alpha risk analyser - risk analysis in terms of value versus growth

Alpha Investment Management Risk Analysis in terms of Value versus Growth Six months to June 30th 1999

Alpha Risk Analyser

Alpha Investment Management 2

Alpha Risk Analyser

Alpha Investment Management commenced managing its first

wholesale client mandate on the 22nd

of December 1998. From

inception to June 30th of June 1999, the Investment team out-

performed the ASX All Ordinaries Accumulation Index benchmark by

6.14%.

During this time bond yields increased from a low of 4.83% to a value

of 6.17% at the close of the 30th

of June 1999.

The diagram below shows the relationship between bond yields and

the portfolio structure over this period. The line chart shows the bond

yield movement and each diagram illustrates the portfolio tilt in terms of

large industrial, small industrial, value and growth. This tilt is in terms of

tracking variance rather than portfolio weight for each of these

categories. A more detailed description of this chart is given later in this

report.

Buy or Sell at the right timeBuy or Sell at the right time

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Large

Growth

Small

Value -10.0%

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10.0%

20.0%

30.0%

40.0%

Large

Growt h

Small

Value 0 .0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Large

Growt h

Small

Value

4 . 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 9

Dec/Jan April/May June -

In the months proceeding December 1998, Alpha was managing a trial

portfolio preparing for cash inflows that occurred in December 1998. As

can be seen in December/January 1998, the portfolio was tilted

towards a growth bias. In April/May, as the realisation of higher bond

yields and therefore cost of capital was built into stock valuations. The

portfolio tilt was shifted to a neutral value and growth bias. In early

June, the portfolio moved to that of a value tilt. In April/May the portfolio

also had a strong resource tilt, with 58% of the tracking variance

coming from this resource exposure versus 22% in June 1999.


Features on the Alpha Risk Analyser

The Alpha Risk Analyser allows Alpha's fund managers to thoroughly

understand all aspects of the portfolio. It concentrates on the overall

risk of the portfolio that is represented by the beta of the portfolio

relative to the benchmark. Not only does the analyser give a break-

down of stocks’ contributions to the portfolio beta, it also highlights the

impact 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 to

movements in the benchmark – the overall risk of the portfolio. The

beta explains most of the portfolio's expected returns. However, unless

the portfolio has an identical beta to the benchmark, a slight tracking

deviation will exist.

The tracking deviation is analysed and attributed between different

stocks and sectors. The Portfolio Analyser will, for example, highlight

those stocks that make up most of the likely volatility in the excess

returns of the portfolio against the benchmark. In particular, this

volatility may also be due to stocks excluded from the portfolio. The

inclusion 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 30th of

June 1999.]

Overall break-down of tracking variance

In analysing the tracking error of the portfolio against the benchmark,

the tracking variance is used because, mathematically, only variances

can be added and subtracted. The chart below provides a quick

snapshot of the level of additional risk within the portfolio due to

specific and/or groups of stocks, which tend to move together – either

in 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 just

looking at the sector exposures as defined by the ASX.

-0.020% 0.000% 0.020% 0.040% 0.060%

Stock specific

effect

Sector effect

Total

The remainder is the risk flowing from the respective stock weighting'.

This is a function of how heavily weighted in the portfolio the stock is

relative to the benchmark, and/or the volatility of the stock’s returns

relative to the benchmark. The ratio between specific variance and the

“sector effect” can be used as a measure of the level of “stock

selection”. The expectation would be for a small fraction of the risk

resulting from the “sector effect”.


Stock contributions to tracking variance

The following pie chart shows the contribution of each stock in the

portfolio to tracking variance. The 'Risk Ranking' spreadsheet can also

be viewed to see the impact on tracking variance to stocks outside of

the portfolio. For instance Coles Myer Limited was not in the portfolio

yet represented 6.2% of the tracking variance.

