Building of An Optimal Risky Portfolio

FIN 650 Investment Analysis & Portfolio Management
Building of an Optimal Risky

Portfolio
Prepared for Prof. Peter Domasky
Team Members
Sneha Ramakrishnan Rushi Patel
Snehee Shah Sai Charan Konduru
Chenghao Han John Morrison
Menglai Fan
2
Contents
Background 3
Risk Profile 3
Investment 4
Mandates
Sector Analysis 5
Fundamental 7
Analysis
Asset Class: Equity 8
Asset Class: 12
Treasury Bonds
Asset Class: Bonds 16
Scenario Analysis 19
Conclusion 21
Team Members
Menglai Fan
3
At the outset we, would like to introduce ourselves as the representatives of the
asset portfolio management team of Morgan Sachs. As new hires our task is cut out
for our training period. We have been entrusted by our senior management team to
build an optimal risky portfolio for a client.
Background
Our client is thirty-four years old, with a steady job earning $88000 per annum. He
is in receipt of $1 million as a result of a settlement for medical malpractice, where
his wife was the victim. His investment horizon is a medium term of five years and
he expects to earn around 5%-8% on his investment. As this is the first time he is
investing in a portfolio of securities he wants to play safe.
Risk Profile
Based on our discussion with the client, we have drawn up his risk profile. A
number of criteria were considered for this exercise and as a result of which we
deduced his risk appetite into three major categories namely, his ability to take risk,
his willingness to take risk and his need to take risk. Our internally decided risk
weights for the three risk levels; high, moderate and low based on the FSA
guidelines were assigned to each of the criteria depending on his ability,
willingness and need to take risk. See table below:
Team Members
Menglai Fan
Criteria Ability/ Rw Willingness/Rw Need/Rw
Steady Earnings High/1 Low/3 Moderate/2
Existing Debt Low/3 Low/3 Low/3
Investment Moderate/2 Low/3 Moderate/2

Horizon
Investment Goals/ High/2 Low/3 High/1

E(R)
Age & Experience Low/3 Low/3 Moderate/2
The risk levels and the corresponding risk weights have been assigned to the
various criteria, as they define his financial ability, leverage, investment goals,
horizon, psychological behaviour towards risk. Based on the above analysis, we
determined that the investee is risk averse, willing to accept low level of risk with a
risk tolerance of less than or equal to 5%.
Investment Mandates
Our portfolio management style is that of passive management one that is
associated with management style associated with mutual and exchange-traded
fund’s portfolio mirrors a market index. We firmly, believe in the efficient market
hypothesis. The EMH states that it is impossible to “beat the market” because stock
market efficiency causes existing share prices to always incorporate and reflect all
relevant information.
Sector Analysis
Team Members
Menglai Fan
5
Our sector analysis is based on the GICS sectors. There are a total of 11 sectors.
See diagram below:
We used a top down approach for our sector analysis and it is based on the S&P
500 Indices. From the above 11 sectors we narrowed down to 5 based on the 5-year
CAGR, YTD. The said 5 sectors, narrowed down have a 5-year CAGR and YTD
greater than or equal 10%. The sectors are; Consumer Discretionary, Energy,
Financials, Healthcare and Information Technology. Out of the 71 industries in the
5 sectors, we came down to 9 industries, part of the above said sectors. The basis
for this was 5-year CAGR greater than equal to 10%, YTD greater than equal to
10% and beta less than equal to 1.
Team Members
Menglai Fan
From the above 5 sectors we drilled down to three sectors and 7 industries, based
on YTD, 5-Yr: CAGR, Beta, S Dev, P/E (actual and estimated), EPS, Growth in
EPS, ROE, ROI, Total D/E and Dividend Yield.
The said sectors are, Consumer Discretionary, Healthcare and Information

