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In: Finance

Performance evaluation of a portfolio is difficult. What challenges can investment managers face and what recommendations...

Performance evaluation of a portfolio is difficult. What challenges can investment managers face and what recommendations would you make in effort to meet these challenges?

Portfolio insurance has always had an intuitive appeal to investors, particularly if the cost isn't too great. What are some advantages and disadvantages that investment managers should be aware of?

Expert Solution

Performance evaluation of a portfolio is difficult.

Portfolio insurance has always had an intuitive appeal to investors.

The securities have a risk and return relationship. An investor wants to maximise the returns and minimise the risk.

A portfolio or a combination of securities spreads the risk over the securities.

We have to diversify our investments across various industries.

Performance evaluation of a portfolio helps the investor to know the return on the investments.

He evaluates the returns and decides if he wants to reinvest some securities to minimise the risks.

Convention method:

We compare the performance of the investment portfolio with the market index.

The level of risk of the investment portfolio does not match with the market index.

The investment portfolio can be more or less risky as compared with the benchmark.

Risk adjusted methods:

The Sharpe ratio calculates the risk premium of the investment portfolio per unit of total risk of the portfolio.

Risk Premium = Return of the portfolio - risk-free rate of interest

The total risk is the standard deviation of returns of the portfolio.

The Treynor ratio calculates the risk premium per unit of systematic risk.

It calculates the systematic risk of the portfolio as the risk parameter.

The systematic risk cannot be eliminated through diversification.

It is calculated by beta.

Beta is the slope of the regression of the returns of the portfolio to the market portfolio.

Jensen’s Alpha is based on Capital Asset Pricing Model (CAPM).

Alpha is the amount by which the average return of the portfolio deviates from the expected return.

If alpha is greater than zero, the rate of return earned by the portfolio is greater than the expected return of the portfolio.

Modigliani and Modigliani measure (M2) gives a risk-adjusted measure of performance.

The portfolio is adjusted so that it has the same total risk as the market portfolio.

The adjusted portfolio is a combination of the managed portfolio and risk-free asset.

The risk of the adjusted portfolio is the weight on the managed portfolio * the standard deviation of the managed portfolio.

However it is very difficult to understand and apply these methods and they can give different results also.

We can be insured against losses from vehicle accident, fire and theft.

Insurance companies do not insure our portfolio against stock market crashes.

Portfolio insurance is an investment hedging strategy that helps us to avoid losses if the market falls.

We buy stocks in the cash market and put options which means right to sell stocks at a decided strike price in the futures and options market.

When there is a rise in the stock price, we gain and if the price falls, we can exercise our put option to sell the stocks at the strike price, therefore we limit our losses.

Portfolio insurance also comes at a premium just like any other insurance policy

It is the price investors pay to buy a put option.

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