MAF707 – PORTFOLIO INVESTMENT AND

FINANCIAL PLANNING

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 CONTENTS

1. EXECUTIVE SUMMARY………………………………………..3

2. DESCRIPTIVE STATISTICS…………………………………….4
 Mean return…………………………………………………….4
 Standard Deviation……………………………………………..4
 Skewness……………………………………………………….4
 Kurtosis………………………………………………………...4
 Covariance and Correlation……………………………………4
 Portfolio return and Standard deviation………………………..4

3. MEAN VARIANCE OPPORTUNITY SET……………………....5

4. PORTFOLIO CONSTRUCTION…………………………………6
 Portfolio A……………………………………………………...6
 Portfolio B……………………………………………………...6
 Portfolio C……………………………………………………...6
 Portfolio D……………………………………………………...6

5. PORTFOLIO TRACKING MARKET INDEX…………………...7

 Problems Associated with Index Tracking…………………….8

6. TARGET BETA PORTFOLIO……………………………………9

7. CONCLUSION...………………………………………………...10

8. REFERENCES…………………………………………………...11

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 EXECUTIVE SUMMARY

The purpose of this report is to analyze the performance of different portfolios that
were constructed with the given 14 stocks and suggest the XYZ Superannuation Ltd
with the investment strategy. Different people have different financial backgrounds
and different interests towards risk. So each individual requires different portfolio
based on their preference. For this analysis, we have considered the performance of
14 stocks from past five years. We have used continuously compounded method for
finding the returns of individual stocks and portfolios.

We assumed different target returns and generated different portfolios, with various
returns and risks involved in them. Using these different portfolios we produced mean
variance opportunity set in a graphical form. We discussed the performance of these
efficient portfolios with respect to the performance of individual stocks and market
index. In the next part we advised on portfolio construction with returns of 7%, 18%,
32% and global minimum variance portfolio. In our analysis we found that the
portfolio with 7% return is not an efficient portfolio. So it is better to choose a
portfolio which has same risk and 15% return. Global minimum variance portfolio is
the best one to choose for the investors who are totally risk averse. Based on the
current fund manager’s advice, we have constructed a portfolio that tracks the S&P
ASX 200. To construct this portfolio we have used the annualized market index return
as our portfolio return. We found that this portfolio sits close to the global minimum
variance portfolio. Finally we constructed a portfolio based on the betas of individual
companies. Upon the clients interest it is decided that the target beta of the portfolio is
1.2. We compared this target beta portfolio with efficient portfolio that lies on the
efficient frontier.

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 DESCRIPTIVE STATISTICS
In a continuously compounded method the returns from the stocks are compounded to
N number of times to get the maximum possible returns.

MEAN RETURN: - Mean return is the average continuously compounded daily

return of each stock. CSL Limited has the highest daily return of 0.16%.

STANDARD DEVIATION: - This measure the amount of risk involved in each

stock. Higher the standard deviation higher is the risk involved in the stock. Almost
all the 14 stocks have standard deviation of above 20%. Santos Ltd has higher risk of
31.2% of all the 14 stocks.

SKEWNESS: - Skewness measures whether the distribution is symmetrical or not. If

a distribution has zero skewness then it tells that top half numbers are just mirror
image of bottom half numbers. Any distribution will have skewness between -1 and
+1. If the distribution has nonzero skewness then the distribution is biased to either
top or bottom side. The stocks CSR LTD and RIO TINTO LTD has high skewness of
-0.63 and +0.69.

KURTOSIS: - Kurtosis measures the number of observations that fall in the extreme
ends of the distribution. Kurtosis has a lower bound of 1 and it does not have any
upper bound. For a normal distribution kurtosis is said to be 3. BBG LTD is the only
stock that has normal distribution. Quantas Airways and Rio Tinto have high kurtosis
of 9 and 10. That is many observations are far away from mean and median.

