is a key concept in portfolio management.

• A person's tolerance for risk, investment objectives, and time horizon

are all critical factors when assembling and adjusting an investment
portfolio.
Expected return(ER) on the portfolio :

EX:
• Suppose that we have the following data on a portfolio consists of two
stocks (a) and (b):

The expected The expected Investment

return of stock return of stock ratios
A B A B
10.5 % 11.4 % 40 % 60 %

• To calculate expected return on this portfolio, we use the next formula :

(ER of stock A× Investment ratios A) + (ER of stock B× Investment
ratios B)
= (10.5% × 40%) + (11.4% × 60%) = 11.%
 PORTFOLIO PERFORMANCE
EVALUATION
• The portfolio performance evaluation primarily refers to the
determination of how a particular investment portfolio has
performed relative to some comparison benchmark.
• The evaluation of portfolio performance is important for several
reasons:
• First, the investor, whose funds have been invested in the portfolio,
needs to know the relative performance of the portfolio.
• The performance review must generate and provide information
that will help the investor to assess any need for rebalancing of his
investments.
• Second, the management of the portfolio needs this information
to evaluate the performance of the manager of the portfolio and
to determine the manager’s compensation, if that is tied to the
portfolio performance.
• The performance evaluation methods generally fall into two
categories, namely conventional and risk-adjusted methods.
 CONVENTIONAL METHODS

• We have two method methods for determining this style:

• A: Benchmark Comparison:
• The most straightforward conventional method involves
comparison of the performance of an investment portfolio
against a broader market index.
• The most widely used market index in the United States is the S&P
500 index, which measures the price movements of 500 U.S.
stocks compiled by the Standard & Poor’s Corporation.
• The level of risk of the investment portfolio may not be the same
as that of the benchmark index portfolio.
• Higher risk should lead to commensurately higher returns in the
long term.
• This means if the investment portfolio has performed better than
the benchmark portfolio, it may be due to the investment
portfolio being more risky than the benchmark portfolio.
• Therefore, a simple comparison of the return on an investment
portfolio with that of a benchmark portfolio may not produce
valid results.
• B: Style Comparison:
• A second conventional method of performance evaluation
called ‘‘style-comparison’’ involves comparison of return of
a portfolio with that having a similar investment style.
• While there are many investment styles, one commonly used
approach classifies investment styles as value versus growth.
• In order to evaluate the performance of a value oriented
portfolio, one would compare the return on such a portfolio
with that of a benchmark portfolio that has value-style.

• Similarly, a growth style portfolio is compared with a growth-

style benchmark index. This method also suffers from the fact
that while the style of the two portfolios that are compared
may look similar, the risks of the two portfolios may be
different. Also, the benchmarks chosen may not be truly
comparable in terms of the style since there can be many
important ways in which two similar style-oriented funds vary.
 RISK-ADJUSTED METHODS

• There are two kind about risk, Systematic risk and

Non-Systematic risk:

• Systematic risks:

Those risks that afflict the financial market and cannot

be avoided, as all public institutions and companies in
the market are exposed to these risks, such as the risks
of inflation, fluctuations in interest rates ... etc.; hence, it
cannot be predicted or measured.
 NON-SYSTEMATIC RISK

• These risks affect some establishments, and therefore they

can be avoided and eliminated through the
rationalization of diversification in investments, so that this
diversification leads to the achievement of negative
correlation coefficients between investment returns,
hence, it can be predicted or measured. And we use the
risk-adjusted methods in this case.

• The risk-adjusted methods make adjustments to returns in

order to take account of the differences in risk levels
between the managed portfolio and the benchmark
portfolio. While there are many such methods, the most
notables are the Sharpe ratio (S), Treynor ratio (T), Jensen’s
alpha (a), Modigliani and Modigliani (M2), and Treynor
Squared (T2).
• Sharpe ratio:
In finance, the Sharpe ratio measures the performance of an
investment (e.g., a security or portfolio) compared to a risk-free
asset, after adjusting for its risk.
EX:
• Jensen's alpha:
Jensen's measure is one of the ways to determine if a portfolio is earning
the proper return for its level of risk.
If the value is positive, then the portfolio is earning excess returns. In other
words, a positive value for Jensen's alpha means a fund manager has "beat
the market" with their stock-picking skills.
The formula for Jensen's alpha is:
Alpha = R(i) – {R(f) + B x (R(m) - R(f))}
where:
R(i) = the realized return of the portfolio or investment
R(m) = the realized return of the appropriate market index
R(f) = the risk-free rate of return for the time period
B = the beta of the portfolio of investment with respect to the chosen
market index.
• For example: assume a mutual fund realized a return of 15% last
year. The appropriate market index for this fund returned 12%.
The beta of the fund versus that same index is 1.2, and the risk-
free rate is 3%. The fund's alpha is calculated as:
Alpha = 15% - (3% + 1.2 x (12% - 3%)) = 15% - 13.8% = 1.2%.

 A positive alpha in this example shows that the mutual fund

manager earned more than enough return to be compensated for
the risk they took over the course of the year.
• If the mutual fund only returned 13%, the calculated alpha would
be -0.8%. With a negative alpha, the mutual fund manager would
not have earned enough return given the amount of risk they were
taking.
 INTERNAL MARKET AND AN
EXTERNAL MARKET
• The internal market, also called the national market,
consists of two parts: the domestic market and the
foreign market. The domestic market is where issuers
domiciled in the country issue securities and where
those securities are subsequently traded.
• External market is the market where securities with
the following two distinguishing features are trading:
1) at issuance they are offered simultaneously to
investors in a number of countries; and 2) they are
issued outside the jurisdiction of any single country.
 MONEY MARKET AND CAPITAL
MARKET
• Money market is the sector of the financial market
that includes financial instruments that have a
maturity or redemption date that is one year or less at
the time of issuance. These are mainly wholesale
markets.
• Money market securities: They are short-term
securities (have a maturity of one year or less).
• The capital market is the sector of the financial
market where long-term financial instruments issued
by corporations and government's trade.
• Here “long-term” refers to a financial instrument with
an original maturity greater than one year and
perpetual securities (those with no maturity).
 PRIMARY MARKET&SECONDARY
MARKET
• Primary market: is the market for new issuers or where
new capital is raised. It is the market where securities
are sold for the first time. At the primary market sale
proceeds of the securities offered flow directly from
the buyers or investors to the issuers of the securities.
• Secondary market: is the market for trading securities
that have been sold or issued in the primary market
and already in the hands of the public. Once
securities have been successfully issued in the primary
market, they are subsequently traded in the
secondary market. This is where stock markets, stock
exchanges or OTC markets by whichever name the
market may be referred to, provide the facilities for
secondary trading.
OVER-THE-COUNTER MARKET (OTC)

• An over-the-counter (OTC) market is a decentralized

market in which market participants trade stocks,
commodities, currencies or other instruments directly
between two parties and without a central exchange
or broker. Over-the-counter markets do not have
physical locations; instead, trading is conducted
electronically.
• In general, OTC markets are typically less transparent
than exchanges and are also subject to fewer
regulations.
• Because of this liquidity in the OTC market may come
at a premium