Thompson Asset Management

Executive Summary

Based on the case “Thompson Asset Management” from HBS Professor William Fruhan and writer John Banko, this group exercise has the purpose to discuss various investment philosophies and consider the advantages of quantitative investing, especially technical analysis. Moreover, it should discuss the return variability and risk/return characteristics of the “Thompson Asset Management” funds, the ProIndex and the ProValue funds, regarding its returns, absolute and relative risks, as well as its risk relative to a benchmark index. The way to rebalance the ProValue fund should also be assessed as well as the improvements that can be done in order to improve the rebalancing process.

To conclude, this group exercise aims to present the statistics and portfolio characteristics that TAM should present in the ProValue fund, when assuming different levels of investment.

Exercise 1

An investment philosophy is a core set of principles or approach to maximizing returns that an investor can use in order to manage its portfolio. Some focus of the investment philosophies can be on value, growth, indexing or quantitative analysis.

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Value investing is the philosophy of investing in a security when its share price undervalues its intrinsic worth. The investors that use this strategy search for companies’ stocks that from their point of view the market has undervalued. Moreover, value investors believe that fluctuations in stock prices do not correspond with the company's long term fundamentals but to the market’s overreactions to positive and negative news, being a methodology based on facts?driven reasoning. Typically, value investors select stocks with lower?than?average price?to?book or price?to?earnings ratios, as well as with high dividend yields.

The main concern for the investors that use this strategy is in estim ating the intrinsic value of a stock. Because of this uncertainty, value investors only take a position when the investment offers a reasonable margin of safety, which is the difference between the intrinsic price and the estimated value. It is also important to bear in mind that some value investors only place value on present earnings and others only on future growth but in the end all of them are looking for an opportunity to profit by acquiring a long position when the price is deflated.

Growth investing is a philosophy of investing in securities which the investor believes that yield a worthy growth potential. These are stocks of companies that indicate an earnings growth that is well above the average rate when compared to other firms within  their industry and within the overall market. Usually this investing philosophy is commonly associated with technological companies or with the ones that dominate a niche market, as well as with emerging markets, since in these cases, companies are frequently valued as being worth more than their earnings or book values. Moreover, growth investors often associate this investment philosophy with a capital growth strategy, since their principal aim is to maximize their capital gains. Due to this, investors take a position on investments that from their point of view will outperform income stocks, which exhibit a slow growth, and focus on growth stocks in which the earnings are reinvested into the company in order to yield even further growth.

Indexing or passive strategy is an investment philosophy in which the investor matches the performance of its investment portfolio to the one of a targeted index, meaning that through this strategy, the yielded return and risk will be the same as the ones of the index. In the case of believing that the market works in the most efficient way and that it is impossible to outperform it, indexing should be the investor’s strategy when managing its portfolio. In this financial strategy the portfolio decision?making process is minimized as possible, in order to reduce transaction costs. Passive investors are limited in following an index and do not have a broader choice of assets or the opportunity to invest against, for example, some countries that are facing an economic downturn or political instability.

This is a passive strategy that is not the same as minimizing risk since it can be achieved through diversification and here investors are able to do it and are not concerned with relative risk and return, but with absolute. Quantitative analysis is an investment philosophy in which investors base their portfolio decision?making process on quant models in order to increase their chances to beat the market. This investment strategy focuses on patterns and numbers and chooses the investment that, for the same level of return, offers the lowest level of risk, being also not affected by the investors’ feelings often associated with financial decisions.

In order to not incur in more risks than necessary and choose the investment that yields the highest level of return for a certain level of risk, investors compare several risk measures such as alpha, beta, R?, standard deviation and the Sharpe ratio. Moreover, quant models turn the trading process much more straightforward and less costly by being able to analyze a very large number of investments simultaneously, as well as exploit inefficiencies much quicker than traditional investors do. Besides this, there is no need to hire as many analysts and portfolio managers. It is also important to bear in mind that quantitative investing strategy is based on historical data that do not include future events and although models are constantly updated in order to predict abnormal market events, it is not possible to do it  every time.

Likewise, high turnover generated when the economy faces a greater?than? average volatility, creates high costs such as commissions and taxable events. In this strategy we can refer to technical analysis that bases its work on price movements of securities. It is a method of evaluating securities by analyzing the statistics generated by market activity, such as past prices and volume. Rather than focusing on analyzing the business of each company, technical analysts try to measure the “market sentiment” and predict and benefit from future movements of prices. Our opinion is that technical analysis by itself may fall short on fully understanding the real causes of price movements and predictions. On one hand, there is no strong rational reason to believe that past movements and tendencies will repeat indefinitely in the future.

On the other hand, we believe that fundamentals of companies play the major role in their stock prices, and therefore should also be subject to close analysis. Technical analysis is best used to identify moments in which the market deviates from its fundamental values and decide when to take advantage of such discrepancies. To conclude, it is our belief that in order to achieve proper diversification, one should deal with quant strategies, including technical analysis, as an investing style that can be combined with traditional strategies such as with the ones previously mentioned: value, growth or indexing.

Exercise 2

ProIndex is a fund that replicates the S&P 500 with a capital of $ 100 000 000. It was the first fund of the “Thompson Asset Management” and it has been active since January 2009.

ProValue is a fund that consists of 9 mid?cap stocks (Rockwood Holdings, Polaris Industries, MRC Global, E*TRADE Financial, Energen, U.S. Cellular, Booz Allen Hamilton Holding, Fidelity National Financial, LPL Financial Holdings). This fund started in December 2012 with a capital of $1 999 244 invested only in the first 4 stocks mentioned above. In each quarter, the capital of the fund increased as well as the number of stocks, ending with a total invested capital of $5 509 070 in 9 stocks. In order to discuss the characteristics of each fund, we computed its cumulative return, absolute risk, measured by the annualized standard deviation, relative risk, measured by ? and risk relative to a benchmark, measured by.

The cumulative returns were calculated by computing the holding period return, that is. For the ProIndex this ratio was applied directly. However, to compute the return for ProValue the ratio needed to be adjusted in order to take into account the different timings of increases in capital and addition of new stocks. Hence, we calculated separately the returns of each group of stock (according to the quarter they were added to the portfolio) and weight it by the capital invested in each quarter over the total invested capital. Since ProIndex has a longer duration than ProValue, it is reasonable that its cumulative return (303,06) is considerably higher than ProValue’s (42,11%). The absolute risk is measured by the annualized standard deviation. The information was given to ProIndex (30,32%). Regarding ProValue (27,12%), we applied the portfolio variance formula

The relative risk is measured by Beta which was calculated by regressing a portfolio's returns against the market returns. ProIndex was compared to S&P 500 whereas ProValue compared to S&P mid?cap 400. Both the funds present a similar value and close to 1, meaning that the risk is close to market. ProIndex (1,014) has a lower value than ProValue (1,089) which is reasonable since the former is a fund that replicates the S&P 500. The risk relative to a benchmark is measured by alpha, which is computed as, that is equal to the constant of the previous regression. ProIndex (0,064%) presents a lower alpha than ProValue (0,488%) meaning that the latter fund is more attractive.