COVARIANCE AND CORRELATION: - In a portfolio investors are concerned

with the total risk associated with portfolio rather than the individual assets risk.
Covariance measures the relative movement of one assets return to the other asset.
Correlation is a relative measure of covariance.

PORFOLIO RETURN AND STANDARD DEVIATION: - In an equally weighted

portfolio all assets are allotted with equal amount of money. So the $200 million are
distributed equally to all 14 stocks. So each stock is allotted with $14.28571429
million. Annualised return of equally weighted portfolio is 15.06%. Annualised
standard deviation of equally weighted portfolio is 14.87%.

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 MEAN VARIANCE OPPORTUNITY SET
With the given amount to invest in a portfolio, the return of the portfolio can be
increased or the risk can be decreased by changing the amount allotted to each stock.
We are going to invest all the $200million in different ways and find various returns
and risks that are involved in different portfolios.

The graph clearly shows us that diversification in the investment gives better yield
rather than investing in a single stock. The blue dots in the graph represent different
portfolios with different return and risk and the brown dots represent the performance
of individual stocks. All the portfolios that are above the global minimum variance are
all efficient portfolios. These efficient portfolios have outperformed when compared
with the performance of individual stocks and market index. With the given 14 stocks
the highest return that could be generated is 41.2% and the risk involved in that
portfolio is 28.8%. In individual stocks CSL Limited has outperformed with a return
of 41.6% and a standard deviation of 29.6%. Even though the individual stock CSL
had highest return than all the portfolios, it has higher risk involved in it. Where as
these efficient portfolios have only systematic risk involved. The market index with
200 stocks had performed better than the individual stocks in respect to the standard
deviation. But when the market index is compared with the portfolios of 14 stocks,
there is a portfolio with same risk involved but the return of portfolio is 19.06% and
the return of the market index is 10.2%. This efficient portfolio had generated double
the return of market index with the same risk involved. Individual stocks like
Stockland and Qantas Airways have almost 0% annualized return and the risk
involved is higher. Instead of investing in these individual stocks, we can invest in
efficient portfolios that have returns of 36% and 39% with the same risk involved.
Since these efficient portfolios have performed much better than the individual stocks
and market index, investors would prefer to choose these portfolios that have same
risk but higher return.

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 PORTFOLIO CONSTRUCTION
DISCRETE CONTINUOUS STANDARD
RETURN RETURN DEVIATION
PORTFOLIO A 7% 6.76% 13.82%
PORTFOLIO B 18% 16.55% 14.05%
PORTFOLIO C 32% 27.78% 17.39%
PORTFOLIO D 11.12% 10.51% 13.56%
PORTFOLIO A: - This portfolio has a return of 7%. The standard deviation of the
portfolio is 13.8%. Out of 14 stocks only 11 stocks were chosen for this portfolio, the
rest of the three stocks were not allotted any amount. The three stocks that were not
chosen had a standard deviation of 30% each. In this portfolio FGL is allotted with the
highest amount of $38.37 million. SGP is allotted $31.2million. CBA and WOW are
allotted with $27 million each. All the other stocks are allotted with less than 20
million dollars each. When this portfolio is compared with the efficient set portfolio, it
will be better to choose the portfolio that has a return of 15% and standard deviation
of 13.7%. Since the risk involved in both the portfolios is same, investors would
prefer to select the portfolio that has higher return.

PORTFOLIO B: - This portfolio has a return of 18% and it comes under efficient set
of portfolios. This portfolio has a standard deviation of 14.05%. Two stocks, BHP and
BLD were not allotted any amount. WOW was allotted with highest amount of $40.7
million. Stocks CBA, CSL, FGL, and WPL were allotted around $25 million each.
Remaining stocks were allotted with less than $10 million each.

