Asset Allocation in Active Portfolio Management using Treynor-Black Model and Technical Trends

Asset Allocation in Active Portfolio Management using Treynor-Black Model and Technical Trends

Asset Allocation in Active Portfolio Management using

Treynor-Black Model and Technical Trends

Abstract

Active Portfolio Management is considered to be a very costly process and the results of this process may not be entirely fruitful Conventionally, fundamental analysis is used to evaluate a stock, which is usually carried out by experts and consumes a lot of time The Treynor-Black model

is a multifactor model applied to the equity universe Equities being relatively less risky to tives, suit the appetite of a moderate risk friendly investor

Deriva-Today, with the amount of free and reliable data available, one can use it generate information to make profits It is required that this information is transferred into a form suitable to be used in portfolio optimisation models

The main objective of the project is to use technical trends to analyse equities and use it to ate optimum portfolios Thus the software is able to generate technical charts for a stock and calculates the expected returns, the sensitivity of the stock to the index The data however has to be manually collected and altered to be used by the software

cre-This is a project designed in Java following the object oriented methodology for emulating the entities of a stock market This allows extending the software to different kinds of investment in-struments like bonds and derivatives

The software package provides a GUI, divided into two distinct sections One for representing Technical Analysis and Regression analysis, and the second for emulating the Treynor-Black Mod-

el

The first section allows the user to select a stock from a list of stocks and generate technical charts After evaluation, the user may proceed to add the stock to his portfolio and evaluate the portfolio using the Treynor-Black Model

The software can be improved to show more detailed technical charts and allow the comparison

of two or more portfolios

Attestation

I understand the nature of plagiarism, and I am aware of the University's policy on this

I certify that this dissertation reports original work by me during my University project except for

the following (adjust according to the circumstances):

 The section on Technical Analysis in Chapter 2 was largely derived from

Table of Contents

Abstract 1

Attestation 2

Acknowledgements 3

Table of Contents 4

List of Figures 6

1 Introduction 7

1.1 Background and Context 7

1.2 Scope and Objectives 7

1.3 Achievements 7

1.4 Overview of Dissertation 8

2 State-of-The-Art 9

2.1 Modern Portfolio Theory 9

2.2 Technical Analysis 10

2.2.1 Technical Trends 11

2.2.2 Support and Resistance 12

2.2.3 Volume 12

2.2.4 Charts 13

2.2.5 Moving Averages 14

2.3 The Treynor Black Model 16

2.4 Current Software for Technical Analysis and Portfolio Optimisation 16

2.5 Issues addressed by the Software Package 17

3 Technical Overview 18

3.1 ActivePortfolioManagementApp class 19

3.2 ActivePortfolioManagementView class 19

3.2.1 Charts for Technical Analysis 21

3.2.2 The Treynor-Black Model results-Black Results 23

3.3 ActivePortfolioManagementEquity class 25

3.4 ActivePortfolioManagementPortfolio class 25

3.5 ActivPortfolioManagementHistory class 25

3.6 ActivePortfolioManagementTick class 25

4 Testing 26

4.1 Data Sets 26

4.2 Testing Functionality of the software 29

4.3 Usability Testing 29

4.4 Testing conclusions 29

5 Conclusion 31

5.1 Summary 31

5.2 Evaluation 31

5.3 Future Work 31

References 33

Appendix 1-Downloading and updating data files 34

Appendix 2 – User guide 38

Appendix 3 – Installation guide 39

List of Figures

Figure 1 Example of Trend Investopedia.com[4] 11

Figure 2 Support and Resistance Levels Investopedia.com[5] 12

Figure 3 Line Chart example Investopedia.com[6] 13

Figure 4 Candlestick Chart Example Investopedia.com[7] 14

Figure 5 Moving Averages Investopedia.com[8] 15

Figure 6 Trend indicator using Moving Averages Investopedia.com[9] 15

Figure 7 Design Preview of GUI 20

Figure 8 Chart for Alliance Trust from January 01, 2009 to January 01, 2010 22

Figure 9 The Treynor-Black Model optimisation results 24

Figure 10 Risk Parameters[1] 26

Figure 11 Macro Forecasts[1] 27

Figure 12 Computation of Optimal Risky Portfolio using Treynor-Black Model[1] 27

Figure 13 Results of produced by the software package 28

Figure 14 Yahoo!Finance 34

Figure 15 Symbol lookup for Tesco 34

Figure 16 Stock information 35

Figure 17 Selecting Daily price list 35

Figure 18 Download the file 36

Figure 19 Saving the file in the "Data" folder 36

Figure 20 Updating headers of data files 37

1 Introduction

This chapter gives a brief overview of the project and the software development lifecycle It lines the background and context of the project It spans into the scope and objectives continuing into the achievements

