Introduction to Finance

Coursework Assignment
Deadline April 13th 2020, 23:59

This coursework is worth a total of 100 marks, which constitute 30% of

the total marks for this course.

Please submit a pdf file containing a report with a detailed description of

the analysis. The corresponding Matlab code should also be submitted
as a separate file. Please, create an appropriate zip folder and upload it
online. If you have any problem with submitting your files in the system,
you may send them to Mykola via email (m.babiak@lancaster.ac.uk).

Good Luck!

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You oversee the equity portfolio for Bronze Sachs Ltd and should develop
a new investment strategy that provides a better risk-return tradeoff. In
particular, you should create a benchmark portfolio of the company from
the stocks traded on the market in addition to the return of the market
portfolio.

Furthermore, you have six investment styles that the company has ac-
cess to – you will find your investment styles in a separate .mat file. You
should combine these investment styles with the benchmark portfolio so
that you can offer a better solution to your company than an initial strat-
egy.

An investment style is a portfolio constructed on the basis of certain firm

characteristic. Therefore, you will have to come up with the optimal com-
bination between the return of the benchmark portfolio with the return
of your investment styles. In the Appendix you will have more details of
what an investment style is.

Your data: You will find the dataset that you need to work with. The
dataset is a Matlab data file (.mat). The data only contains returns of the
market and the six factors in the following order: size, value, momentum,
investment, profitability, low volatility. You need to answer and discuss
the following questions.

1. Download the historical data for prices of at least five stocks. You can
choose any companies of your interest. Construct monthly returns
for the companies chosen and combine the data with the market and
investment style returns. To ensure that you are comparing like-with-
like, if the data for one of the price time-series is shorter than for the
others, use the shorter time period.
2. Compute and report the mean, volatility and Sharpe ratio of your
chosen stock returns, the market return and investment styles using
the entire sample. Discuss this result.
3. Using the entire sample, compute and report the VaR95 of your cho-

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 sen stock returns, the market return and investment styles and dis-
cuss this result.
4.1. Using a rolling window of M = 120 months (or shorter if your data
covers a shorter period), run an out-of-sample analysis where you
construct (i) a mean-variance portfolio with a risk aversion coeffi-
cient of 5 (ii) a minimum-variance portfolio (iii) a CVaR95 portfolio
(iv) an equal-weight portfolio that combine the market portfolio and
the stock returns of your chosen companies in each estimation win-
dow. For each estimation window, construct your optimal portfolio
and evaluate it with the returns of the next period, and repeat this
analysis until the end of your sample. Report the portfolio returns
without transaction costs and when the investor has to pay transac-
tion costs each period. In the latter case, assume a constant transac-
tion cost of κ = 0.5%. Then, compute and discuss the mean, volatility
and Sharpe ratio obtained for each strategy above. [5 marks]
4.2. Compare the mean, volatility and Sharpe ratio obtained above with
the corresponding statistics of the market return and the investment
styles in isolation. Briefly discuss the possibility to use factor invest-
ing technique to improve the performance of the benchmark portfo-
lio.
4.3. Using a rolling window of M = 120 months, run an out-of-sample
analysis where you combine each of the benchmark portfolios from
part (4.2.) with the six investment styles. Choose the optimal weights
in the six factor portfolios by (i) minimizing the standard deviation
of the portfolio return and (ii) maximizing a mean-variance portfolio
with a risk aversion coefficient of 5. Add the constraint that the sum
of all weights on the six factors has to be less than 60%, which is
equivalent to imposing a leverage constraint. Also, add the constraint
that the weights on the six factor portfolios are nonnegative. Report
the portfolio returns without transaction costs and when the investor
has to pay transaction costs each period. In the latter case, assume a
constant transaction cost of κ = 0.5%.
- Which of the six anomalies are exploited by the portfolio?
- Compare the performance of the resulting mean-variance efficient

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 portfolio with that of the equally weighted portfolio considered in
Part 1. Is the Sharpe ratio of the mean-variance portfolio higher than
that of the equally weighted portfolio?
- Compare the time evolution of the wealth of an investor who holds
this smart-beta portfolio with that of an investor who holds the Markowitz
portfolio. Does the investor who holds the smart-beta portfolio beat
the benchmark portfolio and the market in terms of wealth out of
sample?
5. Using the out of sample period, regress the returns from the strategy
that optimally combines the benchmark portfolio and your invest-
ment styles on the three factors of Fama and French: the market
return, the size and the value. Report the slope coefficients and the
t-stats and discuss your results.
6. Using the out of sample, look at the 20 worst bechmark portfolio
episodes (i.e. 20 periods with the lowest returns of a Markowitz
portfolio) and discuss how your factor investing strategy helps you
to cope with the poor market performance.
7. After the implementation: Imagine a situation where you have im-
plemented your strategy for 6 months and you have experienced a
loss of 50%. Give reasonable arguments for this bad performance
that would convince your boss of not firing you. Be brief in your
explanation and to the point.

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Appendix:

Data description

In the Data.mat file, you have two variables. Mkt stands for the time se-
ries of market returns. The variable FF6 are the returns of the six risk
factors: size, value, momentum, investment, profitability, low volatility.
To load your data, simply use command “load(Data.mat)” from the direc-
tory where you have saved your files.

What is an investment style?

An investment style can be seen as a factor. This is a source of risk expo-

sure in financial markets. When we talk about the market value weighted
factor, we think of the returns on the market portfolio, which is usually
represented by an index. The co-movement of a stock with the factor de-
fines the risk profile of the asset. There are many different factors such as
the value or the size factors. These factors are normally constructed with
firm attributes that are related with the factor. For instance, the value
factor is constructed by sorting stocks on the basis of the ratio book value
to market capitalization (i.e. book value/market value). Once we sort the
entire universe of stocks on the basis of this firm characteristic, we go long
in a portfolio of companies in the top decile of book to market, and go
short in a portfolio of companies in the bottom decile of book to market.
The size of these portfolios is the same, and therefore the factor is con-
structed as the returns of a zero cost portfolio. The same idea applies for
the size factor or other factors constructed on the basis of other specific
firm characteristics.

Constructing an investment style

Consider at time t a given firm specific characteristic (e.g. value, size,

momentum). In addition, consider a universe of N stocks. Therefore, you
have at time t N different stocks. You sort those stocks using the specific
firm characteristic that you are interested in. Once the sorting is done,
you construct an equally (or value) weighted portfolio with the top N/10

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companies, and another equally (or value) weighted portfolio with the
bottom N/10 companies. Then you look at the spread of expected returns
offered by these two portfolios, and if this spread is large enough, you go
long in the portfolio with the largest expected return, and short in the
portfolio with the smallest expected return. The return of this longshort
(zero cost) portfolio corresponds with the factor.

What are the three Fama and French factors?

Eugene Fama and Kenneth French are the godfathers of style investing.
Their three factor model is an asset pricing model that explains both the
time series and the cross-section of stock returns. The first factor is the
market portfolio. The second factor is named small-minus-big (SMB).
This is an investment style that buys one dollar of an equally weighted
portfolio of small companies, and shorts one dollar of an equally weighted
portfolio of big companies. The third factor is named high-minus-low
(HML). This is an investment style that buys one dollar of an equally
weighted portfolio of companies with high book value relative to their
market value, and shorts one dollar of an equally weighted portfolio of
companies with low book value relative to their market value.