PORTFOLIO C: - This portfolio has 32% returns. Since the return of the portfolio is
high the risk involved in this portfolio is also high. This portfolio has a standard
deviation of 17.4%. This portfolio has got risky stocks like BHP, CSL, RIO and STO.
One third of the total money is invested in CSL because this stock has higher
annualised return of 41.6%. At the same time the risk involved in this stock is also
higher. Another one third of the money is invested in WPL and WOW. Investment is
not made in stocks like BBG, BLD, CSR, QAN and SGP because these have very low
annualised returns.

PORTFOLIO D: - This portfolio is global minimum variance portfolio. With the

given set of stocks this is the portfolio that has lowest possible risk involved. This
portfolio is located exactly at the turning point of the efficient frontier. This portfolio
has a return of 11.12%. The standard deviation of the portfolio is 13.56%. Investment
was not made in risky stocks like BHP and RIO. $100 million were invested in three
stocks WOW, FGL and CBA. These three stocks have very low risk involved in them
compared with other stocks. Stocks FGL and WOW have performed close to the
normal distribution, so the chances of the expected returns to occur are high from
these stocks. This is the reason for one third of investment in these two stocks. $60
million were invested in QAN, SGP and WES. These three stocks have low
annualised returns and low risk involved in them. Remaining $40 million were
invested in rest of the stocks. Low amounts were invested in stocks like BLD, CSL
and CSR, because the risk involved is very high.

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 PORTFOLIO TRACKING MARKET INDEX

To construct a portfolio that tracks the market index, we consider the annualized
return of the market index to be our portfolio return. This portfolio moves exactly
with the fluctuations in market index. The return of the portfolio will be same as
market index return. The annualised return of the market index is 10.2%, so we create
a portfolio that exactly has this return. The standard deviation of the portfolio is
13.56%, where as the standard deviation of market index is 14.38%. The difference
between the two standard deviations is 0.82 and this is known as the tracking error.
Even though the market index with 200 stocks is better diversified than the portfolio
with 14 stocks, the risk involved in the market index is higher. This tells us that with
the proper allocation of money in a portfolio, we can achieve with portfolios of either
lower risk or higher return.

The graph clearly shows us that the portfolio tracking the market index is sitting close
to the global minimum variance portfolio. There is only a slight difference in their
return and standard deviation. By a close analysis of these two portfolios, we can
conclude that we can form a portfolio with almost minimum variance by tracking the
market index. This happens because market index is well diversified than any other
portfolio and when we track this index and do the optimisation, we end up with a
portfolio that has almost minimum variance. This portfolio will be one of the best
options for the people who are totally risk averse.

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 Name $ Amount
BHP AU Equity 0
BBG AU Equity 5044482.073
BLD AU Equity 3201030.127
CBA AU Equity 28875808.78
CSL AU Equity 4432505.839
CSR AU Equity 7853222.566
FGL AU Equity 33635782.67
QAN AU Equity 17537865.24
RIO AU Equity 0
STO AU Equity 8966888.998
SGP AU Equity 21755842.23
WES AU Equity 20049350.56
WPL AU Equity 13432658.34
WOW AU Equity 35214562.57

In this portfolio two of the stocks BHP and RIO were not allotted any amount. Fifty
percent of the total investment is made in WOW, FGL and CBA. These three stocks
have low risk involved when compared with the other stocks. Twenty eight percent of
the money is invested in WES, SGP and QAN. Remaining 22% is invested in other
stocks. High weightage is given to the stocks that have lower risk and lower returns.

