Tom Max TMP, quantitative analyst, has developed a portfolio construction model
ID: 2773474 • Letter: T
Question
Tom Max TMP, quantitative analyst, has developed a portfolio construction model
about which he is excited. To create the model, TMP made a list of the stocks currently
in the S&P 500 Stock Index and obtained annual operating cash flow, price, and total return data for each issue for the past five years. As of each year-end, this universe was divided into five equal-weighted portfolios of 100 issues each, with selection based solely on the price/cash flow rankings of the individual stocks. Each portfolio’s average annual return was then calculated. During this five-year period, the linked returns from the portfolios with the lowest price/cash flow ratio generated an annualized total return of 19.0 %, or 3.1 percentage points better than the 15.9 % return on the S&P 500 Stock Index. Max also noted that the lowest price-cash-flow portfolio had a below-market beta of 0.91 over this same time span.
a. Briefly comment on TMP use of the beta measure as an indicator of portfolio risk in light of recent academic tests of its explanatory power with respect to stock returns.
b. You are familiar with the literature on market anomalies and inefficiencies. Against
this background, discuss TMP use of a single-factor model (price–cash flow) in his
research
Explanation / Answer
Portfolio Management
a.
Max’s use of the beta measure as an indicator of portfolio risk sought to note the expected changes in the prices of the portfolio in relation to the adjustments of the market stock returns. The lowest price-cash-flow portfolio had a lower-market beta of 0.91 over its expected market returns. This is important in understanding the expected changes in the prices of a portfolio. Max understood the need to use beta in examining the volatility of the portfolio in relation to the market. This also implied that investors were willing to accept more risks in search of high returns from higher beta investments. This indicates some of the reasoning of Max in using the beta measure determines the level of portfolio risk.
b.
The research study by Max only uses the price/cash flow approach that provides results that indicates a naïve anomaly. The results are only representative for other important factors. In order to obtain better results, it is recommendable for Max to understand additional research using more robust model design to confirm his results. Since, such results cannot be discredited under strong research work and study.