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StockTrak Strategy Paper

Our Philosophy

Our fund’s goal is to maximize short term returns given a level of volatility with an investment horizon of 2 to 3 months. We have a general positive economic outlook and believe markets are slowly recovering and are currently very momentum driven in the short-run. With this in mind, we chose stocks that have shown strong positive momentum in the past 3 month, 6 month and 1 year periods.

Investment Strategy

Our fund generates returns by investing in equities that are currently aligned with the largest record bull run that the market is having since the 2008 financial crisis. We focused on sectors that are currently doing well, but also made sure our portfolio was diversified and invested across industries. We utilized market indices to determine which industries seemed to have positive momentum. Some industries that stood out were the energy, financial, and technology sectors. In addition to looking at current trends we looked at what experts were investing in to help us develop investment ideas and did our own qualitative and quantitative analysis of those investment options.

Our strategy is high risk-high return, seeing as our ultimate goal is to not build a portfolio that will last 5 years, but one that will generate high returns in 2 months. When looking at investments, we looked for qualities such as volatility, strong momentum and growth-focused rather than value-focused. Volatility will give us the best chance of seeing price movement in our given investment horizon; this coupled with our research, we hope to be able to pick out the winners from the losers. For example, taking positions on volatile investments include shorting the Yen or investing in a recent tech IPO, Rally. We decided to take on these positions because our research has shown strong indications of price movement in a particular direction. We also looked for signs of possible momentum such as looking at companies with upcoming earnings reports in a favorable sector. If one company had an earnings report that was positive, we would look at comparable companies with upcoming earnings reports. Given our belief in market momentum, we believe performances of these companies in the same industry would be correlated leading to positive earnings surprises. For example, after Citigroup’s strong earnings, we looked at large financial institutions and invested in BX and JPM before their earnings report.

Most of our equity holdings can be classified as either value or growth. Our portfolio places an emphasis on growth since it generally takes the market longer to realize something is undervalued than it does for the market to recognize growth. We used both quantitative measures (high P/E, rev. growth, EV/EBITDA etc.) and qualitative assessments (business strategy, upcoming product releases, etc.) to identify whether a stock is growth or value focused and if it is an attractive investment.

While we are not particularly risk averse in our chase for returns, risk management is still a priority. A core component of our portfolio is dedicated toward pharmaceuticals (LLY, PFE, JNJ) since that industry is generally uncorrelated with the market, enabling us to better diversify our portfolio[1]. We also looked at possible hedging strategies for our risky positions such as our short on Yen futures where we considered securities that would benefit from Yen appreciating against the USD.

Allocation

Our fund’s investment decisions begin on the individual level. For each round of investing, each member of our team came up with securities to invest in based on qualitative or quantitative information that complement our fund’s overall strategy. After presenting each idea to the group, the group would decide whether or not an investment matches the goals of the fund and if it should be included in our portfolio. Our overall strategy is centered on short term and long term momentum (i.e. earnings releases, positive performance over the past year/6month/3month) and diversification. If a security fits these criteria, we would include it in our fund.

Our broad allocation strategy is to invest ~90% of the fund in equities as we firmly believe the market is in a state of steady recovery. The last ~10% is devoted to high risk strategies such as currency futures along with the appropriate hedges that may offset some of this risk.

For the equity portion of our fund, we strived to create the mean-variance efficient portfolio for our collection of stocks. We did this by calculating the expected returns and volatility (standard deviation) for each stock. We used weekly adjusted closing prices from Jan 1, 2009 to April 26th, 2013 from Yahoo Finance as our dataset for each stock. We used a weighted average, favoring recent events more than past events. This weighted average interprets more recent price movements as more relevant and important than those from several years ago, complementing our belief that the market is currently momentum driven[2]. However, while we believe in market momentum, we also acknowledge the flaws of using a weighted average and the sensitivity weights have toward expected returns and volatility. To smooth out our data, we also took into account un-weighted returns and returns projected by the CAPM model[3]. We used un-weighted returns to calculate volatility as we believe volatility is less dependent on market momentum. Our portfolio weights are determined by maximizing the Sharpe ratio of our portfolio given a min-max restraint of 2.5% and 10%.

We have chosen to stay away from certain assets such as ETFs and bonds. We have stayed away from bonds because we think given our short investment horizon, the stability they provide is not worth the low returns. We have stayed away from ETFs because we think the benefits of holding a fund will not be realized in the short run and fees may erase the returns. In addition, we think information is very valuable in making investment decisions. In the case of ETFs, it would be difficult for us to gain a thorough understanding of all the assets managed by the fund and measure its value added while with individual companies, we are better equipped to understand the company’s business model and will be able to use this information in our analysis and make better investment decisions. Lastly, we avoided large consumer retail companies because we think, while the economy may be recovering, the retail industry will probably be the last to recover as it takes longer periods of positive economic performance for consumers to gain confidence and start spending again. 

Measuring Performance

We intend to measure the performance of our portfolio in three ways: returns, comparing actual returns to our calculated expected returns, benchmarking to the S&P, and comparing to the performance of other groups.

The first measure of performance will be returns. Given the money we invested, we would like to see if our returns were positive or negative in the time frame that we had.

The second method of evaluation is to determine how reasonable our assumptions and calculations were. We based our strategy on a hypothesis that the market improving and momentum was the main driver in our investment horizon. We also hypothesized many things about a company during our research and acknowledge that we made many assumptions so this measure would show how accurate and reasonable the assumptions we made were as well as our use and interpretation of the data we collected. We would also like to extend this measure of performance to securities we developed a certain position on based on our research to see how many of our ‘bets’ were correct.

We will also compare our portfolio to a benchmark (S&P). We will compare excess returns first because returns may not necessarily reflect our strategy but rather the overall market movement. Our excess returns to the S&P will show how much of those was due to our investment decisions. We will also compare the Sharpe ratio of our portfolio against the S&P’s over this 2 month period to see how well optimized we were.

Finally we want to see how we do in comparison to the other groups. The simplest measurement for this will be our ranking. We may also want to compare our returns in excess of the S&P to those of the other groups to see how our investment skills fair against the other groups.

Challenges

We foresee some potential challenges in our short positions. For example, we chose to short the Yen, but recognize the potential risk in doing so. Since shorts are not a “typical” investment, and currencies are in a different market than equities, we recognize that in order to minimize the risk, we could not simply “diversify” the risk away. Therefore, to hedge this risk, we looked at investment opportunities that would generate returns should the Yen appreciate against the USD. For example, we looked at investing in Japanese bonds. This would balance out the risk of appreciation, because we would be able to generate returns from these investments relative to the Yen.

Additionally, we foresee challenges with timing our entering and exiting positions. While we have been able to determine asset allocation with mean-variance calculations, we have not determined when would be the optimal times to exit an investment. Ideally, we would like to enter an investment at a low and exit at a high. However, there is no set way to determine when an investment has reached a high or low. While we have chosen investments we think will jump in the short run, we have offset some of this uncertainty by also investing in assets we believe will continue to grow in value so we can hold those until the end of our investment horizon. Should we see a particular equity that is severely underperforming; we will reevaluate and determine whether it would be more profitable to sell than hold.

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