Alpha Investment Management Alpha Risk Analyser Risk Analysis in terms of Value versus Growth Six months to June 30th 1999. Combining in-house statistical factor Risk Model with bottom up Valuation. Incorporating the relationship of bond yield to valuation; interest rate sensitivity to portfolio risk; and explaining these relationships using Value versus Growth terminology.

1. Alpha Investment Management
Risk Analysis in terms of Value versus Growth
Six months to June 30th 1999
Alpha Risk Analyser

2. Alpha Investment Management 2
Alpha Risk Analyser
Alpha Investment Management commenced managing its first
wholesale client mandate on the 22nd
of December 1998. From
inception to June 30th
of June 1999, the Investment team out-
performed the ASX All Ordinaries Accumulation Index benchmark by
6.14%.
During this time bond yields increased from a low of 4.83% to a value
of 6.17% at the close of the 30th
of June 1999.
The diagram below shows the relationship between bond yields and
the portfolio structure over this period. The line chart shows the bond
yield movement and each diagram illustrates the portfolio tilt in terms of
large industrial, small industrial, value and growth. This tilt is in terms of
tracking variance rather than portfolio weight for each of these
categories. A more detailed description of this chart is given later in this
report.
Buy or Sell at the right timeBuy or Sell at the right time
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50.0%
60.0%
Large
Growth
Small
Value -10.0%
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20.0%
30.0%
40.0%
Large
Growt h
Small
Value 0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
Large
Growt h
Small
Value
4 . 5 0 %
5 . 0 0 %
5 . 5 0 %
6 . 0 0 %
6 . 5 0 %
2 2 / 1 2 / 9 8 2 1 / 0 1 / 9 9 2 0 / 0 2 / 9 9 2 2 / 0 3 / 9 9 2 1 / 0 4 / 9 9 2 1 / 0 5 / 9 9 2 0 / 0 6 / 9 9
Dec/Jan April/May June -
In the months proceeding December 1998, Alpha was managing a trial
portfolio preparing for cash inflows that occurred in December 1998. As
can be seen in December/January 1998, the portfolio was tilted
towards a growth bias. In April/May, as the realisation of higher bond
yields and therefore cost of capital was built into stock valuations. The
portfolio tilt was shifted to a neutral value and growth bias. In early
June, the portfolio moved to that of a value tilt. In April/May the portfolio
also had a strong resource tilt, with 58% of the tracking variance
coming from this resource exposure versus 22% in June 1999.

3. Alpha Investment Management 3
Features on the Alpha Risk Analyser
The Alpha Risk Analyser allows Alpha's fund managers to thoroughly
understand all aspects of the portfolio. It concentrates on the overall
risk of the portfolio that is represented by the beta of the portfolio
relative to the benchmark. Not only does the analyser give a break-
down of stocks’ contributions to the portfolio beta, it also highlights the
impact on tracking variance of stocks selected both within the portfolio,
and those excluded from the portfolio – the active portfolio.
The beta of the portfolio is the measure of the expected sensitivity to
movements in the benchmark – the overall risk of the portfolio. The
beta explains most of the portfolio's expected returns. However, unless
the portfolio has an identical beta to the benchmark, a slight tracking
deviation will exist.
The tracking deviation is analysed and attributed between different
stocks and sectors. The Portfolio Analyser will, for example, highlight
those stocks that make up most of the likely volatility in the excess
returns of the portfolio against the benchmark. In particular, this
volatility may also be due to stocks excluded from the portfolio. The
inclusion or the exclusion of a stock in a portfolio is an active decision.
[The following tables and charts represent the Alpha portfolio as at the 30th
of
June 1999.]
Overall break-down of tracking variance
In analysing the tracking error of the portfolio against the benchmark,
the tracking variance is used because, mathematically, only variances
can be added and subtracted. The chart below provides a quick
snapshot of the level of additional risk within the portfolio due to
specific and/or groups of stocks, which tend to move together – either
in the same or opposite directions. This extra risk is referred to as the
“sector effect”, and it is a more general in its application than just
looking at the sector exposures as defined by the ASX.
-0.020% 0.000% 0.020% 0.040% 0.060%
Stock specific
effect
Sector effect
Total
The remainder is the risk flowing from the respective stock weighting'.
This is a function of how heavily weighted in the portfolio the stock is
relative to the benchmark, and/or the volatility of the stock’s returns
relative to the benchmark. The ratio between specific variance and the
“sector effect” can be used as a measure of the level of “stock
selection”. The expectation would be for a small fraction of the risk
resulting from the “sector effect”.

