WILDCAT INVESTORS CLUB

December 03, 2012

ISSUE I

WI Research Newsletter
On-Campus Office:
ASTeCC 123

The Dynamic Weight Relative-Return Fund (DWRRF)

Using Sector ETFs to beat the S&P 500 In our experience as Investment Club managers, the largest challenge in seeking excess returns with a medium-term investment horizon was our capital constraints. With just a few thousand dollars in student investments, it is difficult to balance diversification and transaction costs. Because of this, WI decided to launch a paper-fund that seeks to minimize equity index tracking error but targeting alpha through a sector allocation strategy. Using a top-down approach with macroeconomic indicators, we are in process of rebalancing sector weightings within a typical S&P 500 allocation, DWRRF (dwarf). Thus far, there have been three rebalances. Energy, Consumer Discretionary, and Health Care are currently overweight. Technology, Consumer Staples, and Telecommunications are currently underweight. WI presents sector analysis that recommends adding to the allocation of a sector ETF in the portfolio and selling from another Telecom (IYZ) 0.0% to create a position-cost neuSP-500* Utilities (XLU) tral transaction. These presen3.4% DWRRF tations use a combination of Materials (XLB) 3.4% fundamental / technical ecoIndustrial (XLI) 10.0% nomic indicators and industry Cons. Staples (XLP) 8.9% analysis to make a case for Energy (XLE) 13.6% (against) leading (lagging) secCons. Disc. (XLY) 13.5% tors that comprise the S&P Healthcare (XLV) 15.0% 500.
Financial (XLF)
14.9%

E-mail:
wildcatinvetors@gmail.com

Meetings Fall 2012:

Wednesdays 5:00 B&E 309

Website:
www.wildcatinvestors.com
New members are always welcome. Contact us for more information on how to get involved. Performance Updates (Since Inception 10/25): DWRRF Portfolio [Gross] +0.66% S&P 500 Inde x +0.28%

Current Holdings (P/L): GTU (+0.99%) EWBC (-7.45%) F (+9.55%) DAR (+2.60%)

INSIDE THIS ISSUE:

Capturing the Carbon Trade Commodities Rolling Over Investors The Effect of BPs Criminal Settlement Building an Optimal Portfolio Is Market Efficiency a Paradox? Mathematical Dependence of Returns Art, the Newest Hard Asset Cons. Discretionary vs Cons. Staples
Alternative Assets

2 2-3 3 4 4 5 5-6 6

Technology (XLK) Our portfolios gross perfor17.2% mance is outperforming the 0% 5% 10% 15% 20% *https://www.spdrs.com/product/fund.seam?tic ker=spy S&P 500 Index by 38 basis points. We plan on maintaining this allocation throughout the rest of the year and will revisit our weightings when the club reconvenes in January. A synopsis of the analysis of the Consumer Discretionary and Consumer Staples trade can be seen on page 5.

Art, the Newest Hard Asset

BY WILLIAM SPENCE

Commodities retain value either by providing utility in some way or because of their scarcity. Oil and gold are two quintessential commodities that fit into this mold. Oil is valuable for its high energy content, while gold holds value simply because it is scarce and has been sought for millennia. In light of recent equity volatility, low government security rates, and extreme monetary intervention, art seems to be acting much like gold, providing a safe haven for investors leery of other asset classes. However, unlike gold, there is very little chance of previously unknown works being discovered; there is a limited supply of truly unique works...
The Scream By Edvard Munch.
(courtesy of www.edvard-munch.com)

Equities
In the Meetings...

Continued on page 5.

WI RESEARCH NEWSLETTER

Page 2

Alternative Assets
Exploring Trading Opportunities Across Multiple Markets

Capturing the Carbon Trade

BY DANIEL NALL

According to an article on redOrbit.com, global carb on emi ssion s a re expected to set record high s in 2012. Although dev eloped coun tries such as the US and those in the E U a re reducing emi ssi ons, the emerging economies of India and China con tinue to dri ve em ission s high er.