The Treynor-Black model was designed in 1973, with an effort to understand the relationship of risk and return while constructing a portfolio of assets

"According to Miller [1], this model is being used extensively in many portfolios ing software It is an easy to understand model requiring little information providing the solution in an easy to understand algebraic formula."

optimis-Fundamental Analysis has been the conventional tool of stock evaluation; however this project tries to implement the alternate to fundamental analysis Technical analysis is traditionally used for identifying trends in intraday trading However, the same theories can be applied to evaluate long term trends The results of this analysis can be used as inputs to the Treynor-Black model

This project tries to use Technical Analysis for analysis to help investors who are relatively new

to investment

The main aim of this project is to build an independent desktop application to help a moderately knowledgeable investor to analyse stocks listed on FTSE100 and create a viable portfolio

The functions of the software are:

1 Create technical charts for analysis using previously downloaded data

2 Display results of regression

3 Evaluate results for the Treynor-Black Model

The first two sections can be used as a standalone tool for technical analysis as well

The software developed performs all 3 functions stated in the scope and objectives section The software was tested using predefined test cases and was able to reproduce the same results as gen-erated in Excel Spreadsheet [1]

1.4 Overview of Dissertation

The rest of this dissertation will introduce the State of the Art in chapter 2, presenting a general cussion of Technical Analysis and The Treynor Black model Chapter 3 introduces the technical implementation of the classes related to the software architecture Chapter 4 discusses the testing of the software Chapter 5 will provide the conclusion reached by this project

All investors will look forward to maximise their profit on their investments with the least risk

as possible The risk appetite of the investor will determine the cost of profit It is highly likely that

a risk averse investor will make less profit as compared to an investor who is willing to take more risks, in the same market environment However, this does not undermine the fact that both types of investors stand to make a loss/profit at the end of their investment horizon which is equivalent to their risk appetite

All investors are exposed to the same kinds of risk irrespective of their risk appetite The risks are mainly of two different kinds First the systematic risk, which is inherent to the equity that the investors invest in Inherent risks arise due to the performance of the equity The underlying factors supporting the instrument For example, consider an investment in buying stocks of a car manufac-turer The systematic risk will include the sales of the company, the manufacturing capacity of the company, the competition in the car market, the demand of cars manufactured by the company, etc

If an investor is keen on purchasing stocks for a car manufacturing company, he is exposed to all of the above mentioned risks for one single company To reduce one's risk, the best option is to diver-sify the investment to minimise systematic risk If applied properly, diversification can help

eliminate systematic risk completely

The unsystematic risk on the other hand depends on macro economic factors, for example the state of the economy (recession/depression), the interest rates, external influential factors like natu-ral disasters, war All investments are equally exposed to the unsystematic risks and will react to bad news in the same manner An investor at all times will expect to minimise the unsystematic risk and eliminate the systematic risk

Thus, it implies that investing will always be a trade off between the expected return on an vestment whilst being exposed to risk As commonly observed, investments with higher expected returns tend to be more risky This leads to classifying investments based on their systematic risks Traditional investments in financial markets include bonds, equities and derivatives Bonds are considered to be the least risky of the three and derivatives the most risky An investor will invest

in-in all or any of these in-investments based on his risk appetite The in-investor can choose to combin-ine the three different kinds of investments to be included in his portfolio

"According to Markowitz [2], Modern Portfolio theory proposes a method to design a

portfolio with a highest possible return with the lowest possible risk According to the

theory, it's possible to construct an "efficient frontier" of optimal portfolios offering the

maximum possible expected return for a given level of risk."[3]

The four basic steps of Portfolio selection are:

1 Security Valuation after analysis

2 Choosing the security

3 Optimising the portfolio

4 Measuring performance of Portfolio

Security valuation helps us to determine whether a security is undervalued or overvalued as compared to the theoretical value of the security It is safe to say that an undervalued security will appreciate in price and an overvalued security will depreciate Irrespective of the different kinds of investors, there exist two ways to analyse an investment and predict the future prices of the securi-

Technical analysis theory assumes that the market discounts everything The price of the stock flects all factors which determine the price of a stock This means that technical analysis adopts the Efficient Market Hypothesis and studies the price movement Analysing the price movements helps

re-to forecast prices; this is one of the fundamental ideas of Technical analysis It is always observed that prices tend to move in trends Thus establishing a trend will help predict the direction of the

price movement Once a price movement is determined, the historical information available helps

to determine the amount of profit/loss one makes on a particular movement

The different kinds of trends help us establish different kinds of trading patterns, consistent with the trading strategies of investors Technical Analysis does tend to help traders more than investors, due to the fact that traders usually have a short time horizon as compared to fundamental analysts

