USC - MARSHALL SCHOOL OF BUSINESS

FBE 555 Investment Analysis and Portfolio Management

David Solomon Spring 2017
Homework Assignment #4
[due: Thursday, April 20th at 11:59pm]

Section 1 Calculations:

1. Here is some data on four mutual funds (A,B,C,D), market index (M), and risk-
free asset fund (F):

Fund Average return(%) Standard Deviation(%) Beta

A 14 6 1.5
B 12 4 0.5
C 10 6 0.5
D 20 10 2.0
Market 16 8 1.0
Risk-free 3 0 0.0

a. Calculate the Sharpe measure for each mutual fund and rank them.

b. How much would the return on fund B have to change to reverse the
ranking relative to A?

c. Calculate the Treynor measure for each mutual fund and rank them.

d. Calculate the Jensens for each mutual fund and rank them.

e. Explain why the rankings using Jensens are different from those given
using the Treynor measures as in c).

2. Two portfolio managers, Mr. P and Mr. Q, claim that they are both good at
picking under-priced stocks. Over the years, the average return on the portfolio
managed by Mr. P has been 17%, with standard deviation 15%, while the average
return of Mr. Qs portfolio has been 18%, with standard deviation 17%. Over the
same period, the average return on the market portfolio has been 15%, with
standard deviation 12%. You estimate that the covariance between Mr. Ps
portfolio and the market has been PM=0.0173, while the covariance between Mr.
Qs portfolio and the market has been QM=0.0202. Finally, you estimate that the
average return on money market funds has been 5%.

a. Compute the expected returns on Mr. Ps and Mr. Qs portfolios that

would be consistent with CAPM.
 b. Given the CAPM as the benchmark, are either of the two managers over-
performing the market? Explain your answer carefully.

3. Suppose we analyze a fund manager using a 4-factor model. That is, we evaluate
the manager using an APT model with the market factor, the size factor (SMB),
the book-to-market factor (HML) and a momentum factor (WML). The market
portfolio is the simply the value-weighted average of all stocks. The factor
mimicking portfolios for the SMB and HML are same as in the Fama-French
model. The FMP for the momentum factor is a portfolio that goes long past 6-
months winners and shorts past 6-month losers.

Suppose that the risk premia for the market factor is 6% per year, the risk premia
for SMB is 4% per year, the risk premia for HML is 6% per year and the risk
premia for WML is 8% per year. The risk-free rate is 3% per year. Suppose we
regress the excess return of the fund on the excess return of the market portfolio,
SMB, HML and WML using the past 5 years worth of monthly data. We find that
the factor loadings are 1.10 on the market, -0.20 on SMB, 0.10 on HML and 0.25
WML. Over this period, the fund manager has achieved a return of 11.0% where
as the market has returned 9.0% (6% above the risk-free rate).

a) According to 4-factor model, has this fund manager produced superior returns?

b) Rather than investing in the fund, construct a portfolio that invests in the factor
mimicking portfolios that produces the same risk profile as the fund. (That is, you
want a portfolio that has the same risk loadings as the fund itself) Assume that
you have $1Mil to invest. That is, how should the money be allocated among the
market portfolio, SMB portfolio, HML portfolio and WML portfolio?

c) Given the beta estimates from the four-factor model, does the fund manager
appear to have invested more in small stocks or in large stocks?

d) Given the beta estimates from the four-factor model, does the fund manager
appear to have invested more in value stocks or in growth stocks?

e) Given the beta estimates from the four-factor model, does the fund manager
appear to have invested more in stocks with high past 6 month returns or in stocks
with low past 6 month returns?

Section 2 - Data

Part A - Figuring out how to get data to run regressions.

A friend tells you that you should invest in the Goldman Sachs Mid Cap Value Fund
A shares, which has the ticker GCMAX. Your friend is a smart guy and you trust
him, but it would disgrace your finance professor if you didnt analyze the fund
yourself.
First you need to get GCMAX historical returns, and historical returns from the Fama
French Factors. Do this with the following steps.

1. Download the historical prices of GCMAX from Yahoo finance. You want
monthly historical prices from inception (August 1997) to the present. Click
Download to Spreadsheet, and save the prices. NOTE YOU WANT TO USE
ADJUSTED PRICES TO CALCULATE RETURNS! These are prices that
correct for stock splits, add dividends back in etc. If you use the raw closing
prices, you will need to calculate these adjustments yourself (red hot tip, you
dont want to do that.)