In an effort to curtail greenhouse gas emissions, specifically carbon dioxide, European Union launched its Emission Trading System (ETS) in 2005 as a part of the Kyoto Protocol. The system includes three phases of development in which a cap and trade infrastructure will be built throughout the EU. The first two phases (Phase I: 20052007, Phase II: 2008-2012) were characterized by National Allocation Programs (NAPs). The NAPs are decided by the EU countries to allocate fixed allowances to individual emitters on the basis of historical emissions, subject to approval by the European Commission. For Phase I, each country is allowed to auction up to 5% of their total allowances, which was raised to 10% in Phase II. Starting in 2013, as the emission cap becomes more stringent, auctions will amount to nearly 50% of the total European Union Allowances (EUAs) in an effort to reduce emissions by 20% of the 1990 levels. In addition, the total cap will be determined by the European Commission, and the auctions will be held by the individual member

states. There are skeptics and proponents of the cap and trade system, between which the effectiveness of the system thus far is debated. Emissions have fallen, more than expected, during Phase II, which was due in large part to the economic crisis. The EU has already begun selling Phase III permits, which sold at a discount to the prevailing spot market price. It is evident that there is still an excess supply of carbon allowances in the EU while the demand has yet to pick up. Heading into Phase III, EUAs are hitting all-time lows at 6/metric ton of CO2. According to Bloomberg's predicted aggregation of trading volume, the total carbon market value will fall in 2012 to 85 billion euros, 8% below last year's level. However, the allowances will slowly be-

come more scarce as the third phase gets in motion and the cap begins to shrink. Bloomberg predicts demand to increase as economic conditions improve, power generation (and therefore carbon emissions) increase, and "free" allowances die out. This means that there could be value found in the Carbon Trade in coming years. On November 14, 2012 California, the worlds eighth largest economy, held its first auction of greenhouse gas emissions, initiating the cap-and-trade system in the United States. The program, though, does not currently have national support and wont be mandated federally in the near future. Perhaps the rest of the country is still getting over the last time California tried to create its own market (see Enron). Nonetheless the carbon trade is gaining momentum globally, and may present a unique opportunity for trade. Both the California allowances and the EU allowances are tradable with futures on the Intercontinental Exchange (ICE).

Commodities Rolling Over Passive Investors

BY TAYLOR MALUEG In a year that some have termed the fundamental "trifecta" (corn, wheat, and soybeans), 2012 market pressures in agricultural commodities have been unprecedentedly bullish. While an historic drought throughout United States has dominated the headlines of mainstream agricultural news, a determined push by the financial industry over the last few years to make commodity index products a widely-held investment has gone largely unnoticed. Whether because of appealing stories of coming commodity market tightness or search of further portfolio diversification,
(Continued on next page)

Since June, CMEs Front Month Corn Futures contract has returned over 15% more than the CORN ETF.

Page 3

ISSUE I

Commodities Rolling Over Passive Investors (cont.)

buy and hold investors have made products tracking commodity baskets increasingly popular. The problem with index funds that are backed by commodity futures is that at some point the future that the fund holds will expire. In order to have constant exposure to the commodity of choice, a fund must "roll" its commodity exposure to another future with a different contract month. Usually longer dated futures cost more than the upfront ones; as funds roll their positions into more costly futures, they usually incur what is called a negative roll yield. These negative yields slowly eat away at the index fund's profits, causing a stark disconnect in performance relative to the commodity market(s) they track. For example through the worst drought and corn crop of recent history, prices for front month corn gained 59.3% during June and July while the commonly traded Teucrium Corn Fund (Symbol: CORN) only gained 43.6% during the same period. This phenomenon is not only witnessed in agriculture index products, but in almost every commodity fund. Imagine the passive investor that bought the United States Natural Gas Fund at the start of the 2012. The fund at one point was down nearly 20% while the front month futures actually gained a stunning 24%. This problem gets more exaggerated as these negative roll yields slowly compound over time. Over the last five years, the United States Natural Gas Fund has lost close to 90% of its value. Commodities will probably continue to roll over investors for years to come. As the Wall Street Journal reminds us, It is good to remember, even when commodities win, investors can still lose.

Graham and Doddsville

Christian Sgrignoli

It had been awhile, so I flipped through a few pages in The Intelligent Investor and found a quote in the appendix: The Washington Post company in 1973 was selling for $80 million in the market. at that time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million. The company owned The Post, Newsweek, plus other TV stations. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. Now if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice and Wonderland. Buffet discusses the claim that EMH fans call investors that beat the index lucky. Buffet admits that there is some truth to this statement. He gives an analogy of coin-flipping. But the fact that the workers from Graham and Newman had such incredible track records speaks also to statistics.

