Quantitative Insight

September 9, 2010

Enhanced basket– an optimised banking portfolio

A blend of Relative Strength Analyser and Efficient Frontier model

Banking Stocks which can exhibit strength The Nifty achieved its 31-month high on the back of broad participation
Stock 1M RSA 3M RSA from most sectors, especially banking. The banking space saw a
Andhra Bank 50.68 57.14
stupendous run up. Despite being bullish on the sector, investors are
Bank of Baroda 60.13 59.49
sceptical that the banking stocks are near the overbought territory and
Canara Bank 54.41 58.9
may witness profit booking. This is where the Relative Strength Analyser
(RSA) comes into the picture. It identifies the banking stocks where
HDFC Bank 59.63 57.11
enough steam is still left for upsides. Also, weights are allocated to these
PNB 64.6 60.97
stocks that can maximise the portfolio returns with the help of the
SBI 63.24 59.98
Markowitz efficient frontier.
Step 1: RSA model identifies a set of banking stocks exhibiting strength
Z Scores : (price deviation from sector mean ) / risk
A number of banking stocks have given phenomenal returns in the last quarter. This
Stock Z-Score
is also reflected in the one-month Relative Strength Analyser (1 M RSA) of the Bank
Andhra Bank -0.78 Nifty, which is at 80 levels. However, there are still a few stocks, which have shown
Bank of Baroda -0.77 inherent strength but the stock price is not reflecting the same. There is scope for
Canara Bank 0.23 more upsides in these stocks when compared with the top performers of the
HDFC Bank -0.6 banking space. To identify these stocks, 1 M and 3 M RSA is calculated for the
PNB -0.21 banking stocks along with the Bank Nifty. The stocks where 3 M RSA are near 60
SBI 0.44
levels suggest the stocks have seen relatively higher gains over losses over a period
of three month. This exhibits the strength in the stock. In addition, if the 1 M RSA of
these stocks is still lower than 1 M RSA of the Bank Nifty, it suggests that the given
Banking stocks with optimum weight allocation stocks are not overbought in the short-term and have potential for further upsides.
Stock Optimised Weights Step 2 : Z-score identifies underperformance of stock price vs. sector per unit of risk
Andhra Bank 33.67% Z-score is calculated for each stock, which is identified through the RSA model. In
Bank of Baroda 41.95% the current scenario, Z-score is the deviation (under performance) of stock returns
Canara Bank 6.36% vis-à-vis sector average return per unit of standard deviation. It helps to filter the
stocks, which have shown inherent strength but could not exhibit it in price upsides.
HDFC Bank 0.82%
These stocks have enough steam left to outperform the sector in the forthcoming
PNB 17.07%
months. The stocks are represented in the table on the left side.
SBI 0.13%
Step3: Enhance portfolio returns using Mean Variance Optimisation technique
Total 100%
The portfolio of the given stocks can be optimised by enhancing the Sharpe’s ratio
of the portfolio. Sharpe’s ratio is maximised by generating the higher alpha per unit
Monte Carlo simulation : Key outcomes risk. Alpha is the excess return generated in the portfolio over the risk-free return.
Sharpe Ratio 1.25 Step4: Markowitz Efficient frontier identified using Monte Carlo simulation
Portfolio Mean 50% We have used the Markowitz efficient frontier theory based on mean variance
Standard deviation 37% optimisation technique to allocate appropriate weights to the given portfolio in order
to attain the optimal portfolio mean and standard deviation and, hence, to maximise
Sharpe’s ratio. Historical returns and volatility have been used as inputs and 1000
Sco
iterations are run through Monte Carlo Simulation to achieve the efficient frontier.

res :
Analyst Various combinations of weights are used during Monte Carlo Simulation with the
Amit Gupta objective of providing the best risk-return trade-off. The line along the upper edge of
amit.gup@icicisecurities.com the region given in the above chart is known as the efficient frontier. Combinations
Azeem Ahmad along this line represent portfolios for which there is lowest risk for a given level of
azeem.ahmad@icicisecurities.com (price deviation from return. Hence, for a given amount of risk, the portfolio lying on the efficient frontier
sector mean ) / risk represents the best possible return.

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Quantitative Insight

Key terms:

Relative Strength Analyser (RSA): It is an indicator to measure the momentum by

comparing the magnitude of recent gains to recent losses in an attempt to
determine strength/weakness in a stock.

Z-score: Z-score indicates the deviation of the price from its mean per unit of risk

Portfolio optimisation: An optimisation technique to calculate the optimal weights

for each scrip in a portfolio to maximise the return per unit of risk.

Mean Variance optimization theory: Mean variance optimisation (MVO) is a

quantitative tool, which allows one to make the portfolio allocation by considering
the trade-off between risk and return. For this, historical returns, variance of a scrip,
and covariance between two scrips are used as inputs.

Markowitz efficient frontier: The Markowitz efficient frontier is the upper side of the
curve formed by the dense area shown in the chart on the previous page. It is the
set of feasible portfolios that have the maximum return for a given level of risk. Any
portfolio above the frontier cannot be achieved. Any portfolio below the frontier is
dominated by Markowitz efficient portfolios. The dense area is formed by the
portfolio return vs. risk, which is calculated for various weight combinations
allocated by Monte Carlo Simulation through numerous iterations.

Monte Carlo Simulation: A simulation technique to approximate the probability of

certain outcomes.

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