4. Alpha Investment Management 4
Stock contributions to tracking variance
The following pie chart shows the contribution of each stock in the
portfolio to tracking variance. The 'Risk Ranking' spreadsheet can also
be viewed to see the impact on tracking variance to stocks outside of
the portfolio. For instance Coles Myer Limited was not in the portfolio
yet represented 6.2% of the tracking variance.
MBL
12%
WMC
10%
FHF
8%
MIM
7%
ARL
6%
HIH
6%
NBH
5%
EML
4%
RIO
4%
LEI
3%
BHP
2%
SGB
2%
CWO
1%
WSF
1%
WBC
1%
Remainder
28%
This chart is useful for visually identifying any large single stock or
sector positions. Using the chart above it can be seen that as at the
30
th
of June 1999 the portfolio had a well distributed contribution of
each stock to tracking variance. It is important to look at a stock's
weight relative to its contribution to portfolio risk. For example,
Macquarie Bank Limited (MBL) is only 3.8% of the portfolio by weight,
yet represents 12% of the portfolio risk.
Slicing & Dicing
The 'Slicing & Dicing' approach to the portfolio segregates the tracking
variance of the portfolio into different risk perspectives. These risk
perspectives may change over time and are a function of how Alpha
views the Australian sharemarket. The advantage of this technique is
that Alpha is not bound by a certain risk model or paradigm in
analysing the Australian sharemarket. For example, stocks could be
classified into a “bottom-up” risk classification, perhaps by balance
sheet and earnings risk. However, at other times, style classification
may be more important – growth versus value stocks. By using
different views of risk, a fund manager is unlikely to be surprised by the
emergence of a new clustering of stocks in the portfolio.
The risk perspectives are based on two different techniques – a
classification technique and a factor analysis. The first classifies stocks
by either inclusion or exclusion of certain groupings or sectors. There
are five different views of the portfolio risk based on this method:
♦ ASX sector break-down;
♦ small and large-capitalised segmentation;
♦ value and growth views;
♦ property trust sectors; and
♦ economic sectors. ('Alpha sectors')

5. Alpha Investment Management 5
The other method looks at the correlations of different stock returns. If
two stocks display similar return profiles, irrespective of their ASX
sector classification, it might suggest that they are being affected by
certain common factors. By unravelling the correlations of all the
stocks, a number of common factors can be identified as driving the
returns of stocks
Using a factor analysis of the correlations of all stocks, the Australian
market is divided into industrial and resources stocks. These sector
groupings are different to the ASX break-down, for example Orica
Limited tends to display a return profile similar to resource stocks.
Further, these sector groupings are not just based on inclusion and
exclusion of the sectors. A loading or sensitivity for each stock is
calculated for each factor.
An advantage of this factor analysis is that the stocks’ returns reveal
potentially new groupings in the Australian market – which would not
be evident using a simple classification system based on a certain risk
model or paradigm.
Sector analysis – ASX break-down
Sector analysis compares the portfolio against the ASX sector
groupings. The tracking variance is attributed between the different
sectors and graphed in the bar chart.
If the beta is different to 1.0 then part of the tracking error will be due to
the higher or lower sensitivity of the portfolio against the index. This
extra risk is classified as “market risk” because a higher or lower beta is
equivalent to taking an increased or decreased position against the
market.
-5.0% 0.0% 5.0% 10.0% 15.0%
GOLD
METALS
DIVRES
ENERGY
UTILITIES
DEVCON
BLDMAT
ALCTOB
FOODHH
CHEMIC
ENGIN
PAPER
RETAIL
TRANSP
MEDIA
BANKS
INSUR
TELECOM
INVFIN
PROPTY
HEALTH
MISIND
DIVIND
TOUR

6. Alpha Investment Management 6
Size analysis
The next view of the risk, divides the portfolio into large and small
capitalisation stocks. These are further sub-divided into industrials and
resources. Again, the tracking variance is attributable across these
different sectors. The definition of a small capitalisation is a company
classified in the ASX Small Ordinaries index.
Risk Analysis By Size
-10.0%
0.0%
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20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
Large
Industrials
Small
Industrials
Large
Resources
Small
Resources
Alpha sector categorisation
This style view classifies stocks into 'Alpha sectors'. These Alpha
sectors have been created by classifying ASX sectors into six
categories. These are: Resources, Domestic Cyclical / Consumer/
Manufacturing, Infrastructure & Utilities, Communication/Content,
Healthcare & Biotech , Tourism & Leisure , Property and Financials.
-5.0%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Resources
Infrastructure&Utilities
Domesticcyclical
/Consumer/Manufacturing
Communication/Content
Finance
Property
Healthcare&Biotech
Tourism&Leisure

