Rationale behind Constructing the Index & Portfolios’ on Market Watch

- Group 1, PGDM 2014-16

Our client is a company (institutional investor) which is looking to park its money in risk-free and low risk liquid investments to get the benefits of return earned on investments rather than keeping the money idle as cash. Most important criteria for this company’s investments are having sufficient liquidity (continuous income) and being risk-averse (with no adverse price fluctuations) to complement company’s other operating income each year.

Hence, Policy statement is prepared accordingly and portfolio allocation is done broadly as 55-65% in bonds & 35-45% in domestic equity. In line with the Investment policy statement and risk profile of the customer, Equity investments are suggested to be made in Large-cap defensive stocks. These are less volatile with the market and some move against the market when they’re going down. Also, one of the Investment objective is to maintain liquidity and capital preservation.

1. Index construction on Bloomberg: (Rationale & Steps)

(Under Equity Screening Function of Bloomberg (EQS))

1. Security Universe is defined as the total equity instruments around the world. 2. Among them, from the actively traded stocks, NASDAQ composite Index is chosen as

we are investing in US equities. It consists of all the US common stocks & similar other securities. (also as we have to simulate the Index on Market watch and Indian stocks are not available on Market watch)

3. Next, Country of Domicile is chosen as United States as NASDAQ composite Index contains stocks of companies from other countries too in form of ADRs (American Depository Receipts)

4. Year to date Raw Beta <= 1 screening criteria is applied as we are looking for Defensive stocks which are less volatile compared to market (i.e. having less systematic risk & less volatile to market fluctuations)

5. Average of Yearly Dividend Yield >= Relative Sector, to filter out the companies which are paying more dividends (on average) compared to other companies from their sector relatively. (for continuous income on our portfolio)

6. Average of Yearly Market Cap >= $ 10billion, as our portfolio investments are planned to be made in Large-Cap equities.

With the application of above screening criteria, our universe got reduced to 75 securities which can be as the Index for benchmarking the portfolios. (In our case, we constructed a Value-weighted index from the above 75 securities)

Snapshot of screening criteria applied for the construction of Index on Bloomberg is shown below:

2. Construction of Passive portfolio on Market Watch: (Rationale & Steps)

The time and cost it would take to hold all 75 companies in the index for full replication could be harmful for the portfolio because it is too high and therefore, we chose the top 30 stocks as per the value weights assigned to each stock in order to partially replicate the benchmark index. The procedure is explained as follows:

1. We arranged the 75 companies in descending order of the average of yearly market capitalization. This was done to segregate the largest cap stocks in our index.

2. Top 30 were selected to create the portfolio. The total market capitalization of these 30 companies is $2734.4 billion and the total market capitalization of all 75 companies is $3558.3 billion. As we note, these top 30 account for nearly 77% of the share in the index. Therefore, we decided to replicate our index using these stocks with an orientation that it provides for a good approximation.

3. Taking only the selected 30 companies, we arranged them in descending order of market capitalization and provided them with weights reflective of their market value.

4. The Market Watch simulation offers a total buying power of $20 million for each portfolio. Therefore, according to the weights assigned in Step 3, we divided the share of funds out of this $20 million to be allotted to each company.

5. At the time of taking positions in these stocks, the price at which they were trading was noted down. The share of funds to be invested in each company was divided by this price to arrive at the number of stocks to be bought.

6. Once the above calculations were complete, we searched for each company on Market Watch and bought the required number of stocks to create a passive portfolio.

Partial replication, however, introduces a tracking error, the measure of the deviation of the chosen portfolio from the index. The aim is to monitor the performance of our portfolio in comparison to the benchmark index in order to minimise this tracking error. Our approach is to calculate the tracking error as the deviations in differences of portfolio return from that of the index.

Snapshot of the current status of the constructed passive portfolio is shown below:

3. Construction of Active portfolio on Market Watch: (Rationale)

From the above mentioned excerpt on our investment policy statement, our investment universe is defined as largely defensive stocks. Also, in the present bear market (Observed in the past week in global markets), defensive stocks make a lot of sense to invest in and generate that excess return over Index by outperforming (Alpha-returns)

A Top-up approach is followed by first analyzing macro-economic scenario at present which predominantly is about high volatility & sell-off in global markets triggered by recent de-valuation of Chinese currency. Specific Sectors such as FMCG, Apparel etc. are identified which generally out-perform better during bear markets (based on historical returns) & Companies with sound fundamentals are selected among the specific sectors based on individual company analysis

4. Construction of Absolute-return portfolio on Market Watch: (Rationale)

To construct an Absolute-return portfolio, we followed a Market-neutral strategy which can neutralize market risk by using shorting to reduce long exposure. Beta of the portfolio is near Zero and the goal is to generate absolute-returns.

Absolute-return portfolio was constructed by going long with 100% amount on stocks which are likely to go up & short with another 100% amount which are likely to go down so that the risk is neutralized.