Macquarie University Applied Finance Centre

AFCP801 Portfolio Management and Valuation

Eagle Assignment 2015 term 4 Sydney
Assignment Submission: Your assignment assessment piece will be submitted via iLearn.
Please refer to the Assignment section on your units iLearn site for instructions. The cover
sheet to include in your assignment submission is also located there.
Penalty for Late Submission: If you have extenuating circumstances that prevent you from
submitting your assignment by the due date please make arrangements with your lecturer
prior to the due date. Unless prior arrangements have been made, any late submission of
assignments will automatically be penalised. In the absence of special circumstances, a zero
mark will apply.
Format: A written submission (eg a word document) is required from each student showing
any important formulae used. Do not submit spreadsheet files or print outs of spreadsheets
with your assignment answer.
Nature: Teamwork is encouraged in carrying out data analysis. However, all explanations,
interpretations and recommendations must represent your own work and not that of
another person. You must clearly and accurately acknowledge the source of any reference
material you use. If you infringe these rules or encourage or assist another person to infringe
them, penalties will apply (refer to the Universitys Academic Honesty Policy ).
Copies: Students should retain a back-up copy of their assignment submission on paper.
Value: 35% of the assessment for Portfolio Management and Valuation is represented by this
assignment.

Grant Archer
Grant Archer has successfully managed equity portfolios at a high profile funds management
firm for ten years. The firm employs teams of specialist managers to actively manage each
individual asset class. This process typically produced a pre-fee return that was above the
client portfolios benchmarks over a medium term (eg three years) but underperformed on
an after-fee basis.
Archer became familiar with the disappointment expressed by his clients when the actively
managed portfolios periodically underperformed their benchmarks. They were also
continually dissatisfied with the significant fees necessary to employ active managers. Archer
therefore saw the attraction of a much less active investment management process which
closely match index returns and charged a slightly lower fee. He resigned from his high
profile employment and set up a new firm, Eagle Investment Management.
Eagle Investment Management
Archer has employed a well-qualified and experienced team of analysts, portfolio managers
and dealers. Most of the team had worked for Archer at his previous employer and were
keen to follow him to participate in the success of the new business venture. The team will
manage portfolios representing each major asset class with an enhanced index flavour.
These asset class portfolios will each replicate an appropriate index but take on security and
sector tilts (within tight risk controls) for example, on the basis of firm size and relative
value, in the context of shares.
Archer has contacted a few of the clients he previously managed at his old firm mainly
large superannuation funds. He has received an encouraging response to his plan to provide
lower cost investment products. Eagles clients are typically risk averse and have portfolios
which consist of allocations across the major asset classes with some allocation to cash depending on the particular clients level of risk aversion. The next step is for Eagle to
establish its investment process and generate some example portfolios. Archer decides to
start with building an equity portfolio.
Security Analysis
To demonstrate the eventual implementation of the equity portfolio, Archer will need to
develop an approach to managing the security selection. He has decided to provide a simple
demonstration of security selection by using a sample of just seven shares. Coincidentally,
the funds management firm he had previously worked for was owned by a bank. His
previous role had involved being a member of the senior management team of that bank. In
this capacity, Archer had received internal memos outlining strategic initiatives which he
believed would eventually lead to significant earnings growth for the bank. He therefore
included the banks shares on in the list of shares to be analysed.

Archer has collated total return index data on shares, cash and the share market index
(contained in the excel file). This data will be useful in analysing the performance of the
individual shares relative to the share market in a simple index model. The results from this
analysis will be employed in constructing an appropriate share portfolio.
In analysing this data, Archer became concerned about the overall validity of the model and
its resulting betas - ie he was concerned about whether high betas were actually
representative of higher risk premia. He therefore conducted a second pass regression test
of the single index model (including relevant data on additional shares that he had previously
collated) to evaluate this approach. He also wondered whether there were better
approaches to estimating betas being employed in the industry.
Further, the idea that a single index model was the best way to understand the share
portfolios exposure to the underlying sources of risk and return also posed challenges for
Archer. As he became more familiar with the way in which the firms security selection was
driven by firm characteristics, he became concerned that they werent modelling the
relevant risk factors. He therefore attempted to provide a stronger mapping of the way the
security returns were explained by firm characteristics specifically, in the context of shares:
firm size and relative value. This testing also made Archer curious as to whether Eagles
competitors were using multi factor models and, if so, what factors they were using and how
they were implementing the models.
Portfolio Construction
There are a number of alternative approaches to constructing share portfolios and Archer
will be required to decide on which is the most appropriate for the context of Eagles
approach to portfolio construction and its overall investment management philosophy. To
start with, he has limited the range of portfolio objectives they will evaluate to four, ie: a
maximum alpha; a maximum alpha but with a beta constraint; a minimum non-systematic
risk portfolio; and a maximum Sharpe ratio portfolio.