Technology. Based on sector performances, the IT sector seems to be more
balanced. It has a better YTD at 8.3%, compared to 3.9% and -5.4% of the
consumer discretionary and healthcare sectors respectively. Its 5-yr CAGR is only
marginally less than the other two sectors at 13.8% versus, 15.9% and 14.4% of the
consumer discretionary and healthcare respectively. Standard deviation of 13.7%
although slightly higher than the rest of the two sectors is in our desired range.
Except for the revenue growth which is exceptionally high for the Healthcare
Team Members
Menglai Fan
7
sector, IT sector has outperformed the others in terms of EPS growth, ROE, ROI
and dividend yield. Also a lower Total D/E makes it more attractive, for a risk
averse client. The two industries we came down to based on the above analysis;
Internet Software Services and Data Processing & Outsourced Services.
Fundamental Analysis
This section examines the top two allocated equity securities in the iShares MSCI
Taiwan Capped ETF: Taiwan Semiconductor Manufacturing Co Ltd and Hon Hai
Precision Industry Co., Ltd. TSM accounts for over 22% and Hon Hai accounts for
roughly 8%. The Company is engaged in the manufacturing, selling, packaging,
testing and computer-aided design of integrated circuits and other semiconductor
devices.
TSM’s net income has grown by close to 20% from 2014 to 2015. Also in 2015,
they have lowered their total liabilities by 6% while continuing to increase their
total assets. They have taken their cash from operating activities to make capital
expenditures mainly in the form of increasing capacity of their manufacturing
facilities. They have explained that manufacturing is one of their strongest
competitive advantages. In the summer of 2016 they have acquired the contract to
exclusively produce Apple’s (AAPL) application processors.
Hon Hai Precision Industry Co Ltd was incorporated in Taiwan on February 20,
1974. The Company along with its subsidiaries is engaged in the manufacture,
sales and service of connectors, case, thermal module, wired/wireless
communication products, optical products, power supply modules, and assemblies
for use in the IT, communications, automotive equipment, precision molding,
automobile, and consumer electronics industries.
This company had revenues of 4.48 trillion in 2015. However, they have increased
Team Members
Menglai Fan
8
revenues year over year but in 2015 they have sold off a significant portion of
assets. The total assets have declined by 6.23%. Also they have seen some negative
effects in the Indian market, due to demonetization. Revenues in this market have
declined by 50%. As we see this as an apparent threat we believe it will not have a
significant long term impact.
Asset Class: Equity, Taiwan ETFs
Team Members
Menglai Fan
Team Members
Menglai Fan
10
Since inception Taiwan ETF iThe Fund seeks to track the investment results of the
MSCI Taiwan 25/50 Index (the “Underlying Index”), which consists of stocks
traded primarily on the Taiwan Stock Exchange. A capping methodology is applied
that limits the weight of any single component to a maximum of 25% of the
Underlying Index. Additionally, the sum of the components that individually
constitute more than 5% of the weight of the Underlying Index cannot exceed a
maximum of 50% of the weight of the Underlying Index in the aggregate. The
Underlying Index may include large-, mid- or small-capitalization companies.
Components of the Underlying Index primarily include financials, information
technology and materials companies. The components of the Underlying Index,
and the degree to which these components represent certain industries, are likely to
change over time. Prior to the selection of the Underlying Index on December 1,
2016, the Fund tracked the MSCI Taiwan Index.
Team Members
Menglai Fan
11
Performance Information The bar chart and table that follow show how the Fund
has performed on a calendar year basis and provide an indication of the risks of
investing in the Fund. Both assume that all dividends and distributions have been
reinvested in the Fund. Past performance (before and after taxes) does not
necessarily indicate how the Fund will perform in the future. Supplemental
information about the Fund’s performance is shown under the heading Total Return
Information in the Supplemental Information section of the Prospectus.
Team Members
Menglai Fan
12
Asset Class: Treasury Bonds, Goldman Sachs Treasury Bonds
● Goldman Sachs Asset Management (GSAM) developed an Exchange-