Equity Analysis
Thoughts and Investigations in the US Equities Market

The Effect of BPs Criminal Settlement

BY CORY LAAKER Captivated by the discussion in Dr. Cliffords FIN300 class, I decided to share the information I learned from an article regarding the Criminal Action Lawsuit against British Petroleum: On November 15th BP agreed to pay $4.5 billion in a criminal settlement with the US Government in regards to the 2010 oil spill. BP plead guilty to a total of 14 criminal charges including the deaths of 11 rig workers, and intentionally misleading congress and investors about the severity of the spill. Release of this news definitely had a drain on BPs stock price right? Wrong. As pointed out by Dr. Clifford, the stock price of a company is based on the discounted expected future cash flows of a company. Investors became aware that there was going to be criminal and civil settlements directly after the spill happened and the market adjusted accordingly two year prior in 2010. Even though $4.5 billion dollars is an astronomical amount, it still was less than expected causing an increase in share price from $40.30 to 42.02, or approx. 4.3%, from the news release on November 15th to November 23rd.

Chart courtesy of Yahoo! Finance

However, there is still continuing uncertainty in relation to the oil spill because of the outstanding civil penalties BP faces under the Clean Water Act. Fines could range from $1100 to $4300 per barrel spilled making the possible price tag between $5.4 billion and $21 billion. So, when news breaks of the settlement of these penalties remember that its not a matter of BP having a cash outflow, but whether or not it is more than expected that will predict the effect on its share price.

WI RESEARCH NEWSLETTER

Page 4

Is Market Efficiency a Paradox?

BY CHRISTIAN SGRIGNOLI There has been an investment philosophy that has gained much traction in the past few decades. The momentum for this strategy can be traced back to Harry Markowitz portfolio selection paper in the March 1952 issue of the Journal of Finance. At the time, Markowitz was a graduate student at the University of Chicago. Up until this time, there had not been much study on the subject; which can be noticed in the lack of sources in Markowitzs paper. Markowitz was interested in the relationship of risk/reward. He recognized that most investors, even professionals, had tunnel vision on reward. His answer to this problem was covariance. The technical name of this investment philosophy is modern portfolio theory (MPT). It is taught heavily in finance courses. It proposes that the market is efficient. There is a weak, semi strong, and strong form of this efficiency. At the core, market efficiency claims that the equilibrium of buyers and sellers provide an optimal level of discounting future events. If markets are efficient, and all actors optimally discount information, security analysis is a waste of time. The proper thing to do is to diversify into different asset classes and minimize firm specific risk. After a while other people conclude the same thing. But what happens when many, or the majority believe and invest accordingly? What will happen is a dispersion from true value; resulting in a paradox. As more investors believe the market is efficient, the less efficient it gets. These investors will use indexing strategies and vague qualities such as growth vs. value to satisfy their diversification needs. These generalities do not provide the true value of an equity security-the discounted residual value available to the shareholder.

Classification Agriculture Energy

Ticker COW UHN JNK

Math Economics Seniors taking Principals of Operations ReQQQ PowerShares QQQ Trust search (MA416) with Dr. MolReal Estate VNQ Vanguard REIT ETF zon had to conduct iShares Dow Jones US Medical Dev. Healthcare IHI (ETF) an efficient frontier CurrencyShares Swedish Krona for a group of diCurrency FXS Trust PowerShares Listed Private Eq. verse asset classes. Financial PSP (ETF) Government iShares Barclays 3-7 Year Treasry Using linear proBonds IEI Bnd Fd gramming techPowershares DB Base Metals Fund Metals DBB (ETF) niques with the use Mid Cap PowerShares S&P 500 Hgh Qlty Prtfl Growth SPHQ (ETF) of Excel and R, I analyzed returns of 11 different ETFs to determine the optimal portfolio during a strong bull market, from 2009 to 2012.
Junk Bonds Large Cap Growth

Description iPath Dow Jones UBS Livestock Total Return Sub-Index ETN United States Diesel-Heating Oil Fund LP SPDR Barclays Capital High Yield Bnd ETF

Building the Optimal Portfolio (2009-2012)

BY DANIEL NALL However this was not enough information to determine an optimal portfolio. Given a specific investors risk tolerance, the efficient frontier would be enough to pick out a specific allocation. But without this information, there are a few ways of ranking portfolios to determine which is optimal. In this analysis two measures were used to create optimal portfolios: the Sharpe Ratio and Jensens Alpha. Looking at the efficient frontier, it is clear that an equally weighted portfolio, the S&P 500, and most of the individual assets were dominated by the efficient frontier. However, high yield bonds (JNK), the Nasdaq Index (QQQ), and the Vanguard REIT ETF (VNQ) all lie on the efficient frontier. This was somewhat expected after taking into account the strength of the bull market during the time period analyzed, which was characterized by high returns with low variance (which can be seen in the total return chart). Using the portfolio ranking methods, both optimal portfolios were characterized by low risk on the efficient frontier, and both consisted of allocations to just three assets: 3-7 Year Treasury Bond Fund (IEI: 48-67%), High Yield Bond Fund (JNK: 26-43%), and Large Cap Growth Equities (QQQ: 7-8%).

