Portfolio construction for Robins Hewins using Markowitz theory

Investment Management

After holding a meeting with our client named Robins Hewins on the January 1st 2007, our organization presents the client the best performing portfolio that we believe will suit his requirements. NYZ Investment Fund will manage the investment portfolio of our client with initial investment of £100,000 starting from May 2012. Classification of our client reveals that Robins Hewins is a risk averse investor, and would like to achieve a return of not less than 8% per annum from his investment. While investor is enthusiastic in investing his money in our investment portfolio, however, the client is not ready to put his money into a fund unless he is fully satisfied about how his investment will be created and will be managed. The construction of the portfolio will take into account the costs of maintaining and managing the portfolio. More importantly, the portfolio that we will present to our client will be well spread over the market sector to achieve market gain. To construct the investment portfolio for our client, we use Markowitz Ian portfolio theory. The weekly share prices of FTSE 100 index and FTSE 100 shares from January 2000 will be used to construct the client investment portfolio. FTSE 100 consists of 100 highest capitalized firms being listed in the London Stock (LSE), and represents 80% of LSE market capitalization. (Mase, 2007).

Based on the client request, we present the well-prepared investment portfolio that we believe that will meet our client's requirements while taking into account the client financial strength and his risk aversion. We assume that the risk free rate to be constant at the rate of 4% per annum.

Method Employed to Construct the Portfolio

This section presents the strategy that NYZ Investment will use to assist our company to sell the investment portfolio to client. With respect to the client risk aversion position, it is strongly recommended for clients to take a non-active strategy and investment in our fund. Emphatically, our index provides low turnover, a good diversification, and considerably low management fees for our clients.

Diversification

Portfolio was constructed following our stock selection strategy. The strategy we use in the stock selection is by analyzing all different stocks listed in FTSE 100. We do not discriminate any industry because we analyze the stocks found in all industry. After analyzing the stocks in all from FTSE 100, the next most important step was to select 10 performing stocks from our portfolio. The strategy we use to select the best performing stock from every industry. The parameters we use are as follows:

Beta

Beta is one of the most importantly tool to measure the equity market volatility. Beta reveals the relationship between the financial instrument and financial market. On the other hand, Beta measures the stock's risks relative to the over risks in the market. Typically, equity with high Beta will underperform when market is going down. For example, if Beta of equity is 2, the equity will significantly underperform when market is going down. Our strategy was by calculating the Beta value of all the stocks selected using the yearly returns between January 2000 and December 2008. We then compare our stock yearly price movement to the yearly price movement of FTSE 100. Based on our analysis, we prefer the Beta, which is less than one.

"Beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2, it's theoretically 20% more volatile than the market." (Investopedia 2012 P. 3). Choosing a better greater than one will be riskier for our investor.

Return on Assets (ROA)

We use the return on assets to measure the rate of return to satisfy the client requirement. We select stocks with high ROA based on the believe that the increase in the company assets lead to high return.

Return on Capital Employed (ROCE)

Although, we prefer selecting the stocks having the highest ratio of efficiency and profitability, however, we still have to consider the risks associated with the stocks before selecting the best performing stocks for our client is since our client is a risk averse

Dividend Yield

Return is the most important parameter that we follow when selecting our stocks. We take into account of dividend yield as well as taking into account of the risk free rate and the Beta of the stock. We select the stocks with excess returns and having the lower risks. In the other word, we select stocks which returns are greater than risks associated with the stocks. We identified the stocks having excess return selected from every industry. (See Table 1).

Table 1: Parameters of all the Stocks

COMPANY NAME

Dividend Yield

Return on Capital

Employed (ROCE)

