Security Analysis and Portfolio

Management

Session-1
 SAPM: Course Overview

Module I : Introduction of Security Analysis and Portfolio Theory

 Investment Analysis and Portfolio Theory
 Capital Allocation to Risky Assets and Optimal Risky Portfolio
Module II: Investment Analysis, Asset Pricing Models, and Portfolio Management
 Multifactor Models of Risk and Return
 Foundations of Factor Investing: Factor Indexes and Factor Models
 Market Anomalies, Style Investing, and Strategy Indices
 Macro-Economic and Industry Analysis
 Introduction to Technical Analysis
Module III: Investment Management and Portfolio Performance Evaluation
 Active vs. Passive Portfolio Management and Portfolio Monitoring
 Portfolio Performance Evaluation: Measurement, Attribution, and Appraisal
 Asset Management and Hedge Fund: An Introduction
Basic Theoretical
Inputs
 The Determinants of Stock Market Development
 Macroeconomic factors such as income level, gross domestic investment, banking sector development,
private capital flows, and stock market liquidity are important determinants of stock market development in
emerging market countries. Political risk, law and order, and bureaucratic quality are important determinants
of stock market development because they enhance the viability of external finance.

 Determinants: Stock Market Development

• Income Level (per capita income)
• Banking Sector Development (bank credit to the private sector as a percentage of GDP)
• Savings and Investment (gross domestic savings and investment as percentage of GDP)
• Stock Market Liquidity (value traded as a percentage of GDP)
• Macroeconomic Stability (real interest rate and current inflation)
• Private Capital Flows (foreign direct investment and net Capital flow as a percentage of GDP)
• Institutional Quality (international Country Risk Guide Risk Rating System)
• Secondary School Enrolment (secondary school enrolment as a percept of total population )
• Domestic credit provided by financial sector (% of GDP)
 Indicators of Stock Market Development
 Financial liberalization promotes transparency and accountability, reducing adverse selection and moral
hazard. These improvements tend to reduce the cost of borrowing in stock markets which eventually increase
the liquidity and the size of the stock market.
 Stock market development has been central to the domestic financial liberalization programs of most
emerging markets.
 Apart from their role in domestic financial liberalization, the stock markets have also been very important in
recent years as a major channel for foreign capital flows to emerging economies. External finance and new
equity issues to finance long term investment.

Certain measures that indicate the state of stock market development:

1. Number of listed companies
2. Market Capitalization (% of GDP) [Capitalization ratio and the number of listed companies to measure the size]
3. Value Traded (% of GDP) [Market depth i.e., value of stock transactions relative to the size of the economy. Measures trading
relative to economic activity]
4. Turnover Ratio (%) [Market Liquidity i.e., activity of the stock market relative to its size. High turnover ratio implies low transaction
and consequently high efficiency]
5. Turnover Velocity [The turnover velocity is the ratio between the Electronic Order Book (EOB) turnover of domestic shares and their
market capitalization]
The
Conceptual
Understandings
 Portfolio Management as a Process
 Portfolio management is an integrated set of steps undertaken in a consistent manner
to create and maintain appropriate combination of investment assets.
 Planning Step Investment Constraints
 Investor’s Objectives and Constraints Liquidity
 Investor Risk tolerance Time Horizon
 Investment Policy Statement (IPS) Tax Concerns
Legal and Regulatory Factors
 Forming Capital Market Expectations Economic Policy Uncertainty
 Creating Strategic Asset Allocation Unique External Shocks
 Execution Step
 Portfolio Construction and Revision Risk management:
 Identifying Risk factors
 Portfolio Optimization  Quantification of exposure to risk
 Tactical Asset Allocation  Map various risks into risk estimation calculation
 Identify overall risk exposure
 The Feedback Step  Continuous measurement of exposure
 Monitoring and Rebalancing  Adjustment to exposure to agreed risk exposure limits
 Alteration based on new information
 Performance Evaluation  360 degree risk management
 Risk Monitoring
 Glimpse of Portfolio Risk Universe
Systematic Risk: Influences large number of assets, difficult to diversify
Unsystematic risk: Influences small number of assets, manageable
Credit and Default Risk: Associated with Bonds and Stocks
Policy Uncertainty Risk: Regulatory and Policy interventions
Geo-political Risk: Related to policies and internal situation of a region or country
Foreign Exchange Risk: due to financial policies of various countries
Interest Rate Risk: Related to Fed policy
Market Risk: Related to market volatility
Headline Risk: Avoid Bad Publicity
Manager Performance Risk
Concentration Risk
Style drift Risk
Fraud Risk
 “The Benefits of Diversification.”

Source: https://www.callan.com/periodic-table-20/
Session 2
Motivation for Multifactor Pricing Model
• The goal of risk analysis is not only to minimize risk but also search for a
methodology to properly weigh risk against return.
• The investor chooses the exact number and identifies the risk factors which affect
the expected value of stock return.
• The basic motivation for the search of alternative multifactor models is from the
limitations of the CAPM.
• In case of CAPM the primary practical problem associated is to estimate the market
portfolio accurately, a process that first requires identifying the relevant investment
universe.
• Other mainstream asset pricing models like Intertemporal Capital Asset Pricing
Model (ICAPM) (Merton, 1973) which suggests that an asset’s risk premium
depends on the prospects of investing for the future with an adverse change in the
future investment opportunity set, also fails to support adequate number of factors.
Asset Pricing Models
Asset Pricing Models
 Asset Pricing Models
Multiple-factor models have many advantages:
 It offers a more thorough breakdown of risk and, therefore, a more complete analysis of risk exposure than other
methods, such as single-factor approaches.
 Because of the economic logic is used in their development, multi factor models are not limited by purely historical
analysis.
 As the economy and characteristics of individual issuers change, multi factor models adapt to reflect changing asset
characteristics.
 They can isolate the impact of individual factors, providing segmented analysis
 for better informed investment decisions.
 Lastly, multi factor models are realistic, tractable, and understandable to investors.