MBL

12%

WMC

10%

FHF

8%

MIM

7%

ARL

6%HIH

6%NBH

5%

EML

4%

RIO

4%

LEI

3%

BHP

2%

SGB

2%

CWO

1%

WSF

1%

WBC

1%

Remainder

28%

This chart is useful for visually identifying any large single stock or

sector positions. Using the chart above it can be seen that as at the

30th

of June 1999 the portfolio had a well distributed contribution of

each stock to tracking variance. It is important to look at a stock's

weight 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 & Dicing

The 'Slicing & Dicing' approach to the portfolio segregates the tracking

variance of the portfolio into different risk perspectives. These risk

perspectives may change over time and are a function of how Alpha

views the Australian sharemarket. The advantage of this technique is

that Alpha is not bound by a certain risk model or paradigm in

analysing the Australian sharemarket. For example, stocks could be

classified into a “bottom-up” risk classification, perhaps by balance

sheet and earnings risk. However, at other times, style classification

may be more important – growth versus value stocks. By using

different views of risk, a fund manager is unlikely to be surprised by the

emergence of a new clustering of stocks in the portfolio.

The risk perspectives are based on two different techniques – a

classification technique and a factor analysis. The first classifies stocks

by either inclusion or exclusion of certain groupings or sectors. There

are 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')


The other method looks at the correlations of different stock returns. If

two stocks display similar return profiles, irrespective of their ASX

sector classification, it might suggest that they are being affected by

certain common factors. By unravelling the correlations of all the

stocks, a number of common factors can be identified as driving the

returns of stocks

Using a factor analysis of the correlations of all stocks, the Australian

market is divided into industrial and resources stocks. These sector

groupings are different to the ASX break-down, for example Orica

Limited tends to display a return profile similar to resource stocks.

Further, these sector groupings are not just based on inclusion and

exclusion of the sectors. A loading or sensitivity for each stock is

calculated for each factor.

An advantage of this factor analysis is that the stocks’ returns reveal

potentially new groupings in the Australian market – which would not

be evident using a simple classification system based on a certain risk

model or paradigm.

Sector analysis – ASX break-down

Sector analysis compares the portfolio against the ASX sector

groupings. The tracking variance is attributed between the different

sectors and graphed in the bar chart.

If the beta is different to 1.0 then part of the tracking error will be due to

the higher or lower sensitivity of the portfolio against the index. This

extra risk is classified as “market risk” because a higher or lower beta is

equivalent to taking an increased or decreased position against the

market.

-5.0% 0.0% 5.0% 10.0% 15.0%

GOLD

METALS

DIVRES

ENERGY

UTILITIES

DEVCON

BLDMAT

ALCTOB

FOODHH

CHEMIC

ENGIN

PAPER

RETAIL

TRANSP

MEDIA

BANKS

INSUR

TELECOM

INVFIN

PROPTY

HEALTH

MISIND

DIVIND

TOUR


Size analysis

The next view of the risk, divides the portfolio into large and small

capitalisation stocks. These are further sub-divided into industrials and

resources. Again, the tracking variance is attributable across these

different sectors. The definition of a small capitalisation is a company

classified in the ASX Small Ordinaries index.

Risk Analysis By Size

-10.0%

0.0%

10.0%

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30.0%

40.0%

50.0%

60.0%

70.0%

Large

Industrials

Small

Industrials

Large

Resources

Small

Resources

Alpha sector categorisation

This style view classifies stocks into 'Alpha sectors'. These Alpha

sectors have been created by classifying ASX sectors into six

categories. 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%

Res

ou

rces

Infr

astr

uct

ure

& U

tili

ties

Do

mes

tic

cycl

ical

/Co

nsu

mer

/Man

ufa

ctu

rin

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Co

mm

un

icat

ion

/Co

nte

nt

Fin

ance

Pro

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ty

Hea

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care

& B

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To

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sure


The table below shows how the ASX sectors have been classified into

the 'Alpha sectors'.

