Alpha Risk Analyser - Risk Analysis in terms of Value versus Growth


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Alpha Investment Management
Alpha Risk Analyser
Risk Analysis in terms of Value versus Growth
Six months to June 30th 1999.
Combining in-house statistical factor Risk Model with bottom up Valuation. Incorporating the relationship of bond yield to valuation; interest rate sensitivity to portfolio risk; and explaining these relationships using Value versus Growth terminology.

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Alpha Risk Analyser - Risk Analysis in terms of Value versus Growth

  1. 1. Alpha Investment ManagementRisk Analysis in terms of Value versus GrowthSix months to June 30th 1999Alpha Risk Analyser
  2. 2. Alpha Investment Management 2Alpha Risk AnalyserAlpha Investment Management commenced managing its firstwholesale client mandate on the 22ndof December 1998. Frominception to June 30thof June 1999, the Investment team out-performed the ASX All Ordinaries Accumulation Index benchmark by6.14%.During this time bond yields increased from a low of 4.83% to a valueof 6.17% at the close of the 30thof June 1999.The diagram below shows the relationship between bond yields andthe portfolio structure over this period. The line chart shows the bondyield movement and each diagram illustrates the portfolio tilt in terms oflarge industrial, small industrial, value and growth. This tilt is in terms oftracking variance rather than portfolio weight for each of thesecategories. A more detailed description of this chart is given later in thisreport.Buy or Sell at the right timeBuy or Sell at the right time0.0%10.0%20.0%30.0%40.0%50.0%60.0%LargeGrowthSmallValue -10.0%0.0%10.0%20.0%30.0%40.0%LargeGrowt hSmallValue 0.0%10.0%20.0%30.0%40.0%50.0%60.0%LargeGrowt hSmallValue4 . 5 0 %5 . 0 0 %5 . 5 0 %6 . 0 0 %6 . 5 0 %2 2 / 1 2 / 9 8 2 1 / 0 1 / 9 9 2 0 / 0 2 / 9 9 2 2 / 0 3 / 9 9 2 1 / 0 4 / 9 9 2 1 / 0 5 / 9 9 2 0 / 0 6 / 9 9Dec/Jan April/May June -In the months proceeding December 1998, Alpha was managing a trialportfolio preparing for cash inflows that occurred in December 1998. Ascan be seen in December/January 1998, the portfolio was tiltedtowards a growth bias. In April/May, as the realisation of higher bondyields and therefore cost of capital was built into stock valuations. Theportfolio tilt was shifted to a neutral value and growth bias. In earlyJune, the portfolio moved to that of a value tilt. In April/May the portfolioalso had a strong resource tilt, with 58% of the tracking variancecoming from this resource exposure versus 22% in June 1999.
  3. 3. Alpha Investment Management 3Features on the Alpha Risk AnalyserThe Alpha Risk Analyser allows Alphas fund managers to thoroughlyunderstand all aspects of the portfolio. It concentrates on the overallrisk of the portfolio that is represented by the beta of the portfoliorelative to the benchmark. Not only does the analyser give a break-down of stocks’ contributions to the portfolio beta, it also highlights theimpact on tracking variance of stocks selected both within the portfolio,and those excluded from the portfolio – the active portfolio.The beta of the portfolio is the measure of the expected sensitivity tomovements in the benchmark – the overall risk of the portfolio. Thebeta explains most of the portfolios expected returns. However, unlessthe portfolio has an identical beta to the benchmark, a slight trackingdeviation will exist.The tracking deviation is analysed and attributed between differentstocks and sectors. The Portfolio Analyser will, for example, highlightthose stocks that make up most of the likely volatility in the excessreturns of the portfolio against the benchmark. In particular, thisvolatility may also be due to stocks excluded from the portfolio. Theinclusion or the exclusion of a stock in a portfolio is an active decision.[The following tables and charts represent the Alpha portfolio as at the 30thofJune 1999.]Overall break-down of tracking varianceIn analysing the tracking error of the portfolio against the benchmark,the tracking variance is used because, mathematically, only variancescan be added and subtracted. The chart below provides a quicksnapshot of the level of additional risk within the portfolio due tospecific and/or groups of stocks, which tend to move together – eitherin the same or opposite directions. This extra risk is referred to as the“sector effect”, and it is a more general in its application than justlooking at the sector exposures as defined by the ASX.-0.020% 0.000% 0.020% 0.040% 0.060%Stock specificeffectSector effectTotalThe remainder is the risk flowing from the respective stock weighting.This is a function of how heavily weighted in the portfolio the stock isrelative to the benchmark, and/or the volatility of the stock’s returnsrelative to the benchmark. The ratio between specific variance and the“sector effect” can be used as a measure of the level of “stockselection”. The expectation would be for a small fraction of the riskresulting from the “sector effect”.