Traded Fund (ETF) that provides access to Treasuries with a maturity of less
than a year, which are backed by the full faith and credit of the US
Government. Investors in the Goldman Sachs Treasury Access 0–1 Year ETF
can gain easy access to Treasury markets while avoiding the operational and
pricing complexities of US Treasury Auctions and the over-the-counter
market.
● GSAM recently launched a series of Exchange-Traded Funds, including a
money market fund ETF, in the US with more than $2 billion in assets under
management.
Why it is suitable for Investors ?
● Seeking exposure to a short-term, diversified portfolio with an on-exchange

tradable product
● That have the capability to access an exchange on which the fund trades
● Seeking low cost liquidity solution
● Considering a passive product tracking an index as opposed to an actively
traded portfolio
● Seeking lower minimum initial investment
● Pursuing potential tax efficiency 1 based on gains and losses in the portfolio
that the client can process
Team Members
Menglai Fan
13
Government T-Bonds and Yield Curves
Team Members
Menglai Fan
14
- The Government T-Bond for 3 months period is 0.53%
The Closing Price for the GBIL is 100.01 as of 12/11/2016
Team Members
Menglai Fan
15
Comparing the GBIL with CITI US , GBIL is the more liquid(easy to liquidate).
GBIL had starting from 3-months to one year treasury bonds.
Historical Premium (Discount) To NAV Since Inception (12.09.16)
In the year 2016 the bonds started with the discounts and at the end of the year
from november it started with the premium.
Team Members
Menglai Fan
16
These are the some of the parameters of the GBIL treasury bonds.
Asset Class: Bond
Microsoft corporate bond is an 3a rating bond which is rated by Standard & Poor,
Moody’s and Fitch. Therefore, it has low credit risk and default risk.
This bond has a $1000 par value, 2.5% coupon rate, 5 year maturity, and pays
coupon semi-annually.
I chose two ratios to measure the solvency of Microsoft. The first one is its cash
ratio, we can see that in last 5 years, although its cash ratio is fluctuant, it kept a
high level of cash ratio. Then let’s see its coverage ratio. Its coverage ratio kept a
down trend during last five years. The reason is that Microsoft issued more bonds
in recent years, so Microsoft paid more interest to investors. For example,
Microsoft sold $11Billion bond last year and its largest corporate bond sale last
year, but the coverage ratio is still very high.
Team Members
Menglai Fan
17
Portfolio analysis
We have constructed a 3-asset portfolio which includes a 5-year U.S. Treasury

bond, a 5-year corporate bond issued by Microsoft, and a ETF. Moody's confirms
Microsoft's Aaa senior unsecured rating, which is the highest rating. Those
characteristics senior tranches, and unsecured terms indicate Microsoft’s bonds to
be superior in terms of default risk than those terms with junior or secured. Other
two risks are reinvestment risk and interest rate risk which would be influenced by
the market, that means “every ship on the sea is going to be up and down with the
tide”.
The expected annualized returns of these 3 assets are calculated by using historical
monthly data, as well as the variance/covariance matrix. As expected, we found
different combinations of assets provide us some degree of diversification. For
example, solely invest in the bond provides us a 2.97% return with St Dev of
0.016. While in the portfolio we have constructed, a 0.016 St Dev could help us
Team Members
Menglai Fan
18
achieve a return of about 3.5%. Bearing the same level of risk, we improved the
return by 0.53%.
Then I have constructed an Efficient Frontier by putting different weights on