In order to use the linear programming solver, mean absolute deviation of the returns was used as the risk measure instead of standard deviation. In order to pick an optimum portfolio, either the return or risk would need to be fixed. For this model, the risk parameter was capped for a maximum return output. A program in R was developed to run loop through risk caps, thus creating an efficient frontier.

Page 5

ISSUE I

Mathematical Dependence of Stock Returns (Part 1)

BY JOHN EVERS

we can begin comparing numbers. First off distribution however you cant use a frequency Ask any person what they think of the stock are the equations, which I will address method. Instead, we must use an algorithm to market and more in Part 2. intelligently partition most will Second are the the space, for some equate it to probability distriexamples please see something butions which the figures. The along the lines arent as easy to algorithm I find easiof Vegas for calculate as you est to understand is the rich. By may first think. the Fraser-Swinney that, people The single variaalgorithm. see the market ble probability as a game of The Fraser Swinney distribution funcprobabilities algorithm partitions tion (PDF) is simand uncertainthe 2 dimensional ple though; all ties not suited space into what are one must do is called equi-probable for the averX=Y=25 uniformly distributed points on the interval [0,1] X and Y are different but both uniformly distributed on [0,1] partition the rectangles where a age Joe. Of rectangle will require no further sub divisions values into equidistant bins and then count course, who the markets are suited for isnt once the product of the marginal equals that of the number which fall in each bin, as you really important to the game, but underthe rectangle, i.e. Px * Py = Pxy . Once this is would do for a histogram. For the bivariate standing the uncertainty and its probabilities done we can then compute the entropy, H(x), is. Thus, in order to uncover these relations and joint-entropy, H(X,Y) such as to compute one could use correlation. This measure howthe mutual information. Once done we can ever fails to decipher non-linear relationeasily see that the mutual information values follow an expected pattern similar to that of ships. That is, let Y be a random variable and correlation. The difference in the numbers let X = Y ^2, then the correlation of the two goes beyond the scope of my reasoning, by that would be 0. The informational approach of I mean finding trading strategies which use entropy and associated mutual information these relationships has proved harder than I at however do not. The theory behind entropy first thought. The goal however going forward and mutual information has been well reis to address this next time around. So look searched, as has the comparison of correlaforward to next months issue! (If anyone tion to mutual information. would like more information on the topic please contact John Evers In order to calculate the entropy version of via wildcatinvestors@gmail.com.) X and Y normally distributed on [0,1] dependence we will need a few things before

In the Meetings...
What goes on in 309 B&E each week

Art, the Newest Hard Asset (continued from cover)

BY WILLIAM SPENCE

As shown in the chart, global art auction revenues have been increasing since 2004, with the exception of the recent financial crisis. In fact, 2011 was a record-setting year with $11.57 billion of art sold. This trend seems to be solidifying as more and more works of art begin replacing others on the list of most expensive works of art

sold. In May of this year, The Scream by Edvard Munch shattered all records by selling privately for just shy of $120 million. ,,,
(continued on next page)

Fine Art Auction Revenues have increased by over 4.5x in the past decade.

WI RESEARCH NEWSLETTER

Page 6

Art, the Newest Hard Asset (fini.)

An investor wishing capitalize on this trend can do so in a handful of ways, depending on the capital employable. One way is to seek out works that are expected to appreciate in valuea costly venture. Anothermore cost effectivemethod would be to look for proxy investments that profit from art transactions. The clear frontrunner in this category is Sothebys International (NYSE: BID). Specializing in art auctions, Sothebys has been in business for over 250 years. By taking a commission from the seller and charging a premium to the winning bidder, Sothebys profits on both ends of the transaction. Additionally, the company offers a multitude of secondary services such as valuation, storage, estate planning, and many more. By focusing on its core competency and exploiting its resources, it has become the industry leading art auctioneer. In FY2011, it sold art totaling over $5.8 billion (including The Scream). With a PE of 15 and 2011 operating and profit margins of 34.8% and 20.6%, respectively, Sothebys maintains strong pricing power while trading for a relatively price. It remains on watch for the Wildcat Investors.

