A REPORT

ON
PORTFOLIO CONSTRUCTION
&
PERFORMANCE EVALUATION










Department of Finance
University of Dhaka




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Efficient Portfolio Construction
&
Performance Evaluation

Prepared for

Prepared By



Date of Submission: 9
th
February 2014



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Table of Contents
Executive Summary------------------------------------------ 4
Introduction----------------------------------------------------5-6
Background Theory--------------------------------------------7-8
Portfolio Construction Steps--------------------------------9-22
Performance Evaluation-------------------------------------23-26
Conclusion-------------------------------------------------------27





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Executive Summary
Knowledge of constructing an efficient portfolio is very important to learn as a student of
finance. Efficient portfolio construction is not only needed by a manager who works in a
brokerage firm or investment institution but also any individual investor who actively trades in
the financial market. While there are many techniques to go for an efficient set, I think the excel
solution is quite easy to understand. The data used for analysis collected from Dhaka stock
exchange. The original trade data is then summarized to know about the risk and return pattern
to construct a portfolio consisting 10 assets.
First of all the theory behind the construction is described and then I showed the step by step
process of choosing assets in six different scenarios: maximizing excess return per unit of risk
when short sell is not allowed, minimizing risk when short sale not allowed, maximizing excess
return per unit of risk when short sale is allowed, minimizing risk when short sale is allowed,
minimizing risk when short sale is not allowed, minimizing risk for a given return when short
sale is allowed.

I have chosen different asset classes so that the unsystematic risk can be diversified away. My
report consists of 10 assets from 5 different asset classes. The entire report is a fundamental
analysis of asset valuation. This analysis uses very simple solver solution so that its not free
from flaws, but by completing this report I have got a good idea about the overall concept of
selecting risky assets in a portfolio.



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INTRODUCTION











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Origin of the report
This report was assigned to me by our honorable Portfolio managements course teachers Mrs. Pallabi Siddiqua
and Mr. Sajib Hossain as a key tool of completing my courses overall agenda.
Objective of the Report
The following objectives are fulfilled while making this report:
Familiarity with the stock market
Overlooking the price changes, volume information and overall trading situation of DSE
Knowing and understanding the systems and major concerns while selecting a bunch of asset classes and
including them to the portfolio
Looking at the overall industry conditions and observing some selecting companies which will be a
pathway for future analysis.
Determining efficient portfolio under different situations.
Methodology
The study mainly focuses on Efficient Portfolio construction. This study is mainly based on primary data
collected from the DSE as well as secondary data collected from different published articles, books, websites
and journals. The basic method that is used to analyze the data is use of solver function for maximizing theta
and minimizing risk.
Limitations
Constructing efficient portfolio is not an easy task to conduct. Several software exists to accurately estimate the
risk and return pattern of a portfolio. While doing my simple analysis I used Microsoft Excel and its solver
function to make my estimation which is subject to several limitations. I hope this initial knowledge will help
me to do better in the future.





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Background Theory












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There are several ways of doing technical analysis. This report uses the simple technique of doing such analysis
using Microsoft Excel spreadsheet software. I have collected trading data from Dhaka Stock Exchange of ten
assets from 5 different asset classes. I showed portfolio construction in six different scenarios. My analysis is a
simple suggestion for asset selection with within the selected asset portfolio.

Efficient Portfolio is a portfolio offering higher return in a given risk level or lower risk at a given Return level.
A Graph is Shown Below where we can see a curve. The point Minimum Variance Portfolio is a portfolio with
lowest risk. Above part of Minimum Variance Portfolio is Called Efficient Frontier. Rf is the risk free rate. A
line starting from the origin at risk free rate tends upward by touching the efficient frontier is known as CML
(Capital market line). The point of tangency is known as optimum or efficient portfolio.


Our main objective in this report is to find the efficient portfolio with a portfolio of 10 securities which are of A
category listed in DSE before 2008. We are working on Monthly data.
The CML equation can be written as maximizing the objective function:

Subject to:
( W
t
) =1 when short sell is allowed. An additional constraint w
i
0 when short sell is not
allowed.