Nevertheless, multi factor models have their limitations.

• They predict much, but not all, of portfolio risk. In addition, they predict risk, not return; investors must choose the
investment strategies themselves.
• The major limitation of a multifactor model is that it is developed with little theoretical guidance as to the true nature of
the risk-return relationship and sometimes considered as an empirical exercise. In this sense, developing a useful factor
model is as much an art form as it is a theoretical exercise.
• The theory of multi-factor models does not define which factors and how many factors should be considered; therefore,
this issue remains to be determined by the researcher.
 Types of Factor Models
• Macro Economic Factors:
• Macro economic factors are those exogenous factors that determine asset prices and identifiable within
macroeconomic forces (e.g., inflation, growth rage of GDP, interest rate, unemployment etc). Macroeconomic factor
models use observable economic time series, such as inflation and interest rates, as measures of the pervasive shocks
to security returns.
• A security’s linear sensitivities to the factors are called the factor betas of the security.
Fama and French (1993) multi-factor model
The three factors are: the market return ( Rm -RF ) , the return on a portfolio of small stocks minus the return on a
portfolio of big stocks ( SMB ), and the return on a portfolio with a high ratio of book value to market value minus the
return on a portfolio with a low ratio ( HML ).
The three factors are: the market return ( Rm - Rf ) , the return on a portfolio of small stocks minus the return on a
portfolio of big stocks (SMB ), and the return on a portfolio with a high ratio of book value to market value minus the
return on a portfolio with a low ratio ( HML ).
Carhart (1997) Four Factor Model
Carhart (1997) show that the addition of a momentum factor (WML) adds explanatory power to the Fama-French
three-factor model (1993) , both in terms of explaining comovements and mean returns.
The Liquidity based Factor Model
• The liquidity factor has been constructed by forming four portfolios from the
intersection of two SZ-based and two LIQ-based portfolios i.e., S/HL (small-
high liquid), S/LL (small-low liquid), B/HL (big-high liquid), B/LL (big low
liquid). The liquidity factor (LQF) is the difference between the simple
average of returns from the two low liquid portfolios and the simple average
of returns from the two high liquid portfolios.
Performance Attribution
Procedures

• A common attribution system

decomposes performance into three
components:
• Allocation choices across broad
asset classes
• Industry or sector choice within
each market
• Security choice within each sector
Performance Attribution Procedures

• Set up a ‘Benchmark’ or ‘Bogey’

portfolio:
• Select a benchmark index
portfolio for each asset
class
• Choose weights based on
market expectations
• Choose a portfolio of
securities within each class
by security analysis
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 Calculate the return on the Explain the difference in return

Performance ‘Bogey’ and on the managed

portfolio
based on component weights
or selection

Attribution
Procedures

Summarize the performance

differences into appropriate
categories
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 Formulas for Attribution

Performance attribution of i th asset class.

Where B is the bogey portfolio and p is Enclosed area indicates total rate of return.
the managed portfolio
Superior performance is achieved by:
• Overweighting assets in markets that perform well
• Underweighting assets in poorly performing markets
Performance Attribution: Example
Performance of the managed portfolio
Bogey Performance and
Bogey Performance and Excess Return:
Excess Return: Return of Index during
Component Benchmark Weight Month (%)
Equity (S&P 500) 0.60 5.81

Bonds (Barclays Aggregate Index) 0.30 1.45

Cash (money market) 0.10 0.48

Bogey= (0.60 × 5.81) + (0.30 ×

1.45) + (0.10 × 0.48) = 3.97%

Return of managed portfolio 5.37%

-Return of bogey portfolio 3.97%

Excess return of managed

1.37%
portfolio
Performance Attribution: Example
A. Contribution of Asset Allocation to Performance

(5) =
(1) (2) (3) (4)
(3)×(4)
Actual
Benchmark Active or Contribution to
Weight Index Return
Market Weight in Excess Performance
in (%)
Market Weight (%)
Market

Equity 0.70 0.60 0.10 5.81 0.5810

Fixed-income 0.07 0.30 -0.23 1.45 -0.3335

Cash 0.23 0.10 0.13 0.48 0.0624

Contribution of
0.3099
asset allocation
Performance Attribution: Example
B. Contribution of Selection to Total Performance

(1) (2) (3) (4) (5) = (3)×(4)

Portfolio Index Excess

Portfolio Contribution
Market Performance Performance Performance
Weight (%)
(%) (%) (%)
Equity 7.28 5.81 1.47 0.70 1.03

Fixed-income 1.89 1.45 0.44 0.07 0.03

Contribution
of selection
1.06
within
markets
Performance Attribution Summary
Contribution (basis
points)

1. Asset allocation 31
2. Selection

a. Equity excess return (basis points)

i. Sector allocation 129

ii. Security selection 18
147 × 0.70 (portfolio weight)= 102.9
b. Fixed-income excess return 44 × 0.07 (portfolio weight)= 3.1
Total excess return of portfolio 137.0

• Good performance (a positive contribution) derives from overweighting high-performing sectors

• Good performance also derives from underweighting poorly performing sectors