However, unlike gold, there is very little chance of previously unknown works being discovered; there is a limited supply of truly unique works.

Consumer Discretionary (XLY) vs. Consumer Staples (XLP)

BY DANIEL NALL & CORY LAAKER

ket has seen a decline.

CCI has increased to its highest level since February 2008.

Despite the stagnant economic conditions, the Consumer Confidence Index (CCI) continues to grow. According to the monthly survey conducted by The Conference Board, the CCI has again increased from 73.10 (October) to 73.70. This is the highest the index has been since February 2008. The 4th Quarter of 2012 has been characterized by stabilized Performance since 10/31 business conditions and sentiment regarding employment opportunities continues to improve, even as the mar-

In a relative strength comparison in the 4th and 1st quarters since 2006, the XLY has outperformed the XLP 67% of the time. And when the S&P 500 has shown a positive return, the XLY outperformed 100% of the time. The seasonality of these sectors seemed to play a role. Because the club was not overly bullish in the mid-term on the market, the allocation to this rebalance was relatively small. Given the XLY is a risker asset than is the XLP, the trade was a Beta+ (adding beta to our portfolio). We decided to add 2% to our XLY allocation while trimming 2% from out XLP allocation.
(courtesy Freestockcharts.com)

Consumer Sentiment vs. XLY/XLP

Consumer sentiment (blue histogram) has had a high correlation with Discretionary outperformance. As it continues to make new highs, we look for the uptrend in the XLY/XLP to strengthen.
Chart courtesy of Bloomberg.

Thus far we have seen an outperformance of 1.8% of XLY over XLP since we initiated the position on 10/31.

Page 7

ISSUE I

Wildcat Investor Officers Join the University of Kentucky CFA

WILDCAT INVESTORS
On-Campus Office: ASTeCC 123 E-mail: wildcatinvestors@gmail.com Meetings Fall 2012: Wednesdays 5:00 B&E 309

Research Challenge
Each year the Chartered Financial Analyst Institute sponsors a global investment analysis competition amongst university students. This year, the University of Kentuckys team includes two Board Members, John Evers and Daniel Nall. The other members of the team are finance seniors Paul Gerwe, Brad Harris, and Thomas Napier. Finance professor, Dr. Chris Clifford will act as a faculty sponsor to guide the team. As a group, each team is required to complete a detailed, sell-side analyst report to be submitted first at a regional level. For the 2013 Competition the universities in the CFA Society of Louisville Region will analyze Humana Inc. (HUM), one of the big 5 national health insurance providers , which is headquartered in Louisville, KY. Over 3,000 students from over 650 universities competed in the 2011-2012 Competition. Last years winner of the Louisville Region was Butler University. And the team that went on to win the Americas division was Illinois Institute of Technology from the Chicago Region.

The market can stay irrational longer than you can stay solvent. -John Maynard Keynes

For more information on our organization or full presentations, visit our website: www.wildcatinvestors.com.

The Wildcat Investors Club is open to new membership of all experience levels at anytime during Fall and Spring semesters. It is studentrun organization designed to foster an environment of learning centered around the financial markets. This includes investment and trading strategies, diversification techniques, retirement account preparation, and any other investment decisions.

Sources:
Denning, Liam. "For Passive Investors, Rolling Commodities Gather a Loss." Wall Street Journal Online. 11 Nov. 2012. "EU Carbon Auction Clears at Biggest Discount to Spot Price." Bloomberg. N.p., n.d. Web. <http:// www.bloomberg.com/news/2012-11-16/eu-carbon-auction-clears-at-biggest-discount-to-spotprice.html>. "Europe's CO2 Trading Scheme: Is It Time for a Major Overhaul?" Europe's CO2 Trading Scheme: Is It Time for a Major Overhaul? by Ben Schiller: Yale Environment 360. <http://e360.yale.edu/mobile/ feature.msp?id=2396>. Graham, Benjamin, and Jason Zweig. The Intelligent Investor. New York: HarperBusiness Essentials, 2003. Print. "Investor Relations." Sotheby's. N.p., n.d. Web. <http://investor.shareholder.com/bid/index.cfm>. Markowitz, Harry. Portfolio Selection Mar. 1952. <http://www.math.ust.hk/~maykwok/courses/ ma362/07F/markowitz_JF.pdf>

Disclaimer: The contents of this newsletter are for educational and informational purposes only. The views and opinions expressed throughout are not necessarily reflective of those of the Gatton College of Business at the University of Kentucky.