“First control your risks; the returns will talk care of
themselves”
— Benjamin Graham —
The lecture component of the Security Analysis class introduces the students to numerous concepts regarding portfolio and security analysis. However, the implications of these concepts cannot truly be understood until they are put into practice. Thus, the goal of this project is to enable you to put into practice the entire process of:
During the course of this project, which will run almost the full length of the semester, you will conduct all the analysis underlying the portfolio management process and apply this analysis to a simulated $20,000,000 portfolio that you will track throughout the semester.
To conduct this project, you will work as part of a five-member team. The scenario for your team is that you are the management team for a start-up hedge fund with $20 million in seed capital. You want to attract additional investors to your fund (and hence additional management fees into your own pockets), so you want to start investing your seed capital and establish a good track record that will draw the attention of potential investors.
Before starting to invest, however, there are a few administrative details that you must first take care of – namely, the development of your fund’s mission statement, objectives, and constraints. Some items to consider in developing these are described below.
This latter question is especially important to consider, because the benchmark for comparison helps define the fund for investors. Moreover, once the benchmark has been determined, it can provide the basis for some of the portfolio’s constraints. This is because the constraints can be stated in either absolute terms or in terms relative to the benchmark. Some examples of portfolio constraints from Haugen’s book include:
· Maximum stock weight is 5%
· No more than 3X S&P 500 cap weight in any stock
· Industry weight to within 3% of S&P 500
· Turnover controlled to 20% to 40% per annum
Other types of restrictions could relate to asset allocation, portfolio beta, portfolio sensitivity to other risk or expected return factors, average portfolio P/E or dividend yield, and so forth. In general, any item on which an individual security could be screened could potentially serve as a constraint for the portfolio (so long as it is consistent with the fund’s mission and objectives), and there would need to be additional constraints regarding how these stocks are combined together into the portfolio and how frequently the portfolio is rebalanced to ensure that it remains consistent with the fund’s guidelines as market conditions change and how high of a turnover there is among the stocks within the portfolio.
At the end of the semester, your team will be required to turn in a binder that documents your portfolio management activities over the course of the semester. You can view this as the “Annual Report” for your fund (albeit for just a semester rather than an entire year), and it is what you use to document to your current and potential investors how professional a job you have done as managers of their money, how good of a return you have earned for them over the term, and the lessons you will carry forward with you that will enable you to continue to do well, or to do even better, on into the future.
Thus, as with the mission statement, your term report serves two purposes – first, to document how well your portfolio has performed, and second, as a marketing tool, to demonstrate to your investors (who are presumably sophisticated, given that they are in a position to invest in hedge funds) how well you understand the market and portfolio dynamics that contributed to that performance. This latter purpose can be especially important if your recent portfolio performance has been less than stellar and investors are trying to decide whether or not to stay with your fund – they are more likely to stick with you if they believe that you understand the markets and what you are doing.
Three components will go into the determination of your grade on this project:
You are free to exercise your artistic and creative abilities with this project and your final report, but, for the purpose of keeping your work for this project organized during the semester, it is recommended that your group purchase a three-ring binder to contain all of the paperwork that this project will generate. Some of the documentation to include in this binder is:
· Group name
· List of group members’ names
·
· Objectives
· Constraints and appropriate benchmark
· Portfolio construction à analysis underlying initial positions taken
· Portfolio management à regular updates (at least every two weeks or so) and analysis of portfolio and security price movements and returns.
→ Evaluation of price movements – if prices of holdings changed significantly, why (or, conversely, if the rest of the market moved and they didn’t, why not)?
→ Analysis of new information – if news came out about a holding, what are anticipated implications of this information on the value of the holding?
· Portfolio revision and rebalancing (note that when, how often, and what turnover levels are entailed in this process should be a subject of consideration for inclusion among your portfolio constraints)
→ If the portfolio is to be revised, then the analysis driving this revision should be presented.
· Portfolio evaluation and performance measurement (at the end of the semester – a summary and analysis of your portfolio’s performance)
→ How well did your portfolio do (on a risk-adjusted basis as well as on absolute terms), and what led to that performance?