PROBLEMS ASSOCIATED WITH INDEX TRACKING:-

Since we are tracking the index with 200 stocks, in practise it is difficult to hold all
the 200 stocks. So we need to pick the stocks that exactly mimic the movement of
index. The stocks underlying the index changes over period based on different factors.
In such cases, if any of the stocks need to be replaced to balance the portfolio then the
costs associated with it is higher. The dividends that are received from the stock can
be either reinvested or taken as cash. In both the cases weights of the portfolio get
changed. This will give rise to a new problem of maintaining the weights of the
portfolio. The selection of trading period is important for comparing the index and the
portfolio. Risk of the assets, liquidity and changes in time to maturity are some of the
factors that complicate index tracking. The tracking portfolio is formed under
assumptions that variances, correlations and expected returns of the stocks remain
same. But in real world risk and return characteristics change over time. This strategy
will be beneficial when the market is bullish or is expected to do well. If the markets
are under recession then definitely this strategy will not be a good one. Because
history of the index tells us that market do not perform well under recession
conditions. Studies from the history have revealed that most of the funds that track the
index had higher tracking error, which is a big concern to the investors.

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 TARGET BETA PORTFOLIO

When we talk about portfolio beta, it is the sum of all individual betas of stocks in a
particular portfolio. Based on the client’s interest it is decided that the portfolio will
have a target beta of 1.2. Portfolio is constructed based upon the betas of individual
companies. This portfolio represents the sensitivity movements of all stocks in the
portfolio, with respect to market index movement. This portfolio has annualized
return of 8.1% and standard deviation of 14.9%.

Name $ Amount
BHP AU Equity 0
BBG AU Equity 0
BLD AU Equity 0
CBA AU Equity 6968254.69
CSL AU Equity 4728293.345
CSR AU Equity 45000591.17
FGL AU Equity 17039957.84
QAN AU Equity 39776964.39
RIO AU Equity 0
STO AU Equity 14445400.61
SGP AU Equity 27920612.91
WES AU Equity 8466187.141
WPL AU Equity 11264784.61
WOW AU Equity 24388953.29

Stocks BHP, BBG, BLD and RIO were not allotted any amount in this portfolio.
Highest amount of $45million is invested in CSR Limited. The beta of this company
is 1.85. $40million was invested in Qantas Airways and $28million was invested in
Stockland. The beta of these companies is 1.27 and 1.04. This tells us that more than
half of the total investment is made in these companies that have higher beta. These
three stocks have annualized returns of less than 3percent. $24million is invested in
WOW and $17million is invested in FGL. Rest of the $40million is allotted to the
remaining stocks. This beta portfolio has higher risk involved in it, because most of
the investment is made in stocks that are more sensitive to index and stocks that have
low annualized returns from past five years. When the beta portfolio is compared with
the efficient portfolio which has same risk; the return of the portfolio increases from
8.1% to 20.7%. This shows us that the efficient portfolio has a return that is almost
three times the return of beta portfolio. The return of the efficient portfolio is higher
because most of the investment is made in stocks that have higher return and
comparatively same risk involved as of the stocks that are in beta portfolio. Because
of higher returns investors will choose efficient portfolio rather than target beta
portfolio.

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 CONCLUSION

After a profound analysis, we found that all the efficient portfolios have performed
better than the individual stocks and market index. With the efficient portfolios, we
are able to generate higher returns than the individual stocks with same risk involved
in both. Global minimum variance portfolio has the lowest risk involved and this will
be best for the investors who are totally risk averse. The tracking error for the market
index portfolio is 0.82. This error will definitely be a concern to investors. We found
that the tracking portfolio has less risk involved than the market index. So it is better
to invest in tracking portfolio rather than market index. The optimization process has
proved that we can generate portfolios with less risk, by changing the investment in
stocks. By tracking the market index, we can come up with a portfolio that almost has
minimum variance. The beta portfolio that we constructed has higher risk involved in
it. So investors will choose efficient portfolio that has same risk and higher return.

We suggest XYZ Superannuation to invest in efficient portfolios based on investor’s

interest, because these portfolios have outperformed than any other investment
strategy.

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 REFERENCES

1. Brailsford, T, Heaney, R & Bilson, C, 2006 Investments: Concepts and

Applications, 3rd edn, Thomson, Nelson Australia.

2. Beal, D. & McKeown, W. 2006 Personal Finance 3rd edn, John Wiley, Milton, Qld,

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