Efficient Portfolio



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Construction Steps of an Efficient
Portfolio




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Steps followed in determining efficient portfolio:
I have followed the following steps for constructing efficient portfolio-

Step-1: Selection of Listed companies:
There are numerous number of companies listed in DSE and CSE. I have selected 10 listed companies of DSE.
As I am using data of five years I have selected companies which are listed before 2008. My selected companies
are
Asset Class Company Category

Pharmaceuticals
Industry
Squire Pharma A
Beximco pharma A
ACI LTD A
Cement Industry Heidelberg cement A
Meghna cement A
Banking Sector Dhaka Bank A
Dutch Bangla Bank A
Food&
beverages
industry
Bangas A
Fu wang A
Insurance Sector Meghna life insurance A

Step-2: Collecting Price related Data:
I used monthly closing price of each companies from January2008 to December 2012. Some companies have
split their share recently. I multiplied the price with split ratio and assumed the situation to be pre split situation.
All the companies have paid dividend throughout the year. I adjusted the dividend with price assuming the
market to be perfect. As per perfect market theory price will increase by the amount of dividend at declaration
date and reduce by the amount of dividend at record date. As there was no information available about the
record date I assumed declaration date and record date are at the same month and adjusted the price in the



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month of declaration date. When declaration date is within last seven days of the month I assumed the record
date is in next month and adjusted the price in the next month.

Price Data are categorized in excel sheet like this:



Then I placed the Cash dividend related data in the excel sheet. Not every company declares dividend in every
month. I have collected dividend related information from DSE and place the dividend per share in a separate
sheet:




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Next I placed stock dividend related data in a separate excel sheet. Like cash dividend stock dividends
data are collected from DSE and placed to the companies according to their declaration month.


I placed right issuance related numerical information next. Only Fu wang issued 100% right
share in 2010 at 10 taka offer price which is shown in the very two next excel sheets.


Some stock gets spilled during 2010 and 2011. For calculating return this information is mandatory.





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Step-3: Determination of return:
In the next step I calculated return for each month. Thus I got 59 returns for each company. We know return
R = [Price of T
1
*(1+stock dividend)*(1+right issue)*stock splits+ cash dividend
price of T
-1
-Right offer Price]/price of T
-1
Or the return can be calculated as Cash dividend+ Capital Gain
First I calculated Dividend yield which is Dividend per share /price per share

Next I calculated the capital gain of each companys stock:




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Total return is calculated by adding both dividend yield and Capital gain:

Step-4 Calculating Mean return:
To calculate mean return first I transposed the return series by copying the whole series and pasting it
special n transposed format, and I have got all rows became columns and columns get to rows like this :




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Mean return is calculated from transposed data:

Step-5 Calculating Risk Free Return
Then I calculated Risk free rate for the 5 year period. I calculated that by multiplying every years Bangladesh
Bank T-bill Rate by 12 and dividing by 12. After that adding the rates and dividing by 59. I multiplied the rate
of 2008 with 11 because as we started from 2008 we cant get the return for January.




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Step-6 Calculating Excess Return:
Then I calculated Excess return by subtracting risk free return from Mean return. The equation is-
Excess Return = Rm-Rf


Step-7 Calculating Variance & Covariance matrix
Then I calculated Variance and covariance of each company using VAR and COVAR functions:







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Step-8 Calculating Excess portfolio return
Then I Calculated Excess portfolio returns by multiplying each excess return with respective weight and adding
all:


Step-8 Calculating portfolio Variance & Standard Deviation:
Then I calculated the portfolio variance p using the theory of matrix .We know in variance we need to
multiply individual variance covariance with weight square. So, my multiplication was like following-


p =[W1,W2,W3,W4,..,W10]




1,12,13,,110
12,2, 23,,210
13, 23, 3,,310
. .
. .
. .
. .
. .
. .
110, 210 310,.., 10
W1
W2
W3
W4
W5
W6
W7
W8
W9
W10








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Portfolio Standard Deviation:
We know portfolio standard deviation p is the square root of standard deviation. Thats why we calculated the
square root of the portfolio standard deviation.




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Step-8 Calculating Theta
Next I calculated the theta. We know-
= (Rm Rf)/ p
Excess Return = Rm Rf
So, = Excess Return / p

Step-10 Calculating Portfolio Return
Then I calculated portfolio return. It is the sum of weighted average of mean return of each company.