7. Alpha Investment Management 7
The table below shows how the ASX sectors have been classified into
the 'Alpha sectors'.
ASX Sector Economic Sector ASX Sector Economic Sector
Gold Resources Retail Domestic Cyclical / Consumer
/ Manufacturing
Metals Resources Transport Domestic Cyclical / Consumer
/ Manufacturing
Diversified Resources Resources Media Communication/Content
Energy Resources Banks & Finance Financial
Infrastructure Infrastructure & Utilities Insurance Financial
Developers &
Contractors
Domestic Cyclical / Consumer
/ Manufacturing
Telecommunications Communication/Content
Building Materials Domestic Cyclical / Consumer
/ Manufacturing
Investment &
Financial
Financial
Alcohol & Tobacco Domestic Cyclical / Consumer
/ Manufacturing
Property Property
Food & Household Domestic Cyclical / Consumer
/ Manufacturing
Healthcare &
Biotech
Healthcare & Biotech
Chemicals Domestic Cyclical / Consumer
/ Manufacturing
Miscellaneous
Industrials
Domestic Cyclical / Consumer
/ Manufacturing
Engineering Domestic Cyclical / Consumer
/ Manufacturing
Diversified
Industrials
Domestic Cyclical / Consumer
/ Manufacturing
Paper & Packaging Domestic Cyclical / Consumer
/ Manufacturing
Tourism & Leisure Tourism & Leisure
Value & Growth
Industrial stocks have been classified into a value, growth or other
category. A “value” stock denotes a company that is selling on a low
price relative to its expected earnings, cash flow or net tangible assets.
Additionally, these companies tend to sell on persistently low PE
multiples – such as the banks.
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40.0%
50.0%
60.0%
Value
Industrials
Growth
Industrials
Other

8. Alpha Investment Management 8
The “growth” label is applied to those stocks that tend to sell on a
persistently high share price relative to their current earnings, cash flow
or net tangible assets. However, they are not just the opposite of a
value stock. Companies may exhibit high PE ratios because current or
expected earnings have collapsed. The distinguishing trait of a growth
stock is its strong comparative advantage against its competitors –
such as Coca-Cola Amatil.
Definition of value & growth industrials.
Value Industrials
Sectors:
Alcohol & Tobacco
Chemicals
Engineering
Banks & Finance
Stocks:
Email - Diversified Industrial
Metal Manufactures - Diversified Industrial
Wesfarmers - Diversified Industrial
Growth Industrials
Sectors:
Media
Telecommunications
Tourism & Leisure
Stocks:
Lend Lease - Developers & Contractors
Villa World - Developers & Contractors
Westfield Holdings - Developers & Contractors
Coca-Cola - Food & Household Goods
Brambles - Transport
Mayne Nickless - Transport
FH Faulding & Co - Healthcare & Biotech
Orbital Engine Co - Miscellaneous Industrials

9. Alpha Investment Management 9
Industrial portfolio plot
This chart brings together some of the results of the previous risk
tables.
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40.0%
50.0%
60.0%
Large
Growth
Small
Value
For the industrial stocks in the portfolio, the style is mapped against the
capitalisation bias. For example, we analyse is most of the risk coming
from value and smaller stocks? This analysis is particularly useful in
assessing different economic environments.
Terms
Beta
This measures the expected average sensitivity to a movement in the
benchmark returns. A figure of 1.10 means that the portfolio is 10%
more sensitive to a movement in the benchmark. For example, if the
benchmark rises by 10% the portfolio would, on average, rise by 11%.
The beta of a portfolio accounts for most of its expected volatility
around the index. The beta of the portfolio is derived from the individual
stocks’ betas which, in turn, have been adjusted to better reflect the
future.
Tracking error
Although the beta explains most of the volatility of a portfolio around
the index, a slight residual error usually remains. This residual error is
caused by stock-specific events (say, an operational failure) or specific
industry events (eg, the removal of a fuel rebate) that is not related to
the overall market effects.
The tracking error incorporates this residual error by measuring the
standard deviation of the excess returns of the portfolio. A figure of say,
2%, suggests that the portfolio will display returns, in the majority of
instances (65%), in a band of plus or minus 2% around the difference
between the mean return of the portfolio and the benchmark.
Tracking variance
This figure is the tracking error squared. In analysing the tracking error
of the portfolio against the benchmark, the tracking variance is used
because mathematically only variance can be added and subtracted –
not standard deviations (tracking error).