Return on Assets

BetaBeta

Admiral Group

3.11%

97.46%

8.46%

1.0

Aggreko

0.95%

27.94%

14.68%

1.1

Amec

2.83%

34.96%

9.45%

1.3

Anglo American

2.06%

17.63%

8.52%

1.6

Antofagasta

1.12%

29.19%

10.56%

2.1

ARM Holdings

0.59%

29.43%

8.67%

1.1

Ashmore Group

3.75%

57.92%

27.98%

1.2

Associated British Foods

2.08%

13.12%

5.30%

0.5

AstraZeneca

6.35%

84.36%

18.90%

0.8

Aviva

8.51%

9.64%

0.07%

1.7

BAE Systems

6.42%

0.00%

5.37%

1.0

Barclays

2.79%

6.96%

0.19%

2.4

BG Group

1.08%

16.83%

6.90%

1.3

BHP Billiton

3.37%

37.56%

22.98%

1.6

BP

4.14%

23.93%

8.77%

1.0

British Land Co

5.51%

13.05%

11.57%

1.1

British Sky Broadcasting Group

3.60%

56.62%

15.13%

0.7

BT Group

3.41%

25.30%

6.38%

1.1

Bunzl

2.64%

48.41%

4.52%

0.8

Burberry Group

1.28%

37.82%

15.27%

1.4

Capita

2.94%

71.73%

6.73%

0.6

Centrica

4.91%

14.98%

2.15%

0.7

Compass Group

3.03%

7.74%

0.7

CRH

4.17%

7.55%

2.76%

1.6

Croda International

2.58%

61.12%

16.79%

1.0

Diageo

2.66%

31.77%

9.61%

0.6

Experian

1.81%

0.00%

7.92%

0.9

G4S

3.01%

27.70%

3.22%

0.7

GlaxoSmithKline

4.99%

62.31%

12.81%

0.5

Hammerson

4.07%

7.98%

5.37%

1.2

Hargreaves Lansdown

2.81%

96.30%

28.96%

1.4

HSBC Holdings

4.76%

12.68%

0.66%

1.2

ICAP

5.36%

49.73%

0.24%

1.3

IMI

3.24%

71.85%

11.57%

1.8

International Power

2.72%

8.72%

2.85%

0.6

Intertek Group

1.35%

42.31%

7.99%

1.0

1.89%

50.63%

8.46%

1.4

Johnson Matthey

2.00%

17.71%

5.61%

1.4

Kazakhmys

2.01%

15.71%

7.93%

2.2

Kingfisher

2.97%

18.94%

6.64%

1.0

Land Securities Group

3.95%

14.14%

11.64%

1.1

Legal & General Group

5.22%

12.39%

0.22%

1.5

Lloyds Banking Group

0.00%

0.00%

-0.29%

2.1

Man Group

12.56%

12.94%

2.34%

1.5

Marks & Spencer Group

4.60%

17.10%

8.33%

0.8

Meggitt

2.62%

65.59%

4.64%

1.0

Morrison (Wm) Supermarkets

3.66%

13.23%

7.00%

0.4

3.05%

69.65%

25.61%

0.6

Old Mutual

3.24%

26.38%

0.41%

1.5

Pearson

3.77%

50.96%

8.51%

0.8

Petrofac Ltd.

2.15%

62.80%

11.03%

1.5

Prudential

3.47%

14.73%

0.54%

1.6

Randgold Resources Ltd.

0.45%

20.71%

14.89%

0.4

Reckitt Benckiser Group

3.57%

0.00%

12.35%

0.6

Reed Elsevier

4.10%

54.47%

34.72%

0.8

Resolution Ltd.

8.21%

0.00%

-0.05%

1.0

Rexam

3.43%

23.66%

6.14%

0.8

Rio Tinto

2.66%

15.32%

4.87%

1.7

Rolls-Royce Holdings

2.16%

33.86%

5.18%

2.1

RSA Insurance Group

8.88%

15.67%

1.89%

1.0

SABMiller

2.01%

23.13%

6.16%

1.0

Sage Group

3.39%

6.89%

0.9

Sainsbury (J)

5.00%

11.50%

5.61%

0.8

Schroders

2.68%

8.82%

2.27%

1.4

Schroders (Non-Voting)

3.45%

8.82%

2.27%

0.8

Severn Trent

4.18%

7.81%

3.56%

0.4

Smith & Nephew

1.81%

41.03%

12.26%

0.8

Smiths Group

3.52%

44.25%

10.58%

1.1

Standard Chartered

3.20%

13.15%

0.81%

1.3

Standard Life

6.25%

12.32%

0.19%

1.1

Tate & Lyle

3.44%

16.67%

5.34%

0.6

Tesco

4.49%

16.36%

5.62%

0.7

Tullow Oil

0.83%

30.01%

6.10%

1.3

United Utilities Group

5.05%

7.08%

4.91%

0.4

Vedanta Resources

2.79%

13.60%

2.67%

2.2

Vodafone Group

5.25%

13.41%

5.27%

0.4

Whitbread

2.44%

17.73%

8.01%

0.8

Wolseley

1.91%

14.80%

3.44%

1.3

WPP

2.93%

73.30%

3.34%

1.2

Optimal Portfolio

After carefully analyzing the table 1 and calculating the financial measures of all stocks in Table 1, we select one high performing stock from every industry listed to have well diversified portfolio. Based on our analysis, we did not select stocks from banking industry because they have relative high risks negative returns and high standard deviation as well as having negative excess return and negative beta. Additionally, we removed the insurance sector from the list because the firms under this sector have low returns with relatively high standard deviation, thus, generally having high risks. Based on our evaluation we need a portfolio that have high returns perspective with generally low risks features. We selected our portfolio from the following industry Food Producers & Processors, Support Services; Travel & Leisure, Beverages, General Retailers, Media, and Mining. Our stocks portfolio is composed of the following securities as being revealed in Table 2.

