Alpha Investment Management
Alpha Portfolio Constructor
October 1999
Alpha Investment Management 2
Table of Contents
Summary ............................................................................................................................................................................ 3
Understanding the shape of the market. ......................................................................................................................... 3
Big Cog / Little Cog ........................................................................................................................................................... 4
From Research to Portfolio - "Which stocks", "When" and "What weight" ................................................................. 4
"What weight" - The language of the Alpha Portfolio Constructor ............................................................................... 5
Risk overlays ..................................................................................................................................................................... 5
Alpha Investment Management 3
Summary
Alpha uses a pragmatic not idiosyncratic approach to portfolio construction. It is robust and built around the
realities of the benchmark. It is disciplined and ensures that each stock is held at a sensible weight within the
portfolio.
Understanding the shape of the market.
The Australian market is concentrated
Cumulative All Ords Weight
11 Stocks equals 52% of the market
69 Stocks equals 90% of the market
40 Stocks equals 80% of the
market
0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00
90.00
100.00
0 10 20 30 40 50 60 70 80 90 100 110Number of stocks
Pe
rce
nta
ge
of
All O
rdin
ari
es
(%
)
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
8.0
9.0
10.0
All O
rdin
ari
es
we
igh
t (%
)
All Ords weight Cumulative All Ords weight
One of the key realities that feed into portfolio construction is the shape of the
market. No portfolio construction model is complete without reference to the
"Big Cogs" in the market. This does not mean they need to be in the portfolio,
but the benchmark risk of excluding "Big Cogs" must be understood. The
diagram above shows that 11 companies represent 52% of the market by
capitalisation, but only 4% by number of the 272 companies that compose the
ASX All Ordinaries benchmark.
Alpha Investment Management 4
Big Cog / Little Cog
Alpha uses the terms "Big Cog" and "Little Cog" to classify stocks within
the benchmark. As can be seen from the diagram below, the Telstra
Corporation Limited share price moved from $9.15 and $7.36 between
the 1st February 1999 and the 5th May 1999. This is the equivalent of
the entire market capitalisation of Woolworths Limited. A 30 cent move
in the Telstra share price has the same benchmark impact as a 100%
move in Seven Network Limited.
Why the big stocks are so important
Telstra Corporation Ltd Price move from $9.15 down to $7.36
(1-Feb-1999 to 5-May-1999)
2nd
Southcorp30th Largest Company
73rd
63rd57th
39th
18th
7.15
7.35
7.55
7.75
7.95
8.15
8.35
8.55
8.75
8.95
9.15
Te
lstr
a (
$9
.15
to
$7
.36
)
Wo
olw
ort
hs -
$6
,37
5 B
ill
Qa
nta
s -
$5
,85
8 B
ill
Am
co
r -
$5
,32
8 B
ill
Co
lon
ial -
$5
,13
4 B
ill
St G
eo
rge
Ba
nk -
$5
,06
0 B
ill
Co
ca
-co
la -
$5
,02
7 B
ill
CS
R L
td -
$4
,92
0 B
ill
We
stfie
ld H
ldg
s -
$4
,89
7 B
ill
We
stfie
ld T
rust -
$4
,84
6 B
ill
Co
ma
lco
- $
4,3
17
Bill
Na
tion
al M
utu
al -
$4
,14
2 B
ill
Ge
n P
rop
Tru
st -
$3
,74
7 B
ill
So
uth
co
rp -
$3
,63
0 B
ill
We
sfa
rme
rs -
$3
,58
9 B
ill
Pio
ne
er
- $
3,5
60
Bill
Fa
irfa
x -
$3
,41
2 B
ill
Ta
bco
rp -
$3
,34
0 B
ill
Sa
nto
s -
$3
,28
9 B
ill
Ma
cq
ua
rie
Ba
nk -
$3
,26
0 B
ill
AG
L L
td -
$3
,09
7 B
ill
Bo
ral -
$3
,01
2 B
ill
Ha
rve
y N
orm
an
- $
2,8
25
Bill
Ja
me
s H
ard
ie -
$1
,78
0 B
ill
Le
igh
ton
- $
1,5
18
Bill
Se
ve
n -
$1
,10
0 B
ill
Te
lstr
a p
ric
e r
an
ge
From Research to Portfolio - "Which stocks", "When" and "What weight"
The path to portfolio construction becomes a question of "which stocks"
are suitable for the portfolio, "When" does a stock enter or leave a
portfolio, and at "What weight" should that stock be held. The answer to
these questions occurs as part of the research process. Here
quantitative and qualitative information is bought together after extensive
research and rigorous valuation. A combination of a "Risk Adjusted Rate
of Return" (RARR) coupled with the reality of the benchmark leads to a
language which feeds into the Alpha Portfolio Constructor.
Alpha Investment Management 5
"What weight" - The language of the Alpha Portfolio Constructor
♦ "not included"
Do not like the stock, hold at zero weight. Applies to "Big Cogs" and "Little
Cogs".
♦ "included less"
Not as good as other stocks in the portfolio. Hence underweight a "Big Cog"
and do not have to be invested in a "Little Cog" as no market impact.
♦ "included"
If we like all stocks in the portfolio equally, then logical mechanism for
spreading excess above portfolio market weight.
♦ "more"
We like the stock more than other stocks in the portfolio.
♦ "much more"
We like the stock much more than other stocks in the portfolio.
Other overrides
♦ "index"
This is used rarely for "Big Cogs" which have no clear direction or valuation.
This is not a core component of the Alpha Portfolio Constructor language,
but is a necessary evil required when a "Big Cog" is subject to large event
risk.
♦ Short-term tactical overrides
Tactical overrides occur during entry and exit of a stock or when taking large
short-term conscious bets outside the standard model.
Risk overlays
Alpha Investment Management has a series of risk overlay tools. These
include a sector view of the decision making by the Alpha Portfolio
Constructor. This is to ensure no unconscious sector bets are taken.
Sectors of particular interest are Banks, Resources, Insurance, and
Property Trusts.
Another tool that Alpha uses is the Advantage research database, which
gives amongst other things details on sensitivity of valuations to bond
yield direction and change.
The Alpha Risk Analyser allows Alpha to apply different paradigms to
the portfolio in both traditional "tracking error" breakdown and weight
exposure. Paradigms may include ASX Sectors, Large stocks versus
Small stocks, Growth versus Value, Industrial/Resources split, Alpha
defined sector exposure, or potentially financial factors based on the
extensive Advantage database.