  4. 4. Alpha Investment Management 4Stock contributions to tracking varianceThe following pie chart shows the contribution of each stock in theportfolio to tracking variance. The Risk Ranking spreadsheet can alsobe viewed to see the impact on tracking variance to stocks outside ofthe portfolio. For instance Coles Myer Limited was not in the portfolioyet represented 6.2% of the tracking variance.MBL12%WMC10%FHF8%MIM7%ARL6%HIH6%NBH5%EML4%RIO4%LEI3%BHP2%SGB2%CWO1%WSF1%WBC1%Remainder28%This chart is useful for visually identifying any large single stock orsector positions. Using the chart above it can be seen that as at the30thof June 1999 the portfolio had a well distributed contribution ofeach stock to tracking variance. It is important to look at a stocksweight relative to its contribution to portfolio risk. For example,Macquarie Bank Limited (MBL) is only 3.8% of the portfolio by weight,yet represents 12% of the portfolio risk.Slicing & DicingThe Slicing & Dicing approach to the portfolio segregates the trackingvariance of the portfolio into different risk perspectives. These riskperspectives may change over time and are a function of how Alphaviews the Australian sharemarket. The advantage of this technique isthat Alpha is not bound by a certain risk model or paradigm inanalysing the Australian sharemarket. For example, stocks could beclassified into a “bottom-up” risk classification, perhaps by balancesheet and earnings risk. However, at other times, style classificationmay be more important – growth versus value stocks. By usingdifferent views of risk, a fund manager is unlikely to be surprised by theemergence of a new clustering of stocks in the portfolio.The risk perspectives are based on two different techniques – aclassification technique and a factor analysis. The first classifies stocksby either inclusion or exclusion of certain groupings or sectors. Thereare five different views of the portfolio risk based on this method:♦ ASX sector break-down;♦ small and large-capitalised segmentation;♦ value and growth views;♦ property trust sectors; and♦ economic sectors. (Alpha sectors)
  5. 5. Alpha Investment Management 5The other method looks at the correlations of different stock returns. Iftwo stocks display similar return profiles, irrespective of their ASXsector classification, it might suggest that they are being affected bycertain common factors. By unravelling the correlations of all thestocks, a number of common factors can be identified as driving thereturns of stocksUsing a factor analysis of the correlations of all stocks, the Australianmarket is divided into industrial and resources stocks. These sectorgroupings are different to the ASX break-down, for example OricaLimited tends to display a return profile similar to resource stocks.Further, these sector groupings are not just based on inclusion andexclusion of the sectors. A loading or sensitivity for each stock iscalculated for each factor.An advantage of this factor analysis is that the stocks’ returns revealpotentially new groupings in the Australian market – which would notbe evident using a simple classification system based on a certain riskmodel or paradigm.Sector analysis – ASX break-downSector analysis compares the portfolio against the ASX sectorgroupings. The tracking variance is attributed between the differentsectors and graphed in the bar chart.If the beta is different to 1.0 then part of the tracking error will be due tothe higher or lower sensitivity of the portfolio against the index. Thisextra risk is classified as “market risk” because a higher or lower beta isequivalent to taking an increased or decreased position against themarket.-5.0% 0.0% 5.0% 10.0% 15.0%GOLDMETALSDIVRESENERGYUTILITIESDEVCONBLDMATALCTOBFOODHHCHEMICENGINPAPERRETAILTRANSPMEDIABANKSINSURTELECOMINVFINPROPTYHEALTHMISINDDIVINDTOUR
  6. 6. Alpha Investment Management 6Size analysisThe next view of the risk, divides the portfolio into large and smallcapitalisation stocks. These are further sub-divided into industrials andresources. Again, the tracking variance is attributable across thesedifferent sectors. The definition of a small capitalisation is a companyclassified in the ASX Small Ordinaries index.Risk Analysis By Size-10.0%0.0%10.0%20.0%30.0%40.0%50.0%60.0%70.0%LargeIndustrialsSmallIndustrialsLargeResourcesSmallResourcesAlpha sector categorisationThis style view classifies stocks into Alpha sectors. These Alphasectors have been created by classifying ASX sectors into sixcategories. These are: Resources, Domestic Cyclical / Consumer/Manufacturing, Infrastructure & Utilities, Communication/Content,Healthcare & Biotech , Tourism & Leisure , Property and Financials.-5.0%0.0%5.0%10.0%15.0%20.0%25.0%30.0%35.0%ResourcesInfrastructure&UtilitiesDomesticcyclical/Consumer/ManufacturingCommunication/ContentFinancePropertyHealthcare&BiotechTourism&Leisure