ASX Sector Economic Sector ASX Sector Economic Sector

Gold Resources Retail Domestic Cyclical / Consumer

/ Manufacturing

Metals Resources Transport Domestic Cyclical / Consumer

/ Manufacturing

Diversified Resources Resources Media Communication/Content

Energy Resources Banks & Finance Financial

Infrastructure Infrastructure & Utilities Insurance Financial

Developers &

Contractors

Domestic Cyclical / Consumer

/ Manufacturing

Telecommunications Communication/Content

Building Materials Domestic Cyclical / Consumer

/ Manufacturing

Investment &

Financial

Financial

Alcohol & Tobacco Domestic Cyclical / Consumer

/ Manufacturing

Property Property

Food & Household Domestic Cyclical / Consumer

/ Manufacturing

Healthcare &

Biotech

Healthcare & Biotech

Chemicals Domestic Cyclical / Consumer

/ Manufacturing

Miscellaneous

Industrials


/ Manufacturing

Engineering Domestic Cyclical / Consumer

/ Manufacturing

Diversified

Industrials


/ Manufacturing

Paper & Packaging Domestic Cyclical / Consumer

/ Manufacturing

Tourism & Leisure Tourism & Leisure

Value & Growth

Industrial stocks have been classified into a value, growth or other

category. A “value” stock denotes a company that is selling on a low

price relative to its expected earnings, cash flow or net tangible assets.

Additionally, these companies tend to sell on persistently low PE

multiples – such as the banks.

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50.0%

60.0%

Value

Industrials

Growth

Industrials

Other


The “growth” label is applied to those stocks that tend to sell on a

persistently high share price relative to their current earnings, cash flow

or net tangible assets. However, they are not just the opposite of a

value stock. Companies may exhibit high PE ratios because current or

expected earnings have collapsed. The distinguishing trait of a growth

stock is its strong comparative advantage against its competitors –

such as Coca-Cola Amatil.

Definition of value & growth industrials.

Value Industrials

Sectors:

Alcohol & Tobacco

Chemicals

Engineering

Banks & Finance

Stocks:

Email - Diversified Industrial

Metal Manufactures - Diversified Industrial

Wesfarmers - Diversified Industrial

Growth Industrials

Sectors:

Media

Telecommunications

Tourism & Leisure

Stocks:

Lend Lease - Developers & Contractors

Villa World - Developers & Contractors

Westfield Holdings - Developers & Contractors

Coca-Cola - Food & Household Goods

Brambles - Transport

Mayne Nickless - Transport

FH Faulding & Co - Healthcare & Biotech

Orbital Engine Co - Miscellaneous Industrials


Industrial portfolio plot

This chart brings together some of the results of the previous risk

tables.

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

Large

Growth

Small

Value

For the industrial stocks in the portfolio, the style is mapped against the

capitalisation bias. For example, we analyse is most of the risk coming

from value and smaller stocks? This analysis is particularly useful in

assessing different economic environments.

Terms

Beta

This measures the expected average sensitivity to a movement in the

benchmark returns. A figure of 1.10 means that the portfolio is 10%

more sensitive to a movement in the benchmark. For example, if the

benchmark rises by 10% the portfolio would, on average, rise by 11%.

The beta of a portfolio accounts for most of its expected volatility

around the index. The beta of the portfolio is derived from the individual

stocks’ betas which, in turn, have been adjusted to better reflect the

future.

Tracking error

Although the beta explains most of the volatility of a portfolio around

the index, a slight residual error usually remains. This residual error is

caused by stock-specific events (say, an operational failure) or specific

industry events (eg, the removal of a fuel rebate) that is not related to

the overall market effects.

The tracking error incorporates this residual error by measuring the

standard deviation of the excess returns of the portfolio. A figure of say,

2%, suggests that the portfolio will display returns, in the majority of

instances (65%), in a band of plus or minus 2% around the difference

between the mean return of the portfolio and the benchmark.

Tracking variance

This figure is the tracking error squared. In analysing the tracking error

of the portfolio against the benchmark, the tracking variance is used

because mathematically only variance can be added and subtracted –

not standard deviations (tracking error).

alpha risk analyser - risk analysis in terms of value versus growth

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