PORTFOLIO MANAGEMENT

Portfolio Management

Portfolio Management

Question 1

(A)

In 1952 The Journal of Finance published an article titled “Portfolio Selection” authored by Harry Markowitz. The ideas introduced in this article have come to form the foundations of what is now popularly referred to as Modern Portfolio Theory (MPT). Initially, MPT generated relatively little interest, but with time, the financial community strongly adopted the thesis, and now 50 years later, financial models based on those very same principles are constantly being reinvented to incorporate all the new findings that result from that seminal work. An important outcome of the research generated due to the ideas formalized in MPT is that today's investment professionals and investors are very different from those 50 years ago. Not only are they more financially sophisticated, but they are armed with many more tools and concepts (Stein, 1996, 429).

This allows both investment professionals to better serve the needs of their clients, and investors to monitor and evaluate the performance of their investments. Though widely applicable, MPT has had the most influence in the practice of portfolio management. In its simplest form, MPT provides a framework to construct and select portfolios based on the expected performance of the investments and the risk appetite of the investor. MPT, also commonly referred to as mean-variance analysis, introduced a whole new terminology which now has become the norm in the area of investment management. Therefore, on the 50th anniversary of the birth of MPT it may be instructive for investment professionals to revisit the building blocks of the profession. This will serve as an overview of the theory and may enable us to appreciate some of the finer nuances of MPT which we now take for granted. In the process we will also gain an understanding of the advent of modern portfolio management, i.e., where it came from and where it is going.

(B)

The ideas that we generate here are central to Modern Portfolio Theory, but they are easily understood, as we are dealing with only two risky assets. Let's begin by illustrating how the return on a portfolio is calculated. For any portfolio, return is calculated as a weighted average of returns. Thus, if we have a two asset portfolio, the return on the portfolio is calculated as the percentage of your wealth invested into Asset A multiplied by the return of Asset A plus the percentage of your wealth invested into Asset B multiplied by Asset B's return. For illustrative purposes, let's assume that we want to calculate the return on a portfolio that consists of a weighting of 40% in Fund A and 60% in Fund B. Let's assume that the return on Fund A is 8% and the return on Fund B is 15%. By substituting 40% for XA, 8% for the RA, 60% for XB and 15% for RB, we find the return on the portfolio to be 12.2%.

(C)

The efficient frontier was first defined by Heath (1992, 77) in his groundbreaking paper that launched portfolio ...