  7. 7. Alpha Investment Management 7The table below shows how the ASX sectors have been classified intothe Alpha sectors.ASX Sector Economic Sector ASX Sector Economic SectorGold Resources Retail Domestic Cyclical / Consumer/ ManufacturingMetals Resources Transport Domestic Cyclical / Consumer/ ManufacturingDiversified Resources Resources Media Communication/ContentEnergy Resources Banks & Finance FinancialInfrastructure Infrastructure & Utilities Insurance FinancialDevelopers &ContractorsDomestic Cyclical / Consumer/ ManufacturingTelecommunications Communication/ContentBuilding Materials Domestic Cyclical / Consumer/ ManufacturingInvestment &FinancialFinancialAlcohol & Tobacco Domestic Cyclical / Consumer/ ManufacturingProperty PropertyFood & Household Domestic Cyclical / Consumer/ ManufacturingHealthcare &BiotechHealthcare & BiotechChemicals Domestic Cyclical / Consumer/ ManufacturingMiscellaneousIndustrialsDomestic Cyclical / Consumer/ ManufacturingEngineering Domestic Cyclical / Consumer/ ManufacturingDiversifiedIndustrialsDomestic Cyclical / Consumer/ ManufacturingPaper & Packaging Domestic Cyclical / Consumer/ ManufacturingTourism & Leisure Tourism & LeisureValue & GrowthIndustrial stocks have been classified into a value, growth or othercategory. A “value” stock denotes a company that is selling on a lowprice relative to its expected earnings, cash flow or net tangible assets.Additionally, these companies tend to sell on persistently low PEmultiples – such as the banks.0.0%10.0%20.0%30.0%40.0%50.0%60.0%ValueIndustrialsGrowthIndustrialsOther
  8. 8. Alpha Investment Management 8The “growth” label is applied to those stocks that tend to sell on apersistently high share price relative to their current earnings, cash flowor net tangible assets. However, they are not just the opposite of avalue stock. Companies may exhibit high PE ratios because current orexpected earnings have collapsed. The distinguishing trait of a growthstock is its strong comparative advantage against its competitors –such as Coca-Cola Amatil.Definition of value & growth industrials.Value IndustrialsSectors:Alcohol & TobaccoChemicalsEngineeringBanks & FinanceStocks:Email - Diversified IndustrialMetal Manufactures - Diversified IndustrialWesfarmers - Diversified IndustrialGrowth IndustrialsSectors:MediaTelecommunicationsTourism & LeisureStocks:Lend Lease - Developers & ContractorsVilla World - Developers & ContractorsWestfield Holdings - Developers & ContractorsCoca-Cola - Food & Household GoodsBrambles - TransportMayne Nickless - TransportFH Faulding & Co - Healthcare & BiotechOrbital Engine Co - Miscellaneous Industrials
  9. 9. Alpha Investment Management 9Industrial portfolio plotThis chart brings together some of the results of the previous risktables.0.0%10.0%20.0%30.0%40.0%50.0%60.0%LargeGrowthSmallValueFor the industrial stocks in the portfolio, the style is mapped against thecapitalisation bias. For example, we analyse is most of the risk comingfrom value and smaller stocks? This analysis is particularly useful inassessing different economic environments.TermsBetaThis measures the expected average sensitivity to a movement in thebenchmark returns. A figure of 1.10 means that the portfolio is 10%more sensitive to a movement in the benchmark. For example, if thebenchmark rises by 10% the portfolio would, on average, rise by 11%.The beta of a portfolio accounts for most of its expected volatilityaround the index. The beta of the portfolio is derived from the individualstocks’ betas which, in turn, have been adjusted to better reflect thefuture.Tracking errorAlthough the beta explains most of the volatility of a portfolio aroundthe index, a slight residual error usually remains. This residual error iscaused by stock-specific events (say, an operational failure) or specificindustry events (eg, the removal of a fuel rebate) that is not related tothe overall market effects.The tracking error incorporates this residual error by measuring thestandard deviation of the excess returns of the portfolio. A figure of say,2%, suggests that the portfolio will display returns, in the majority ofinstances (65%), in a band of plus or minus 2% around the differencebetween the mean return of the portfolio and the benchmark.Tracking varianceThis figure is the tracking error squared. In analysing the tracking errorof the portfolio against the benchmark, the tracking variance is usedbecause mathematically only variance can be added and subtracted –not standard deviations (tracking error).