Questions (marks are equally weighted across the questions)

Question 1.
(a) Calculate average monthly excess returns for the seven shares and the equity index which
have monthly index data in the spreadsheet. Report each shares arithmetic average
monthly excess return, standard deviation of excess return (using the population version of
the standard deviation equation) and the correlation of excess returns between the shares.
(b) Regress the monthly excess returns for each share on the monthly excess returns of the
equity index and report each shares: alpha; beta; t-statistics; and adjusted R squared. Also
calculate and report each shares tracking error - as implied by the betas and standard
deviations of excess return - ie from part (a).
Question 2.
(a) Run a second pass regression by regressing the average excess returns for the shares on
their betas and tracking errors from Question 1 combined with the data for the additional
shares provided in the spreadsheet (refer to BKM section 13.1). Report the gamma 0, gamma
1, gamma 2, standard errors, relevant t-statistics and adjusted R squared.
(b) Run a multi variable regression for each share by regressing the shares monthly excess
returns on the monthly excess returns of the equity index and the additional factor data (ie
HML = High Minus Low and SMB = Small Minus Big) provided in the spreadsheet - refer to
page 425 for an example of a multi factor model (NB: were only running a first pass
regression here) and page 340 for an explanation of the Fama-French factors. Report each
shares alpha, betas; t-statistics; and adjusted R squared.
Question 3. Evaluate the models tested in the previous questions for the purposes of
constructing potential equity portfolios for Eagles clients (300 word limit).
Question 4. Use the results from Question 1 to construct the following share portfolios. Only
include the original seven shares in the portfolio (ie do not include the equity index or the
additional share data from Question 2). Use the full correlation matrix when calculating
portfolio standard deviation but assume zero correlation between the shares nonsystematic returns for calculating portfolio tracking error.
(a) Use solver to find the portfolio weights for a long-only share portfolio with the maximum
amount of alpha. State the portfolio weights, alpha, beta, tracking error, information ratio,
excess return, standard deviation of excess return and Sharpe ratio.
(b) Use solver to find the portfolio weights for a long-only share portfolio with the maximum
amount of alpha combined with a beta of one. State the portfolio weights, alpha, beta,
tracking error, information ratio, excess return, standard deviation of excess return and
Sharpe ratio.

(c) Use solver to find the portfolio weights for a long-only share portfolio with the minimum
amount of tracking error. State the portfolio weights, alpha, beta, tracking error, information
ratio, excess return, standard deviation of excess return and Sharpe ratio.
(d) Use solver to find the portfolio weights for a long-only share portfolio with the maximum
Sharpe ratio. State the portfolio weights, alpha, beta, tracking error, information ratio,
excess return, standard deviation of excess return and Sharpe ratio.
Question 5. Evaluate the portfolio results from Question 4 and their objectives in the context
of selecting a portfolio to best reflect Eagles philosophy of funds management. (300 word
limit)
Question 6. Research two investment managers that use multi factor models in their
investment processes. Describe the factors employed and explain how they are used in
portfolio construction. (400 word limit)
Question 7. Research two providers of share betas. Explain how they estimate beta and
evaluate their approach in the context of constructing share portfolios. (400 word limit)
Question 8. Describe the major ethical issues that arise in relation to Eagle Investment
Management and its portfolio recommendations. Use the three frameworks of ethical
analysis to examine these issues. (300 word limit)

Appendix
Notes on data and spreadsheet analysis
Data
The S&P ASX 200 index data presented in the assignment excel file is a value weighted, total
return index of a broad collection of companies on the Australian stock exchange. The
Bloomberg Australian Bank Bill Index is intended to measure the performance of a typical
Australian managed cash portfolio. The monthly data for the individual shares are also total
return indices. The HML and SMB indices are based on Fama and Frenchs risk factor indices
for relative value and company size for the Australian sharemarket.
Calculating Rates of Return
The annual holding period returns can be calculated using the following formula:
Holding Period Return =

Total Return IndexEND

Total Return Index
1
BEGIN

Spreadsheet Usage
You will need to use a spreadsheet like Microsoft Excel to complete this assignment. You
may find the built-in statistical functions {eg STDEV.P(
) and CORREL(
) etc} to be useful
- in addition to the regression analysis tool. Use the Excel HELP to find out how what specific
equations these functions are applying.
Use of Optimiser
To use the embedded optimiser (entitled Solver) in Excel, select the Data tab and look in
the analysis section. In your spreadsheet, you can make some initial guesses for the weights
of each asset to be included in the portfolio. Calculate the required portfolio return, risk,
performance ratio etc based on these weights. In the pop-up Solver box, set the set
objective to the cell containing the formula for the objective measure (eg the Sharpe ratio
in the context of the optimal risky portfolio etc). Select max (or min if appropriate
etc). In the by changing variable cells field, select the cells containing asset weights. If
you click the solve key, the optimiser will attempt to optimise the performance measure
by adjusting the weights for each asset. It is likely that you will need some constraints for
the optimisation (eg by using the subject to the constraints component). For example,
ensure that the sum of the weights is constrained to equal one. Also, consider adding
additional constraints if they prove appropriate in the context of the assignment.
Marking & Spreadsheets
We do not mark spreadsheet. Do not submit spreadsheet files or spreadsheet print outs with
your assignment answer.