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Step-10 Using Solver ad-ins:
Finally I used the solver function to find the optimum weight for following six situations. The situations are-
1. Maximizing Theta allowing short sell
2. Maximizing Theta by not allowing short sell
3. Minimizing Risk (Standard Deviation) by allowing short sell
4. Minimizing Risk (Standard Deviation) by not allowing short sell
5. Minimizing Risk (Standard Deviation) by allowing short sell for a given return
6. Minimizing Risk (Standard Deviation) by not allowing short sell for a given return
These situations are described below-


Maximizing Theta allowing short sell:
Allowing short sell means the investor can sell certain security of others in an expectation that the price will
go down in near future, and then the investor will buy back the security and return to the real owner. In first
situation I allowed short sale. The only constraint was-
1.Wi = 1



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My findings are I have to short sell excluding only squire pharma and Meghna lifes stock to maximize my
Theta
Maximizing Theta by not allowing short sell:
In this situation I maximized theta by not allowing short sell. In this situations the constrains are-
1. Wi = 1
2. Wi >= 0


My findings are I dont have to invest in

Beximco Pharma
Meghna Cement
ACI pharma
Heidelbarg Cement
Dhaka Bank Dutch Bangla Bank



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Bangas
Fuwang

Minimizing Risk (Standard Deviation) by not allowing short sell:
Then I tried to find the weights in which risk will be minimal. I have not allowed short sell. Constraints are-
1. Wi = 1
2. Wi >= 0
My findings are I got minimum standard deviation if I invest in only
Square Pharma
Bangas
Dhaka Bank
Minimizing Risk (Standard Deviation) by allowing short sell:
Then I allowed short sell to get the weight at minimum risk. The only constraint is
1. Wi = 1
Then I have to short sell the stocks of Squire Pharma.
Minimizing Risk (Standard Deviation) by not allowing short sell for a given return:
Then I considered a situation in which I can earn a monthly return of 3.5% and my risk will be minimal. I have
also not allowed short sell. My constraints are-
1. Wi = 1
2. Wi >= 0
My finding is I should invest in below portion to minimize my Standard Deviation
Squarepharma Beximco
pharma
ACI
LTD
heidelbarg
cement
Meghna
cement
Dhaka
Bank
Dutch
Bangla
Bank
Bangas Fu
wang
Meghna
life
insurance
0.088578396 0.023921604 0.1125 0.1125 0.1125 0.1125 0.1125 0.1125 0.1125 0.1

Minimizing Risk (Standard Deviation) by allowing short sell for a given return:
Then I considered a situation in which I can earn a monthly return of 3.5% and my risk will be minimal.. I have
also allowed short sell. My only constraint is-
1. Wi = 1
My finding is I should short sell Square pharmaceuticals stock to earn a monthly return of at least 3.5.



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Portfolio Performance Evaluation












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Measuring of portfolio performance has become an essential topic in the financial markets for the portfolio
managers, investors and almost all that have something to do in the field of finance and it plays a very important
role in the financial market almost all around the world. Earlier then 1950, portfolio managers and investors
measured the portfolio performance almost on the rate of return basis. During that time, they knew that risk was
a very important variable in determining investment success but they had no simple or clear way of measure it.
In 1952 Markowitz created the idea of Modern Portfolio Theory and proposed that investors expected to be
compensated for additional risk and provided a framework for measuring risk. In early 1960, after the
development of portfolio theory and capital asset pricing model in subsequence years, risk was included in the
evaluation process. The capital asset pricing model of William Sharpe and John Litner marks the birth of asset
pricing theory. The attraction of capital asset pricing model was that it offered power predictions about how to
measure risk and the relation between expected return and risk. Treynor (1965) was the first researcher
developing a composite measure of portfolio performance. He measured portfolio risk with beta and calculated
portfolio market risk premium and later on in 1966 Sharpe developed a composite index which is similar to the
Treynor measure, the only difference being the use of standard deviation instead of beta. In 1967 Sharpe index
evaluated funds performance based on both rate of return and diversification but for a completely diversified
portfolio Treynor and Sharpe indices would give identical ranking. Jensen in 1968, on the other hand, attempted
to construct a measure based on the security market line and he showed the difference between the expected rate
of return of the portfolio and expected return of a benchmark portfolio that would be positioned on the security
market line.According to Prof. K. Spremann, Portfolio measurement has not only the goal to inform about the
quality of a portfolio performance but and thats even more important to decompose and analyze the success
factors of a portfolio.