Table 2: 10 Best Stocks Selected

COMPANY NAME

Industry

Dividend Yield

Return on Capital

Employed (ROCE)

Return on Assets

BetaBeta

Stock 1

Associated British Foods

Food Producers & Processors

2.08%

13.12%

5.30%

0.5

Stock 2

Bunzl

Support Services

2.64%

48.41%

4.52%

0.8

Stock 3

Compass Group

Travel & Leisure

3.03%

7.74%

0.7

Stock 4

Diageo

Beverages

2.66%

31.77%

9.61%

0.6

Stock 5

Experian

Support Services

1.81%

0.00%

7.92%

0.9

Stock 6

G4S

Support services

3.01%

27.70%

3.22%

0.7

Stock 7

General Retailers

3.05%

69.65%

25.61%

0.6

Stock 8

Pearson

Media

3.77%

50.96%

8.51%

0.8

Stock 9

Randgold Resources Ltd.

Mining

0.45%

20.71%

14.89%

0.4

Stock 10

Tate & Lyle

Food Producers & Processors

3.44%

16.67%

5.34%

0.6

Adjustment of our Approach

This section discusses the adjustment of our approach if our client decides to put some of investment in foreign shares. We will use dividend discount model to adjust the foreign exchange movement. Since foreign stocks pay the dividends with the denominated currency. Typically, the cash flow of the investor is denominated in foreign currency. Due to the uncertainty of the exchange rates, the dividends of the investors will be adjusted based on the movement of foreign currency. Moreover, we will use risk-free interest rate for investor.

Based on the data in Table 2, it is revealed that all selected securities are having beta lower than 1. Typically, the selected securities are defensive stocks and defensive stocks are usually less volatile with high beta because they tend to perform better during recession as well being stable during recession. Thus, we select the defensive stocks to protect our position. To spread our investment around the overall portfolio, we select the securities portfolio with the lowest standard portfolio and stock with highest return to satisfy client risk averse preference.

Based on the data presented in Table 3 and Fig 1, the returns of all our select stocks increase from the year 2000 to 2009. With the brilliant performances of our selected stocks from 2000 and 2009, the stocks will perform brilliantly when our clients invest in our portfolio.

TABLE 3: Returns of the 10 Selected Stocks from 2000 to 2009

Associated British Foods

Bunzl

Compass Group

Dieago

Experian

G4S

Pearson

Tate & Lyle

Rangold Resources

Fig 3: Return Performances of Selected Stock from 2000 and 2009

From the data presented, the 0.66% Beta with the 38.1% return reveals that the portfolio selected for investment is portfolio with lowest risks. Our objective is to minimize the Beta and the minimum value of the Beta of selected 10 stocks is 0.4. % and the return is 38.1% as being revealed in table 3 and table 4.

Table.4: Portfolio between January 2000 and 2009

Return

38.01%

Yearly Beta

0.66

Initial Investment Value as of January 2000

£100,000

Initial investment by December 2009

£342,000

Return on the investor fund from January 2007 and January 2008

2007

2008

% change in portfolio value

20%

39%

Gross Portfolio Value

389,40

395,108

Management Fee

1,500

1,500

Net Portfolio Value

310,098

335,88

Behavioral Theory

To meet our client requirements, we created the investment portfolio that meet a broad range of goals. As being discussed by behavioral theory, forming a portfolio practice should be based on preference of investor. An investor should create investment portfolio meeting wide range of goals. As opposed by Modern Portfolio theory, the behavioral theory follows each layer where the lower layer is designed to prevent financial disaster and upper layer to maximize returns.

Conclusion

This report creates investment portfolio for Hewins. Based on our data analysis, we are able to recommend the best portfolio for our client based on his requirements. The portfolio selected was able to meet 24% higher return, which was 14% higher than the returns fixed by investors. Since our client is not ready to take high risks, we select stocks with average of 38% yearly returns. The portfolio selected for our client has proven to yield high return and outperforming the index of FTSE 100. We also follow broker recommendation in selecting our portfolio as being revealed in Appendix 1.With the initial investment of £100,000; client investment will yield £342,000 within 9 years.

List of References

Evans, J & Archer, S (1968) Diversification and the Reduction of Dispersion: an Empirical Analysis. The Journal of Finance . 23 (5): 761-767.

Chandra, P. (2008).Investment Analysis (3rd Edition).Tata McGraw-Hill Education. UK.

Investopedia (2012). Beta. Investopedia. ULC.

Mase, B. (2007), the Impact of Changes in the FTSE 100 Index. Financial Review, 42(3): 461 -- 484.

Statman, M. (1987). How many Stocks made a Diversified Portfolio, Journal of Financial and Quantitative Analysis. 22(3):353-363.

Tarasi, C.O. Bolton, R.N. Hutt, M.D. et al. (2011). Balancing Risk and Return in a Customer Portfolio. a. Journal of Marketing, 75( 3): 1-17.