2021/2022 S1

Investments – Assignment 1

Professors:

Emanuele Rizzo

Giorgio Ottonello
Rules

1. We kindly ask you to direct any questions you may have to the appropriate Moodle forum. The
assignment will be supervised by Rafael Sequeira, who will regularly check and answer
questions via Moodle, so that everyone has access to the same information set.

2. Upload your files in Moodle before the deadline (i.e., October 10th, end-of-day).

 The written document for each group of five students may not exceed five pages
(Times New Roman; 12pt font; 1.5 line spacing; normal margins). This limit excludes
the title page, any introduction, and the appendix.

 The tables and graphs are to be collected in an appendix. The tables should be numbered
and have a short heading, for instance:

Table 1: This table gives an example of what a table should look like. It
reports the alphas and betas of two industries – Industry 1 and Industry 2.
Industry 1 Industry 2
Alpha 1 2
Beta 2 3

 These rules are strict. The grader will only consider the first five pages of answers to
the questions asked below and will consider only correctly referenced and formatted
tables.

 In addition to the written report, you should also upload your calculations file (e.g.,
Excel file) via Moodle.

3. This assignment counts towards 15% of your final grade!

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The data

Each group analyzes a different set of ten industries, which depend on your group number, among
which one is of particular interest (“Principal Industry”).

The industry allocation is presented in the sheet “Industry allocation per group” of the Excel data-
file that is uploaded together with this assignment. For instance, if your industry index is
“1,2,3,4,5,6,7,8,9,10,” then your principal industry is Agriculture, but you will also analyze Food
(Food Products), Soda (Candy & Soda), Beer (Beer & Liquor), Smoke (Tobacco Products), Toys
(Recreation), Fun (Entertainment), Books (Printing and Publishing), Hshld (Consumer Goods),
and Clths (Apparel). Furthermore, the last column of the excel data-file (“Extra Industry”) will
only be used in question 3.d.

For each industry, value-weighted returns are presented in the sheet “Return.”

The one month t-bill return (“RF”), the excess market return (“MKT-RF,” calculated as the value-
weighted average excess return of all stocks traded in the United States), and the remaining factors
for the Fama-French-Carhart four-factor and Fama-French five-factor model are presented in the
sheet “Factors.”1,2

In this assignment, you will analyze data over two periods.

• There is an in-sample period of twenty-six years from 1990 to 2015.

• There is also a holdout (out-of-sample) period of five years from 2016 to 2020.

The holdout sample is used in question 4 and 6 to test whether the performance of investment
strategies over the in-sample period extends out-of-sample. This method of backtesting is popular
in the industry to determine the usefulness of optimization methods in a real-time setting.

1
Throughout this assignment, you may sometimes need to use excess returns (i.e., returns in excess
of the t-bill return) and oftentimes you may need to use total returns. You should read the questions
carefully to make sure that you are using the right one, as the distinction is important economically.
2
Note, a return of -99.99 means the return is missing for that month. Also, for increased
convenience, divide all returns by 100 to have them in percentage terms.

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Questions

1. Start by performing the following tasks.

a. Plot the cumulative return of your principal industry, the market portfolio, and the risk-free
asset. In this plot, you may see that the value of your industry varies dramatically over time.
b. In the context of the dividend discount model, this variation comes from the incorporation
of news about future dividends and/or the discount rate “r” into stock prices. Identify two
events that had an important impact on the valuation of your principal industry and explain
why.
c. Calculate the CAPM beta for your industries and discuss their systematic risk. Moreover,
discuss the differences in betas based on the fundamental characteristics of the industries.

For questions 2 and 3, assume that the risk-free rate is equal to the average t-bill return over the
in-sample period.

2. Present the mean-variance efficient frontier of the ten industry portfolios assigned to your
group. This frontier should be calculated over the in-sample period. Moreover, present the
Capital Allocation Line in the same chart.

3. What is the optimal portfolio for an investor that desires an expected return of 11% per year?
To answer this question, assume the following investment universes:
a. ten industries;
b. ten industries and the risk-free asset;
c. ten industries without short-selling;
d. ten industries and the “Extra Industry”.

Then discuss the: (i) marginal changes in weights of the optimal portfolios, (ii) changes in the
shape of the efficient frontier, and (iii) the relative attractiveness of the optimal portfolios by
presenting their Sharpe ratio.

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4. Use the weights of the tangency portfolio of the ten industries to invest in these over the holdout
sample and present the following performance statistics: average excess return, standard
deviation, Sharpe ratio, skewness and kurtosis.

Compare these statistics to the performance of the tangency portfolio over the in-sample period
and, lastly, discuss what you find interesting in this comparison.

(Note that you have calculated in 3.b the relative weights in the industries for the tangency
portfolio over the in-sample period. The only thing you need to do is rescale the weights in the
ten industries, so that these weights sum to one. Then, you may use those weights and apply
them to the holdout period.)

5. Use the in-sample period to construct a zero-investment (long-short) portfolio based on your
industries’ past performance. In every month of the in-sample period, rank the industries based
on their performance (cumulative returns) over the past 6 months. Then, construct a portfolio
by investing (going long) in the top two industries in each month, and selling (going short) in
the bottom two industries.

Calculate the CAPM, Fama-French-Carhart (FFCM) four-factor, and Fama-French five-factor

model alphas (or abnormal returns) of the portfolio. Discuss the economic and statistical
magnitude of the alphas. Comment on any difference you find in the alphas moving from the
CAPM, to the FFCM, to the five-factor model.

6. Compare the out-of-sample performance of the following portfolios: (i) portfolio from question
4, (ii) portfolio from question 5, (iii) equal-weighted portfolio of the ten industries, (iv) market
portfolio. For this purpose, present the following performance statistics: average excess return,
standard deviation, Sharpe ratio, skewness and kurtosis. Then, discuss what you find
interesting in this comparison.

7. Based on the above evidence, briefly discuss any implication of your findings for the debate
on active vs. passive investing.

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