INVESTMENT ANALYSIS: ACTIVELY MANAGED PORTFOLIO
Unlike the passively managed portfolio, the actively managed portfolio relies on the theoretical basis that the market is not perfectly efficient. This inefficiency allows an investor to outperform the market by utilizing a certain skill or strategy. An active portfolio management usually requires short term, frequent trading, which could potentially result in large trading costs for the investor. Taking this into account, the task was to make a strategy as accurate as possible to cover the large trading cost and make profit. In building an actively managed portfolio, the selected strategy was stock picking. The reason for selection of this strategy is that, according to Schadler & Eakins (2001), professional investors who seek alpha have “post recommendation positive abnormal returns.” The authors mention academic articles in which the recommendations of brokerages houses point out that there are significant positive abnormal returns associated with buy recommendations, particularly in the month such recommendations are announced. Such articles have found that there are no recurring abnormal returns, and since they do not revert, the articles attribute gains to the analysts' recommendations. Albeit they acknowledge the difficulty of stock picking, this work can be really valuable, “even after allowing for transactions costs and risk" (Schadler & Eakins, 2001).
Many traders rely on technical analysis in construction of an actively managed portfolio, which I also tried to incorporate into my actively managed portfolio strategy. The index rotation strategy and the technical analysis were used to analyze individual stocks. In the index rotation, the annual return of the portfolio is assessed by a particular market rate, which shows that it tends to decrease by a certain ratio due to negative summary of performance against the market's rate. On the other hand, the technical analysis shows the expected going rate of return and determines that it would remain the same in the upcoming period. It is concluded, that the expected rate is less than the market rate, which means it will consistently go towards a downward rate. The main advantage of this strategy is that it offers a simple, time-tested guideline to enable investor in their quest for seeking alpha. Furthermore, such results can be tested, reproduced and easily conveyed to other investors. The main disadvantage is the lack of a sound academic foundation (Investopedia, 2006).
The selection of stocks for my active portfolio was based on the following criteria: I had to decide upon an average daily trading volume, which is a good measure of liquidity (Cochrane, 2004). The high liquidity allows for more consistent data over time, enabling technical analysis to be more successful, as there are no ‘gaps’ in the historical series. Furthermore, I used the forward P/E (price-to-earnings) ratio as a measure of finding undervalued stocks. This is a traditional measure, which has been used time and again, to find undervalued stocks in industries as different as aviation and real estate (Tse, 2002).
I set the minimum daily volume to be 2,000 shares of stocks in the U.S. market, as anything lower than that would pick stocks too illiquid and add difficulty to find mispricing. The forward P/E ratio of stocks is limited to 31, the price-to-earnings ratio of Google, which I deem a company with great reputation, and to be currently mispriced by the market. Anything above 31 was discarded from my selection.
Glaxo – Pharmaceuticals; Unilever – diversified consumer products; Amazon – online retailer; Berkshire Hathaway – diversified holdings of Warren Buffet, one of the greatest stock-picking investors (Mann, 2002); Apple – creator of the iPhone, iPad and similar computer products; Google – lead provider of most internet services; Standard Pacific – real estate; NVIDIA – computer graphics; HC Capital – investment company; Starbucks – coffee products and franchises.
As we can see, all of these ten companies are top players in their fields, which form a diversified portfolio and represent a good share of the economy. All of them had the necessary trading volume and P/E Ratio.
Active Portfolio Summary and Analysis
This table illustrates that, even when a proper stock-picking strategy is selected, the portfolio may suffer a downfall. To avoid such results, we could add more stringent requirements (such as increasing the minimum trading volume or lowering the P/E ratio), diversity the portfolio with more stocks, and consider a higher holding period. Even so, market downturns may destroy value because such is the nature of risky investments.
Technical analysis was an important part of my process of stock selection. It allowed me to make a broad screening of stocks in a very large market, and the selection of average trading volume and forward P/E ratio allowed me to check for the liquidity of the assets – an important trait when performing technical analysis – and for the expected value of the stock.
My portfolio selection was also based on fundamental analysis of selected papers in varied industries. I picked the winners of a variety of industries, ranging from online retailing to pharmaceuticals, and that fostered both the quality and the diversification of my portfolio. Technical analysis and fundamental analysis can be applied in unison for better evaluation and stock picking.
This active portfolio did not seem to perform well due to adverse trends in the overall market, which displayed high uncertainty in the selected holding period. Were a longer period selected, results would have been better, because of the quality of the picked stocks and the avoidance of a single downturn trend.
We must point out that our "alpha" stemmed from sound and tested market practices, which capture liquidity, asset pricing, and industry diversification. These are proper qualities to choose stocks in the building of an active portfolio. The information needed came from a reliable, industry standard website, and the adopted procedures for creating the portfolio were in accordance with investor practice.
References
Cochrane, J. H. (2004). Asset Pricing: Liquidity, Trading, and Asset Prices. NBER Reporter,
1. Retrieved from Questia.
Investopedia. (2006, May 05). Technical Analysis: The Basic Assumptions | Investopedia.
Retrieved May 10, 2016, from
http://www.investopedia.com/university/technical/techanalysis1.asp
Mann, B. (2002, February 1). The Warren Buffet CEO: Secrets of the Berkshire Hathaway
Managers. Chief Executive (U.S.), (175), 63. Retrieved from Questia.
Schadler, F. P., & Eakins, S. G. (2001). Merrill Lynch's Focus Stock Picks: A Test of
Analysts' Stock Picking Ability. Quarterly Journal of Business and Economics, 40(2),
17. Retrieved from Questia.
Tse, R. Y. (2002). Price-Earnings Ratios, Dividend Yields and Real Estate Stock Prices.
Yahoo. (n.d.). Yahoo Finance - Business Finance, Stock Market, Quotes, News. Retrieved May 10, 2016, from http://finance.yahoo.com/
