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Bronco Bets, LLC

Portfolio Allocation Project

As of March 2020
FNCE 186 Winter 2020 Class Professor Ning Pu

Client: Mr. Risk Averse

Partners:

Ryan Ebner, Yan Dichev, Andre Cutrim, & Alex Belkeir

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Table of Contents:

1. Executive Summary
a. Scope__________________________________________________4
b. Background______________________________________________4
c. Distribution & Use_________________________________________4
d. Conditions & Limitations____________________________________4
e. Summarized Data & Methodology____________________________5
f. Conclusions_____________________________________________5
g. Recommendations________________________________________6
2. Introduction
a. Scope__________________________________________________7
b. Additional Information about our Client_________________________7
3. Data & Methodology
a. Client Profile & Goals______________________________________8
b. Stock prices & outstanding shares____________________________8
c. Risk Free Rate___________________________________________9
d. Shrinkage method_________________________________________9
e. Methodology_____________________________________________9
4. Analysis and Results
a. Select 15 stocks for our optimal portfolio_______________________10
b. Select the dominant portfolio________________________________11
i. MPT - Step 1_______________________________________12
ii. MPT - Step 2_______________________________________13
iii. MPT - Step 3_______________________________________14
iv. MPT - Step 4_______________________________________15
5. Summary & Conclusion
a. Conclusion______________________________________________18
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Table of Tables

Table 1: Selected Portfolio of Stocks, Weight per Stock, Expected Annual Returns

Table 2: S&P 500 Risk Return and Volatility Measures as of March 9, 2020

Table 3: 5Y Monthly Beta & Industry Average Beta of 15 Stocks in Portfolio

Table 4: Standard Deviation of our 15 Stock Choices

Table 5: 4 Year Returns, Means, Standard Deviation and Variance of 15 Stocks

Table 6: Excess Returns of Portfolio

Table 7: Sample Variance-Covariance & Correlation Coefficient Matrices of Naive

Portfolio

Table 8: Variance-Covariance Portfolio Matrix

Table 9: Shrinkage Variance-Covariance Portfolio Matrix

Table 10: Shrinkage Correlation Coefficient Portfolio Matrix

Table 11: Portfolio Weights and Sharpe Ratio with Shorting

Table 12: Portfolio Weights and Sharpe Ratio without Shorting

Table 13:Shrinkage and Naive Portfolio Comparison

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Executive Summary

A. Scope

The overall objective of this analysis is to:

● Identify a portfolio of 15 stocks with which to invest a $100 million Individual

Retirement Account (IRA) Rollover for Mr. Risk Averse
● Determine the allocation of the $100 million to each of the 15 stocks based on
Modern Portfolio Theory

The process we used to select stocks for the recommended portfolio and allocating the
$100 million investment to each of the 15 stocks will be described in the Data &
Methodology and Analysis sections of this report.

B. Background

This analysis was assigned as a team portfolio modeling project for Santa Clara
University’s FNCE 186 Winter 2020 quarter. For this project we assumed that we were
developing a portfolio for a fictional client, Mr. Risk Averse.

C. Distribution & Use

The report, its conclusions, and recommendations have been prepared for the FNCE
186 Portfolio Analysis project as well as our client, Mr. Risk Averse. This report is not
intended for any other use. The exhibits, contained both in the Appendix and an Excel
file, are an extremely important part of this analysis. This report may be provided to only
our team members’ prospective employers, clients and partners, on the condition that
the full report is provided along with the list of team members.

D. Conditions & Limitations

The base for our analysis included historical stock price returns by month for 10 subject
companies, our understanding of market cycles, and input received from Mr. Risk
Averse. Stock market performance is extremely volatile and impossible to estimate
perfectly. That being said, it should be known that our predicted market performance will
likely differ from the true future market performance. Through our implementation of
certain techniques and assumptions, we believe that the recommendations and
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conclusions reached in this analysis are reasonable given the data and information
available to us.

E. Summarized Data & Methodology

We began by selecting 15 stocks across 5 S&P 500 sectors as possible stocks.