2. Use these adjusted prices to calculate returns (in per cent) using the formula from
lecture 1 :
Ret(t) = 100* [ P(t) P(t-1) ] / P(t-1)

3. Download the data on the risk free rate, excess market returns, and factors (SMB,
HML and momentum). Search for Ken French, and locate his website. Click on
the data library section. Download the Fama French Factors and the
Momentum Factor. These are in separate files.

4. Open up the two files in Excel. Use the Text to Columns function to make each
return in a separate column.

5. Making sure you have the dates lined up, put the GCMAX returns, the Fama
French Factors, and the Momentum factors all in a single spreadsheet. NOTE:
Ken French uses a date convention where each month refers to the end of the
month. So March 1997 means returns FOR THE MONTH OF MARCH (i.e.
Returns as of March 31st 1997). For Yahoo finance, when you choose monthly
data and download it to a spreadsheet, the data is given as the first of each month,
but the adjusted close prices cover the whole month, not that day. So be sure you
adjust the dates so that GCMAX March returns (from February Close to March
Close) match up with March factor returns. IF YOU RUN REGRESSIONS AND
FIND THAT YOU ARE GETTING VERY LOW R2 values (e.g. 0.05 or so)
RECHECK THAT THE DATES LINE UP!

6. Make sure that the returns are either all decimals or all percentages. Then subtract
off the risk free rate from GCMAX to get its excess returns. IF YOU ARE STILL
GETTING VERY LOW R2, MAKE SURE YOU HAVE THE RIGHT UNITS!

Now calculate the following:

4. What is the CAPM alpha of GCMAX? Calculate this by running a regression with
GXMAX Excess returns as the dependent (Y) variable, and Market Excess Returns (Mkt
Rf) as the Independent (X) variable. Regression is found in Excel by clicking Data
Analysis, then Regression.

a) What is the CAPM Alpha of GCMAX?

b) Is the alpha of GCMAX statistically significant?
c) How does this make GCMAX look as a fund?

5. Calculate the 3 factor and 4 factor alpha of GCMAX. Do this by performing

another regression with GCMAX Excess Returns as the Y variable, and either Mkt-Rf,
SMB and HML (for the 3 factor ) or Mkt-Rf, SMB , HML and Mom (for the 4 factor).

a) What are the three and four factor alphas of GCMAX? Are they statistically
significant?
b) What are the loadings of GCMAX on SMB and HML? Are they statistically
significant?
c) What do these loadings tell you about GCMAX as a fund?
d) Why might the CAPM alpha be different from the 3 and 4 factor alphas?

6. What is the timing ability of GCMAX? To do this, we want to calculate a new

variable that equals to the market excess return when the excess return is positive, and
zero otherwise. You can either do this by hand, or do it in Excel as follows:

a) First create a variable that equals 1 if Mkt-Rf is positive, and zero otherwise. Use
the IF statement in excel (use excel help to find out how to do this) to make a
variable that equals 1 if Mkt-Rf is greater than zero, and zero otherwise.
b) Then multiple this by Mkt-Rf to get the new variable
c) Regress GCMAX excess returns on Mkt-Rf and the new variable (call it
MktRfPos).
d) What is the coefficient on MktRfPos? Is it statistically significant? Based on this,
does GCMAX appear to have timing ability?

Part B Identifying Stocks For Stock Pitches

Suppose that youve got an asset management interview coming up, and you know that
youll be asked to discuss some of the stocks you think look like good potential
purchases. Since you took Solomons class, you dont just want to pick a random stock
based on a bogus tip from your friend. You instead want to at least narrow the search
based on factors that actually seem to predict returns market capitalization, the book-to-
market ratio (the total book value of a company, divided by its market capitalization), and
momentum (the cumulative stock return from 2 months ago to 12 months ago.
You can get a reasonable approximation of these things using the Google Finance Stock
Screener (https://www.google.com/finance/stockscreener ).

Your task is to identify three possible stocks that could be described as small, value,
high momentum stocks.
NOTE: Google Finance does not have exact versions of all of the three variables above,
so you will need to think about what concepts they are trying to capture and come up
with reasonable approximations of the variables in question. Explain what variables you
sorted on to decide your list of stocks.