Portfolio Review and Remedial Options Actions: A Comprehensive Analysis

Constructing Portfolio Using Traynor-Black Model

Constructing a portfolio using the Traynor-Black Model is a strategic endeavour that aims to optimize the allocation of assets within an investment portfolio. This model, developed by Jack Treynor and Fischer Black, places a strong emphasis on assessing and balancing the systematic and unsystematic risks associated with various assets. By determining the ideal mixture of passively and actively managed stocks, investors can work to achieve a more efficient and balanced portfolio, ultimately seeking to strike the right balance between risk and return.

• Advantages and Disadvantages of Using the Markowitz Optimization Model & Traynor-Black Model

The advantages of incorporating portfolio planning with the efficient frontier, often harnessed through the "Markowitz Optimization Model," become evident when evaluating the relationship between risk and return. The efficient frontier, graphically represented as an arched line, juxtaposes the expected portfolio return on the "y" axis against the portfolio's standard deviation or risk on the "x" axis. This model, attributed to the renowned Harry Markowitz, often hailed as the "father of portfolio management" (Wallengren & Sigurdson, 2017), forms the basis of Modern Portfolio Theory.

This theory is a comprehensive approach to portfolio investment, encompassing a thorough examination of the broader market and the economy. It endeavours to elucidate how each stock within a portfolio interrelates with others, all while striving to minimize risk while maximizing returns. The Modern Portfolio Theory accounts for the returns of assets along with their systematic and unsystematic risk, as aptly noted by Mangram in 2013. By considering both return and risk in the context of a portfolio, it constructs a line that delineates all available portfolio options, commonly referred to as the efficient frontier. To attain optimal risk-return ratios, a portfolio should ideally gravitate toward or closely align with this efficient frontier. Portfolios falling below this threshold typically entail an excessive amount of risk for the expected return, as described by Investopedia (2017).

The "Treynor-Black Model," conceived by Jack Treynor and Fischer Black, is an asset allocation model designed to determine the optimal blend of passively and actively managed stocks within an investment portfolio. Once the optimal allocation of stocks is established, the model predominantly focuses on the systematic and unsystematic risk associated with these stocks, as outlined by Gerber, Markowitz, and Pujara in 2015.

Nevertheless, the drawback of the Treynor-Black Model lies in its relatively limited emphasis on the "Beta" of stocks and their unsystematic risk. Stocks with higher unsystematic risk are given less weight in this model, potentially leading to a portfolio comprising low-return, low-risk stocks when compared to those offering higher returns and greater risk, as noted by Investopedia (2017).

Critically Analyse Portfolios’ Risk-Return Profiles

The analysis of a portfolio's risk-return profile hinges on the appropriate model, considering 10-year performance data and abnormal returns from the previous year. The Treynor-Black Model is a comprehensive approach that assesses active investment strategies and asset allocation within the framework of the market portfolio. However, it relies on specific underlying assumptions to remain valid. One such assumption is the active involvement of security analysts in managing the organization, delving deep into a relatively small number of stocks within the vast universe of securities (Brown, 2015).

Treynor's measure provides a basis for comparing portfolios, primarily focusing on the alpha-to-beta ratio. In the case of the FTSE security portfolio, the alpha is forecasted as 0, while the risk premium is -0.214, and the standard deviation of the portfolio stock is 0.1425. Conversely, for the optimal risky portfolios, the premium, standard deviation, and Sharpe's ratio values change. These alterations occur in response to shifts in the stock parameters, such as a beta of 1, a risk premium of -0.021, and a standard deviation of 0.143, along with a -0.150 (insert unit) (reference).

Sharpe's approach involves regressing portfolio returns on indices representing a broad spectrum of asset classes. Consequently, the regression coefficient of each index serves as an indicator of the fund's implicit allocation. Given the constraints on these funds, the regression coefficients are typically constrained to be zero or positive, with a total sum of 100 to achieve a full asset allocation (Imai, Van Deventer, & Mesler, 2013). An alpha value of zero implies that deviating from a passive strategy would not add value, and the performance of the index portfolio would predominantly rely on the managers' decision-making. However, it's important to recognize that this scenario is quite rare. Consequently, assessing the impact of one security purchase over another necessitates the utilization of Markowitz models, which consider risk and return factors and employ portfolio diversification to mitigate the impact of risk through diversification (Yang & Yeh, 2015).

• Review Portfolio Performances

Evaluating portfolio performance and implementing effective rebalancing as part of remedial actions involves the practical application of the Markowitz model. This model empowers investors to make informed decisions about the trade-off between risks and returns, spanning from minimal to potentially infinite levels of risk. In the context of a 100FTSE stock portfolio, this trade-off is particularly evident (Guerard, 2016). Calculating the mean return for the portfolio stock is a crucial step, which can be determined using the respective portfolio weights (refer to the FTSE 100 calculation).

Utilizing the attached values, the computation of expected portfolio returns involves the application of these weights. For example, if we have weights (wa, wb, etc.) and corresponding returns (Ba, Bb, etc.), the expected portfolio return can be calculated as follows: Expected Return = wa * Ba + wb * Bb + ... + wn * Bn. In practice, this can be demonstrated as follows: Expected Return = 125% * 0.124 + (-25%) * 0.024 = 0.155 - 0.006 = 0.149.

Assessing the risky nature of the portfolio entails closely examining its beta, a measure of its risk about the broader market. The implication of this beta value is critical for investors in gauging the overall risk of the portfolio. The optimal combination of an active portfolio with a passive one stems from creating an optimal risky portfolio, often composed of two risky assets. This construction involves applying Sharpe's ratio, as articulated by Brigham and Ehrhardt (2013).

In this context, the active portfolio perfectly correlates with the index, indicating the need for diversification. Mixing the active portfolio with the index can potentially yield higher returns and is a strategy often pursued by investors. The success of active management, the contribution of the active portfolio as measured by the Sharpe ratio, and the risky portfolio are compared to the index portfolio (Brown, 2015). Consequently, in assessing the FTSE 100 portfolio stock, it becomes evident that diversification remains the primary available strategy to mitigate the impact of market risk in this scenario.  

• Analysis of the 30 Stocks Portfolio (2016)

The performance of the stock portfolio, in connection with the FTSE market index, unveils important insights. Notably, the portfolio's beta values range from 0.1 to 0.8, indicating varying levels of risk within the individual portfolio components. However, these values tend to decrease when the portfolio is diversified, a trend evident in the portfolio's standard deviation combinations.

When assessing the individual stocks within the portfolio based on their alpha, beta, risk premium, and standard deviation parameters, an interesting pattern emerges. Approximately 10 % of the stocks display lower levels of risk, while roughly 40 % fall into the category of being moderately risky. In contrast, a significant portion, approximately 50 %, of the stocks are categorized as highly risky. This distribution underscores the importance of diversification as a critical strategy for mitigating the impact of these risks and achieving a more balanced and stable portfolio.

Conclusion