We selected the Consumer Staples, Communication Services, Health Care, Consumer
Discretionary, and Real Estate sectors since these sectors stayed stable when historical
viruses that caused worldwide panic such as the MERS-cov and SARS-cov became
infamous. We expect the market to react to the COVID-19 virus similarly, and decided
to look at stocks with low betas and low standard deviations. We then created three
portfolios using Modern Portfolio Theory, Shrinkage approach and an equally weighted
portfolio, and selected the optimal portfolio (lowest risk) for our client.

F. Conclusions

The final step is selecting the optimal portfolio, which is displayed below. The optimal
portfolio is expected to yield 1.87% monthly (22.34% annually), with a standard
deviation of 2.76% and a Sharpe ratio of 64.89%.

Table 1: Selected Portfolio of Stocks, Weight per Stock, Expected Annual Returns
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G. Recommendations, Further Information, and Next Steps

We recommend that our client look over this report and our analysis, and come back to
us with any questions. After this, we can set up meetings regarding feedback or
questions about the assumptions we have made, the methodologies we used, and our
results and recommendations.
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2.Introduction

A. Scope

The overall objective of this analysis is to:

● Identify a portfolio of 15 stocks with which to invest a $100 million Individual

Retirement Account (IRA) Rollover for Mr. Risk Averse
● Determine the allocation of the $100 million to each of the 15 stocks based on
Modern Portfolio Theory

The process we used to select stocks for the recommended portfolio and allocating the
$100 million investment to each of the 15 stocks will be described in the Data &
Methodology and Analysis sections of this report.

Our analysis is limited by these restrictions:

● Guidance from Bronco Bets, LLC:
○ Select a portfolio with 15 stocks
○ Select a dominant portfolio with the highest Sharpe ratio
○ Allocate $100 million to the portfolio using the Modern Portfolio Theory

● Mr. Risk Averse’s goals and objectives:

○ Mr. Risk Averse wants a portfolio that is slightly less risky than the S&P
500 average based on personal pessimism about high risk stocks
○ Since Mr. Risk Averse has doubts that the technology industry is
becoming oversaturated due to a recent trend to overvalue tech
companies who lack profitability, and prefers to not have any large
investments in that industry
○ Mr. Risk Averse believes that luxury companies are not worth investing in
as the recent COVID-19 virus is expected to negatively impact those
companies
○ Based on Mr. Risk Averse’s position in the food and beverage industry
and the introduction of COVID-19, he believes that consumer necessities
are of major importance

B. Additional Information About Our Client

Mr. Risk Averse has managed his own portfolio for 5 years now, however he recently
had two young children and is unable to efficiently split his time between family, work,
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and managing his own portfolio. He would like his IRA Rollover to be professionally
managed because of this and other reasons provided below:
○ He is CEO at a billion dollar food and beverage conglomerate in California
and must commute an hour to and from work
○ He plans to split the value of this portfolio between his wife and two kids
(Joseph and Michael) when they turn 18 (in 15 years)
○ He doesn’t want to be monetarily hurt by economic downturns, allowing a
professional financial manager will allow him to be much less stressed
overall

Mr. Risk Averse is married and has two 3 year old children.
Mr. Risk Averse has a net worth of $180 million, including all his real estate and other
assets. He also has reasonable insurance coverage for all his assets.

3. Data and Methodology

The key data relied upon throughout this analysis were:

a. Client profile and goals as summarized in the objective section above and in the
Client Financial Planning Questionnaire (Exhibit 2)
b. Stock prices, outstanding shares and market capitalization
c. Risk Free Rate
d. Shrinkage methodology

A. Client profile and goals

The client profile and goals were summarized in the Objective section above and in the
Client Financial Planning Questionnaire (Exhibit 2).

B. Stock prices and outstanding shares

Our methodology included downloading historical stock price data and outstanding
shares amounts for our 15 companies, from 2016 until year end of 2019. This data was
downloaded from the CRSP database. The stock price was not adjusted for any reason
except for stock splits or reverse splits. Year end 2019 is the latest data available for our
companies.
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There were no stock splits in the time period we used to complete this analysis, and
therefore no adjustments were made. A significant change in this price can be evidence
of a split of reverse, and in these cases we researched company information to identify
when and for how much any stock splits or reverses affected the company.

