Portfolio planning

EUROPEAN PORTFOLIO

European sector indices and their underlying comparative strength

In the June 2003 issue of PWM, a portfolio of 12 stocks representing the three best sectors on the basis of long-term comparative strength was built.

The indicator used for the selection of the best sector indices and the respective stocks is an excellent composite measure called the information ratio, designed to calculate the reliability of the excess return of a sector or stock against a benchmark.

The most favoured sectors due to the consistently high weighting over a time period of three years are (in order of the highest allocation weighting): tobacco (+), medical products (+), mining and smelting (+), basic resources (+), real estate (-), forest products and paper (+), textile and apparel (0), food and beverages (+), construction (+), retail (+), auto (+), banks (+), cyclical goods (-), wireless (+), non-cyclical goods and services (+).

Most sectors show an improving information ratio (+) over the last 12 months. Only a few of them have either maintained or improved their position versus their ranking nine months ago: tobacco, medical products, mining and smelting, and basic resources.

These are the absolute favourites for a successful stock picking campaign, which consists of taking the first three stocks of each sector (for a total of 12 stocks), then using the information ratio over a 12 month period.

The overall portfolio is expensive on a price to earnings basis, as the mining industry is about to recover from a deep slump. It does however look cheap on an overall yield basis (+2.386 per cent) and above all when taking into consideration the low price to sales ratio (0.5612 times). The beta has a tendency to increase but remains at quite low levels which indicates the defensive character of the portfolio.

Chart 1 – The stocks listed represent a defensive portfolio with no technology exposure. It therefore has very positive performance (portfolio +25.43 per cent against +23.89 per cent of the DJ Stoxx 600 Index). It is tough to beat the index in a bull market.

The new portfolio has reached a new price high, as indicated by the blue line in Chart 2.

Chart 3 shows the low volatility of the portfolio (blue square) against the DJ Stoxx 600 Index (red square). A comparative higher return can be expected.

GLOBAL PORTFOLIO

Model based on optimised risk/reward relationship

In the June 2003 issue, an optimised allocation model was presented which took into consideration the major asset classes.

At that time, the model invested basically nothing in equity markets. One may now argue that this approach must have failed miserably, as the MSCI World Index $ has risen +28.81 per cent since 23 May 2003, when the optimised portfolio was created.

The classic balanced portfolio has shown a return which was 2.23 per cent better than the optimised portfolio. This is an acceptable result when considering that the volatility of the optimised portfolio was only 70 per cent compared to that of the classic balanced portfolio.

The optimisation rules allow for a self-adjusting mechanism that monitors the changes of the risk/reward relationships that take place in the markets over time.

The newly optimised portfolio now takes into consideration a higher equity weighting. Convertible bonds have clearly taken the lead, followed by real estate, which had shown the second lowest weighting in the May 2003 portfolio. The high yield bond market is the big loser and drops from second to seventh position. The emerging nations bond market has remained remarkably stable and gains one position. The money market investments have lost almost 3 per cent in weight. Altin represents hedge funds and has basically maintained its portfolio weight.

The quantitative data used for this optimisation covers 12 months and is ideal for a portfolio duration of six to nine months.

The table above shows the previous asset allocation while Chart 1 illustrates the performance of the optimised portfolio (blue, +8.64 per cent) against a synthetic benchmark of a perfectly balanced portfolio (50 per cent equity, 50 per cent bonds).

Chart 2 – The table shows the weights of each asset class in the newly optimised asset class portfolio.

Chart 3 – The blue portfolio is optimised whilst the red is a classic balanced portfolio. Look at the dramatic effect the diversification among different asset classes has on the Sharpe Ratio, which almost doubles for the optimised portfolio.

Data, charts and comment supplied by Brainpower

For further information on Brainpower’s professional portfolio analysis software, please visit www.brainpowerweb.com or contact Andrew Deakin on +44 (0) 20 7337 9123