Durham Asset Management (DAM) is a small firm with 50 employees that manages the pension funds of small- to medium-sized companies. Durham was founded in 1975 and has grown considerably throughout the years. Initially, DAM managed the pension funds of three small companies whose asset values totaled $30 million. By 1991, DAM’s funds under management were valued at $2 billion.
James Franklin is a senior vice president at DAM, in charge of managing the equity portion of one of its largest pension funds. Franklin meets on a quarterly basis with company officials who supervise his decisions and oversee his performance. His work is measured on several levels, including both subjective and objective criteria. The subjective criteria include estimates of the quality of research reports. The objective criteria include the actual performance of Franklin’s portfolio relative to a customized index of companies in DAM’s investment universe. Franklin attempts to beat the index not by trying to time market moves, but by investing more heavily in those companies he expects to outperform the customized index and less heavily in those companies he expects to underperform the index.
panies he expects to underperform the index. Franklin has several research analysts who are charged with following the performance of several companies within specific industries. The research analysts prepare reports that analyze the past performance of the companies and prepare projections of future performance. The projections include assessments of the most likely or average performance anticipated over the next month.
Franklin analyzes their findings and often asks for additional information or suggests modifications to the analyses. After a period of careful review, the final forecasts for the next month are assembled and summarized. Each month, the analysts’ forecasts are compared to the actual results. Annual bonuses for the analysts are based in part on the comparison of these number
It is now late December 1991, and the projections for January 1992 are indicated in Table 7.13.
The projections have been made for 15 U.S. companies divided into five industry groups. The five industry groups are metals, retail, computer, automotive, and aviation.
Franklin wants to use the portfolio optimization approach to see what portfolios it would recommend. He has data containing end-of-month prices for the past two years for each of the companies. The data are contained in the spreadsheet Durham Asset Management.xlsx. Also included in the spreadsheet is information about dividends and stock splits. Using these data, James constructs a history of 24 monthly returns for each of the 15 companies.
The past data provide useful information about the volatility (standard deviation) of stock returns. They also give useful information about the degree of association (correlation) of returns between pairs of stocks. However, average returns from the past do not tend to be good predictors of future average returns. Rather than using the raw historical data directly, Franklin creates 24 future return scenarios by adjusting the 24 historical returns. The adjustments are made so that the means of the future scenario returns are consistent with the forecasts from Table 7.13. The adjustments are also made so that the volatilities and correlations of the future scenario returns are the same as in the historical data.
Franklin assumes that any of the scenarios defined by equation (7.13) can occur with equal probability. DAM’s policy is never to invest more than 30% of the funds in any one industry group. Franklin measures the risk of a portfolio by its standard deviation of return. He then solves a portfolio optimization model for various minimum levels of mean return to see which portfolios are recommended.After analyzing the trade-off between risk and return, Franklin makes a judgment as to which portfolio to hold for the coming month.