C. Risk Free Rate

Upon guidance from the professor, we have selected 1% as our risk free rate​.

D. Shrinkage Method

Based on our experience and guidance from the professor, we have selected a
shrinkage factor of 0.08%. We applied this shrinkage factor for weighting the optimal
portfolio.

E. Methodology

Throughout our analysis, we applied the following methodology:

1. Selected 15 stocks as possible options that fit Mr. Risk Averse’s criteria
2. Develop 3 different possible stock portfolios each consisting of 10 stocks.
3. Select the optimal portfolio and initial weights to allocate stocks to the portfolio
based on the MPT and Shrinkage approach.
4. Select opinion adjusted weights for each stock within the selected portfolio.

4. Analysis and Results

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A. Select 15 stocks as possible stocks within our optimally selected portfolio

Since analysts had previously predicted the financial market to enter a bear market in
the next few years, COVID-19 has acted as a catalyst of the sort and has already had a
significantly larger impact on the market than previous virus epidemics. Given our
client’s concern regarding an upcoming market correction, we selected stocks with
relatively low betas in terms of their corresponding industry group. Table 6 displays the
difference between our stock picks and their industry’s average beta with 12/15 of our
stock choices displaying less-risky tendencies. Furthermore, most of our stocks are less
volatile than the S&P 500 index as a whole. Table 5 shows the S&P 500’s standard
deviation to be 13.17, whereas our stock pick’s average standard deviation is 7.60%
seen in Figure 7.

Table 2: S&P 500 Risk Return and Volatility Measures as of March 9, 2020
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Table 3: 5Y Monthly Beta & Industry Average Beta of 15 Stocks in Portfolio

Table 4: Standard Deviation of our 15 Stock Choices

C. Select the dominant portfolio

We examined the overall risk and return of the portfolios based on Modern Portfolio
Theory and the Shrinkage approach.
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Table 5: 4 Year Returns, Means, Standard Deviation and Variance of 15 Stocks

Step 1 of MPT: Daily Returns, Standard Deviation, Variance, and Excess Returns

After downloading all of our stock information from CRSP, we researched each of our
stocks on the internet to find out if there were any stock splits during our research
window. After finding none, we calculated the monthly return of each stock, beginning
1/29/2016, and ending 12/31/2019 by taking the current month’s stock price, dividing it
by the previous month’s price, then subtracting 1. Then, we calculated the average
monthly return for each stock over our four year time horizon. Then, we calculated each
stock’s standard deviation and variance using the STDEV.S and VAR.S functions
respectively.

We then calculated our excess monthly return for each stock (monthly return-average
monthly return), followed by mean for each of the stock’s excess return.

Table 6: Excess Returns of Portfolio

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Step 2 of MPT: Sample Variance-Covariance Matrix and Correlation Coefficient

Matrix

Based on the excess returns we calculated, we are able to find the variance-covariance
matrix by multiplying our excess return matrix by itself transposed and dividing that
product by the number of inputs in our time frame minus one. A is the excess return
matrix, M is the number of months we took into account for our analysis. The excel
formula for this is {=mmult(transpose(A), A/ count(months-1)}. Using this formula will
give the variance-covariance matrix for our portfolios.

After calculating this, we used the varcov matrix and standard deviations of each stock
to find the correlation-coefficient matrix. The correlation-coefficient matrix is calculated
from dividing Covar (stock A, stock B) by the product of the standard deviations of A
and B. Covar is found in the variance-covariance matrix and the standard deviations are
found in Step 1 of our analysis.