2.2.1 Technical Trends

One of the most important concepts for technical analysis is the Trend Trends are observed in everyday life, for example if we look at the weather for the past week, we can use it to predict the weather tomorrow Similar trends are observed in stock prices Trend is a dataset spread over a pe-riod of time, indicating a movement in a certain direction Stock prices will never move in a straight line They will always move in a series of highs and lows The number of highs and lows, individually or together, will indicate an Uptrend, a Downtrend or Sideways/Horizontal trends

Figure 1 Example of Trend Investopedia.com[4]

Referring to the figure 1 above, points 2 and 4 are termed as peaks, whereas points 3 and 5 are troughs An uptrend is a series of higher peaks and higher troughs A downtrend is a series of lower peaks and lower troughs A sideways/horizontal trend does not have a clear series of an uptrend or a downtrend In technical terms, it may not be a trend at all The direction of the trend after point 6 is difficult to determine The price may fall down as seen in points 3 and 5 to form a new trough or continue forward to create a new peak If a new peak is formed, it means that the uptrend is extend-

ed and the price will continue to move upwards; however a trough, lower than point 5 may indicate the start of a downtrend which signals a reversal The timelines of the trends determine the length

of the trends

2.2.2 Support and Resistance

Support and Resistance are indicators of supply and demand These are usually the levels where traders tend to buy or sell their stock They are established by stock prices moving in certain set of trends over a period of time

Figure 2 Support and Resistance Levels Investopedia.com[5]

As seen in the figure 2 above, support level is the price level through which a price will rarely fall and resistance level is the price level through which the price will rarely surpass These are the levels indicating the comfort zone of the price movement As long as these levels are not broken, the price will continue to oscillate between these levels Once a support or resistance level is bro-ken, it indicates a start of a new trend and possible shift in the psychology of demand and supply in the market This shift in trend is termed as trend reversal, it holds only if the movement thru either support or resistance is very strong

2.2.3 Volume

Although the price and its movement are of primary concern, technical analysis also terms the volume to be equally important Volume for a security is defined as the total number of shares or contracts that were traded over a given period of time for that particular security Volume indicates the markets interest in a particular stock, the more the volume the more active the stock Volume can confirm a trend; the larger the volume along with the change in price indicates a strong move-ment of price Volume is a reliable indicator of a trend, if price goes up along with volume,

identifying a strong signal to buy the security; similarly a strong volume with reducing price of the security, is a strong signal to sell the security If a correlation between volume and trend doesn't exist, it is considered to be an indicator for weakness in trend Thus, showing that the trend is either over or may soon end

2.2.4 Charts

Charts are more than a mere representation of stock prices over a period of time, the properties

of a chart will help analyse the information available in the chart The time scale property of a chart indicates the range of dates at the bottom of the chart The time scale may vary from a few seconds

to well over a decade Refer figure 3 below for example of a chart

Figure 3 Line Chart example Investopedia.com[6]

The price movements can be represented by different types of charts For example, line chart, bar chart and Candlestick Charts

Line Charts: It's the most basic of all the charts It represents only the closing prices over a

time interval The line chart is drawn by connecting consecutive data points within the time val Apart from the closing prices that are plotted, not much visual information is available from the line chart

inter-Figure 4 Candlestick Chart Example Investopedia.com[7]

Candlestick Charts: These types of charts pack more visual information in their representation

as compared to Line Charts It consists of vertical lines, which indicate the time period's trading range The width of the vertical line is the difference between the opening price and closing price

of the security for the day Colours are used extensively to depict the movement of the stock price

In figure (above), if the stock has closed above the opening price, it is displayed in blue (generally lighter colours), indicating an UP day A DOWN day is represented by the red vertical bars (gener-ally depicted by black or dark colours) The choice of colours is specific to the website or technical charting tool used and a general rule or colour scheme does not exist

2.2.5 Moving Averages

Most charts are difficult to interpret, due to the volatility of price movements To simplify the charts, traders rely on moving averages It is the average price of the security over a period of time Plotting the average price over a period of time helps smooth the price movement on the chart The moving averages help in determining the true trends of a stock price

Simple Moving Averages: Calculated by taking the sum of all the past closing prices over the

time period and dividing the sum by the number of prices in that particular period As seen in the figure below moving averages are less sensitive to fluctuating prices when the time period increas-

es

Figure 5 Moving Averages Investopedia.com[8]