Systems of Evaluation
Different composite measures of portfolio performance evaluation are used in real world. Some are given below
along with the analysis of performance of portfolio comprising:
Squire Pharma
Beximco pharma
ACI LTD
Heidelberg cement
Meghna cement
Dhaka Bank
Dutch Bangla Bank
Bangas
Fu wang
Meghna life insurance
Sharpe ratio:



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The Sharpe ratio (also known as the Sharpe index, the Sharpe measure) is a way to examine the performance of
an investment by adjusting for its risk. The ratio measures the excess return (or risk premium) per unit of
deviation in an investment asset or a trading strategy, typically referred to as risk (and is a deviation risk
measure), named after William Forsyth Sharpe.
The Sharpe ratio has as its principal advantage that it is directly computable from any observed series of returns
without need for additional information surrounding the source of profitability.
Ratio: (Rp-Rf)/p
My portfolio Sharpe ratio is -5.43329068 whereas market Sharpe ratio is -0.475197674meaning that
market ratio is in bad situation than my portfolio performance excess return over risk free rate for per
unit of risk. Though is it hard to identify whether portfolio performance outperforms with individual
Sharpe ratio.

Treynor ratio:
Treynor ratio (Treynor measure), named after Jack L. Treynor, is a measurement of the returns earned in
excess of that which could have been earned on an investment that has no diversifiable risk (e.g., Treasury Bills
or a completely diversified portfolio), per each unit of market risk assumed.
The Treynor ratio relates excess return over the risk-free rate to the additional risk taken; however, systematic
risk is used instead of total risk.The higher the Treynor ratio, the better the performance of the portfolio under
analysis.
Ratio: (Rp-Rf)/
Limitations
Like the Sharpe ratio, the Treynor ratio (T) does not quantify the value added, if any, of active portfolio
management. It is a ranking criterion only. The portfolio with a higher total risk is less diversified and therefore
has a higher unsystematic risk which is not priced in the market.

My portfolio Treynor ratio is 0.491708805whereas market treynor ratio is 0.133170985,
Which lower than the portfolio Traynor ratio. From this perspective portfolio performance is better than market
index return. More over treynor ratio only dealt with the systematic risk rather than total risk because
unsystematic risk is minimized by adding securities in the portfolio.
Jensens Alpha:



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A risk-adjusted performance measure that represents the average return on a portfolio over and above that
predicted by the capital asset pricing model (CAPM), given the portfolio's beta and the average market return.
This is the portfolio's alpha. In fact, the concept is sometimes referred to as "Jensen's alpha..

The basic idea is that to analyze the performance of an investment manager you must look not only at the overall
return of a portfolio, but also at the risk of that portfolio.

Here alpha value for this portfolio is. -0.106155707.

M-squared:
M squared is an extension of sharpe ratio in that it is also based in total risk. The idea behind M squared is to
create a mimicking portfolio by combining a risky portfolio (Pr) and risk free asset so that risk of the mimicking
portfolio becomes equal to the risk of the market portfolio. Because risk of the mimicking portfolio is equal to
the risk of the market , so difference between return of mimicking portfolio and market portfolio should be
equal . If return difference is positive, then mimicking portfolio outperforms the market portfolio and vice
versa.
M squared: (Rp-Rf)*(/ ) - (Rm-Rf)
Like Sharpe ratio , M squared gives similar ranking , If M squared is zero, then portfolio performances similar
to market and it M squared is positive that portfolio outperforms the market.
Information ratio:
The Information ratio is a measure of the risk-adjusted return of a financial security (or asset or portfolio). It is
also known as Appraisal ratio and is defined as expected active return divided by tracking error, where active
return is the difference between the return of the security and the return of a selected benchmark index, and
tracking error is the standard deviation of the active return.
The information ratio is often used to gauge the skill of managers of mutual funds, hedge funds, etc. In this
case, it measures the active return of the manager's portfolio divided by the amount of risk that the manager
takes relative to the benchmark.The higher the information ratio, the higher the active return of the portfolio,
given the amount of risk taken, and the better the manager. Top-quartile investment managers typically achieve
annualized information ratios of about one-half.
Generally, the information ratio compares the returns of the manager's portfolio with those of a benchmark such
as the yield on three-month Treasury bills or an equity index such as the S&P 500.
My information Ratio is calculated as -12.3341.





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Conclusion:
Construction of an efficient portfolio by considering various scenarios can be done with many sophisticated
techniques. But for a new learner it is quite a well approach to start with an Excel Solver function. Ten
companies that I have chosen have different risk and return pattern. I have chosen those companies to diversify
away its systematic risk. Different industries have different risk which is seen when I did all these analysis. It is
very possible to be not properly correct in estimation as I am an initial learner of that topic, so I hope my flaws
will be taken lightly and informative suggestions will be given to improve my future analytical skills