assets, the most-left point is what we called the global min variance portfolio. Then
on the point of 4% annual return, we have maximized the Sharpe ratio of our
portfolio. If we draw a tangent line to the Efficient Frontier, we could see that with
the slope of the tangency line decreases, the marginal return for us is also reduced.
By constructing a CML, we have a Tangency point. As expected, the Tangency
point is where we have the max Sharpe ratio, so this should be the optimal point
for most risk-averse investors.
Team Members
Menglai Fan
19
You could also increase the percentage invested in risky assets to over 100% by
Borrowing investment. Investors who believe their estimates of security values are
correct follow an investment strategy. This is also a use of leverage. Otherwise, we
usually use Lending invest with putting the weight of risky asset less than 100%.
Scenario Analysis
Scenario analysis evaluates the expected value of a proposed investment or
business activity. The statistical mean is the highest probability event expected in a
certain situation. By creating various scenarios that may occur and combining them
with the probability that they will occur, an analyst can better determine the value
of an investment or business venture and the probability that the expected value
calculated will actually occur.
Determining the probability distribution of an investment is equal to determining
the risk inherent in that investment. By comparing the expected return to the
expected risk and overlaying that with an investor's risk tolerance, you may be able
to make better decisions about whether to invest in a prospective business venture.
This article will present some simple examples of various ways to conduct scenario
analysis and provide rationale for their use.
Team Members
Menglai Fan
20
We created 5 scenarios and on the basis of that came up with 16 different allocation
mix. We came up with the optimal solution. We used what if analysis and scenario
analysis of portfolio function of Microsoft excel.
Scenario Select Allocation Mix Comparison
Return Allocation Mix
Result of Scenario Analysis
Security Annualized Beta Std.Deviation Allocation

Return
Taiwan ETF 10.65% 1.04 13.78% 50%
GBIL 0.85% - - 0%-5%
MSFT Bond 2.97% - - 45%-50%
Team Members
Menglai Fan
21
Portfolio S.D 18.37%
Portfolio 7.50%
Return
Conclusion
We have $1,000,000 liquid asset to be securitized for 5 years , expecting return of
7% with bearing the moderate risk. While if we are willing to bear more risk, as
you could see in the chart, by increasing the weight of ETF we could also reach a
return over 4-5%, the Sharpe ratio is still strong. And we putting the weight of our
portfolio half-half into the ETF and the bond. By applying the half-half weighting
on ETF and bond which has low correlations between each other, we reasonably
reduced the unit risk for each unit of return we gain.
Having 100% The probability of success, the portfolio is confident investment
instrument. However we still going to manage portfolio as hybrid management.
Where we are open to reallocate asset and change bond asset into high yield bond
asset class depending on market implications. Such as in market implied high
interest condition our fixed income strategy will change to have more risky asset to
capitalize on rising interest rate.
In conclusion, we have relatively standard market product which will have assured
returns on current market conditions.
Team Members
Menglai Fan
22
Team Members
Menglai Fan

Building of An Optimal Risky Portfolio

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Building of An Optimal Risky Portfolio

Uploaded by

Copyright:

Available Formats

FIN 650 Investment Analysis & Portfolio Management

Building of an Optimal Risky

Prepared for Prof. Peter Domasky

Criteria Ability/ Rw Willingness/Rw Need/Rw

Steady Earnings High/1 Low/3 Moderate/2

Existing Debt Low/3 Low/3 Low/3

Investment Moderate/2 Low/3 Moderate/2

Investment Goals/ High/2 Low/3 High/1

Age & Experience Low/3 Low/3 Moderate/2

The said sectors are, Consumer Discretionary, Healthcare and Information

Asset Class: Equity, Taiwan ETFs

Asset Class: Treasury Bonds, Goldman Sachs Treasury Bonds

● Goldman Sachs Asset Management (GSAM) developed an Exchange-

Why it is suitable for Investors ?

● Seeking exposure to a short-term, diversified portfolio with an on-exchange

The Closing Price for the GBIL is 100.01 as of 12/11/2016

Historical Premium (Discount) To NAV Since Inception (12.09.16)

Asset Class: Bond

We have constructed a 3-asset portfolio which includes a 5-year U.S. Treasury

Then I have constructed an Efficient Frontier by putting different weights on

Scenario Select Allocation Mix Comparison

Return Allocation Mix

Result of Scenario Analysis

Security Annualized Beta Std.Deviation Allocation

Taiwan ETF 10.65% 1.04 13.78% 50%

GBIL 0.85% - - 0%-5%

MSFT Bond 2.97% - - 45%-50%

Portfolio S.D 18.37%

You might also like