Table 7: Sample Variance-Covariance & Correlation Coefficient Matrices of Naive

Portfolio
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Table 8: Variance-Covariance Portfolio Matrix

STEP 3 OF MPT: Shrinkage Method

Upon instruction, we used a .3 shrinkage factor and applied it to our

variance-covariance matrix, and used its complement (.7) for the diagonal variance
matrix. We used .3 as our shrinkage factor because a sample variance-covariance
matrix tends to have a lot of estimation errors, and can result in odd portfolio
optimization strategies. Using a shrinkage factor of .3, we are able to reduce the
frequency of “odd” outcomes, and move the results toward a more normal distribution.
We used the formula varcov(shrinkage)=λ*varcov(sample)+(1-λ)*other matrix. In this
equation. varcov(shrinkage) is our shrinkage-covariance matrix, λ is the shrinkage factor
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(.3), varcov (sample) is the sample variance-covariance matrix, and the other matrix is
the diag_var matrix.

Table 9: Shrinkage Variance-Covariance Portfolio Matrix

Table 10: Shrinkage Correlation Coefficient Portfolio Matrix

STEP 4 OF MPT: Portfolio Weights, Returns, Sharpe Ratio and More

Applying the Shrinkage method to the correlation of our stocks worked as intended and
greatly reduced the correlation between our stocks. We were able to reduce the number
of stocks that had a correlation greater than .5 from 12 to 0 and greater than .2 from 78
to just 2.

To find the optimal weights for both of our portfolios we used excel's solver tool to
maximize the Sharpe ratio of the portfolio. We began by just creating evenly weighted
portfolios and calculating the expected return and the standard deviation. To calculate
the portfolio expected return we multiplied the weights of each stock and their expected
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returns (=MMULT(TRANSPOSE(mean_ret),weightsA) . To calculate the standard

deviation of the portfolio we took the weights of the stocks and transposed it than
multiplied it by the Variance covariance matrix. We then multiplied it by the weights and
took the square root of the whole thing
(=SQRT(MMULT(MMULT(TRANSPOSE(weightsA), sample_varcov),weightsA)).

Once we had the expected return and the standard deviation of both portfolios, we
computed their Sharpe ratio of the portfolio by applying the formula (expected return-
risk free rate)/Standard deviation. The Sharpe ratio is a way to measure efficiency of the
portfolio by taking the risk premium you are receiving and dividing it by the risk you are
taking. We used a risk free rate of 1% a year and divided it by 12 to match our monthly
data.

Once we had a Sharpe Ratio, we used excel’s solver tool to maximize our Sharpe ratio
by changing the weights of stocks in the portfolio. The only constraint we placed at first
was the total portfolio weight had to equal 100%.

Table 11: Portfolio Weights and Sharpe Ratio with Shorting

Above are the results we originally got. We knew immediately that we did not want to
use the Naïve approach as it was allocating over 100% of the weight to PG and was
using a lot of shorting. Its Standard deviation was also slightly higher than the shrinkage
portfolio. We did not want a portfolio constructed like this for Mr. Risk Averse we felt that
shorting was too risky for his risk appetite. We decided to instead focus on our
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shrinkage portfolio that was more evenly weighted. Still we wanted the portfolio to be
less risky, so we decided to add another limitation to solver and make it so negative
were not allowed. This would ensure that we had a portfolio where we were not
shorting. Below are the results

Table 12: Portfolio Weights and Sharpe Ratio without Shorting

This limitation was exactly what we wanted; it lowered our portfolio standard deviation
from 3.25 to 2.76 while keeping an almost equal Sharpe ratio. Most importantly we were
not shorting and still had a relatively evenly weighted portfolio.

Table 13:Shrinkage and Naive Portfolio Comparison

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Conclusion

In all concluding which portfolio to use was simple when we took into account the needs
of our client Mr. Risk Averse. Our naive portfolio while returning an excellent Sharpe
ratio of 80% was just too risky for our client. It required large amounts of shorting and
the portfolio itself was not very evenly weighted with various stocks having a weight
greater than 15% or less than -15%. Our shrinkage portfolio without shorting was better
fit to our client's risk profile. The portfolio had a Sharpe ratio of 64.89 which is still
considerably higher than the S&P 500 average of 50%. The portfolio had minimal risk
with a monthly standard deviation of just 2.76% with a return of 1.87% a month.