Types of Moving averages also include Linear moving averages, Exponential moving averages and Weighted moving averages

Moving averages help to identify trends and establish support and resistance levels They help

in identifying a trend fairly quickly As can be seen from the figure below, as long as the moving average is moving upward and the price remains above the average, it establishes an uptrend Con-versely a downward moving average is with the price below the average is a downtrend

Figure 6 Trend indicator using Moving Averages Investopedia.com[9]

An order of a pair of moving averages can also help determine momentum, for example, if the short term moving average is above a long term moving average, it indicates an uptrend The con-verse will indicate a downtrend

2.3 The Treynor Black Model

Technical analysis will help in stock valuation for designing your portfolio However, portfolio selection and optimisation are a different ball game altogether

"The Capital Asset Pricing Model [10]suggests that an investor should hold on to a market portfolio in absence of special information of the market A market portfolio can easily be constructed by randomly selecting 50-100 securities, as they will tend to high-

ly correlate with the market This eliminates the use of the elaborate balancing algorithms proposed by Markowitz and Sharpe [11,12] However, if the investor has special insights, he needs to convert the insights into expected returns, variances and covariance's the balancing algorithms require as inputs."[3]

The Treynor-Black model, tries to define risk and return when constructing a portfolio of assets The model tries to be consistent with Efficient Market Hypothesis to construct a portfolio, while using alpha, which is the projected return of the security over the market adjusted risk free

rate/return The optimal portfolio will lean towards securities with alphas greater than zero, ing outperformance Alpha is determined in a subjective manner and helps in deciding whether to buy, hold or sell the security

indicat-The model tries to find a mix of securities, where their associated alphas and systematic risks generate the highest possible benefit from active management The ratio of the portfolio alpha (weighted average of the alpha of each asset) to the portfolio specific risk (square root of portfolio variance, where portfolio variance is the weighted sum of the asset specific risks squared) This ratio is known as the "Appraisal ratio/Information ratio", is considered to be a good measure of portfolio optimisation The Treynor-Black model gives one important result, which is, in order to maximise the performance of the portfolio with both active and passive components, as measured

by Sharpe ratio, it is necessary to increase the appraisal ratio of the active component The Black model assumes a time period of one year or more

Software available in the current markets depends heavily on third party software like Microsoft Office Excel This leads to unnecessary licensing costs of the third party software The user also needs to learn to use of these third party software

Customer support for third party software issues is not readily available which could dissuade tomers from using the portfolio optimisation software

cus-2.5 Issues addressed by the Software Package

Portfolio optimisation for a long term investment period requires balancing and rebalancing your portfolio In order to create an optimum portfolio, the investor requires complete information of the investments

The software package is unconventional in terms of technical analysis Most software tion tools traditionally follow the Modern Portfolio Theory and use Fundamental Analysis to evaluate stock and use it in the allocation The software package uses candlestick charts and simple moving averages to value the stock and use it for portfolio optimisation The software package also focuses on the Treynor-Black model as it is designed for using equities for portfolio optimisation The software package helps the user to construct a single portfolio at a time and use the results for investments

optimisa-The software package also focuses on stocks listed on FTSE100 of the London stock exchange The list was compiled on 25th August 2010 The historical prices of these stocks are downloaded from Yahoo finance (http://finance.yahoo.com) and Google finance (http://finance.google.com)

3 Technical Overview

The Software package is designed to carry out 3 main functions

1 Create charts for the stocks selected

2 Determine Alpha, Beta and Correlation of the stock with the index

3 Create the portfolio according to the rules of The Treynor-Black model

Using an object oriented approach to emulate the working of a stock market; the following initial class structure was designed

Class Portfolio encompasses the entire investment universe of 6 equities and is extended by class Equity Class Equity will help store information for equity objects and help to plot charts using class Chart Class History and class Tick help to retrieve and store information for a particular equi-

Treynor-Class Equity

ActivePortfolioManagementApp: Launches the software package

ActivePortfolioManagementView: It is the GUI for the package The layout is designed to help the investor select a stock and add to his portfolio following a series of steps

ActivePortfolioManagementEquity: A class to emulate the behaviour of a stock

ActivePortfolioManagemetnPortfolio: A class to emulate the behaviour of a portfolio

ActivePortfolioManagementHistory: A class to record the information of a stock

ActivePortfolioManagementTick: A class to record information of the stock at a particular date ActivePortfolioManagementChart: A class to generate the chart for the selected stock