Model Portfolios

Main principles of model portfolio formation

Strategy for forming model portfolios

The model portfolios we work out will allow the Company's clients to make investments on the stock market, saving a lot of time and dramatically cutting risks compared to spending cash on equity instruments on one's own. The strategic allocation of assets which make up portfolios is carried out on the basis of fundamental research and corresponds to the best risk/return ratios for various groups of investors and a chosen strategy: conservative, balanced, aggressive and long-term growth.

The Company's client is expected to pick an investment strategy suiting his/her needs and adhere to it when executing transactions on the stock market. On a quarterly basis we revise in our strategic research notes the structure of our model portfolios both by classes of assets and specific instruments in the equity segment. We form an average 50% of the equity segment using second-tier shares. A rather vague focus of stock analysts on a number of second-tier names and scarce information about these concerns make fairly attractive investment opportunities.

Finam Investment Company's equity research department tracks virtually the entire range of second-tier stocks which represent machine engineering, metals, construction, transport, consumer, chemicals and petrochemicals, and commodities sectors, to name but a few. According to our recommendations, model portfolios are revised on a regular basis in order to initiate coverage of new issuers from promising sectors which could outperform the market in the near future and exit equity plays, prospects of which are no longer rosy. Such an approach makes it possible to reap higher returns along with minimizing risks.

We would like to note that the Company's client may choose his/her investment profile independently. However, a well-balanced portfolio of the client may be professionally tailored only by a financial consultant (services of such professionals are offered by Finam: "Asset Management" (AM) and "Advisory Management" (AdM). Also, Finam's clients can enjoy a unique opportunity to see how professional asset managers work and see how real equity portfolios gain or lose in value using the Trade Center system.

Overview of portfolio formation

By and large, the formation of model portfolios looks as follows:

The first stage involves making a macroeconomic forecast. It is the preparatory phase before working out a general investment strategy, including the planned asset reweighting in a portfolio by classes of instruments and by sectors.

The second stage involves forecasting the behavior of the market and specific industries, trends in the RTS Index and sector benchmarks, and the most promising investment vehicles are defined for Russian and foreign investors.

Further, at the third stage analysts pick specific instruments for an investment portfolio. This stage is the most important one in the investment process and upon its completion there is a pool of buy recommendations on 15-20 of the most promising issuers from various sectors.

The fourth stage is to tailor the best structure for model portfolios taking into account portfolio management principles.

Regular revision of the portfolio's structure is essential when it comes to picking up stocks from promising sectors which could exhibit above-average indicators in the near future and selling off instruments that no longer offer handsome returns. Such an approach makes it possible to reap handsome gains amid moderate risks.

How to weight securities in model portfolios

Assets that can be bought for a portfolio may be divided into three classes:

• Those offering interest income (bonds);
• Those offering capital gains with a moderate investment risk (blue chips);
• Those offering capital gains along with fairly high investment risks (second-tiers and greenfield stocks).

The weighting of asset grades in a portfolio is determined on the basis of risk/return analysis using historical data from stock markets. For example, the RTS Index is used as a historical benchmark for the blue chip market and the RTS-2 Index is for second-tier stocks. Fixed-income instruments are expected to lack volatility, generating stable profits of 8% a year.

An analysis of trends in the RTS Index and the RTS-2 Index gives information about average returns of stock markets (expected returns) and their standard deviation (sigma). With an investment horizon equaling 1 year, it may be expected that 88.9% (the confidence interval for six sigma under Cherbyshev's inequality) of annual returns will fall within the range (expected returns – 3*sigma; expected returns + 3*sigma). Further, taking into account the limits for three types of investment strategies by risk factors (the baseline scenario involves a maximum reduction of 5% in the conservative portfolio's value, 15% for the balanced portfolio and 30% for the aggressive portfolio), we'll define the structure of portfolios, meeting required risk characteristics of the portfolio.

The structure of the high-liquidity stock segment in a portfolio is determined based on recommendations assigned by sector analysts. Shares from the high-liquidity segment are equally incorporated if official recommendations are not available for all stocks, but analysts view shares as promising at the time of portfolio formation. In the event that shares added to a portfolio hold upside potential under official recommendations, the stock's weighting in the high-liquidity segment is specified in proportion to a company's upside potential in the aggregate upside potential held by all shares that make up the high-liquidity segment.

The structure of the low-liquidity stock segment in a portfolio is determined based on recommendations assigned by sector analysts, aggregated forecasts made by an economist and expert estimates. Upon analysis of issuers and their prospects conducted by sector analysts, the following characteristics of shares are defined: the fair price of a share and an issuer's risks. Risk classification is described in the table below.

Based on the above characteristics, the company's aggregate risk valuation is determined based on a 10- point scale. In addition, the weighting of each risk in the aggregate valuation is determined by Finam's strategist based on expert estimates. The valuation of the company's risk is received as a result of discounting the company's upside potential (determining adjusted upside). In addition, each point of risk valuation decreases the upside potential by one tenth. Thus, if the company's risks amount to zero, the adjusted upside remains unchanged. In the event that risks are maximum (amount to 10), the upside is adjusted to zero. After that, the share of a stock in the low-liquid segment is determined in proportion to the company's adjusted upside in the aggregate adjusted upside of all the stocks included in the low-liquid segment.

Basic Portfolio with weekly reweighting

The Basic Portfolio is calculated based on our balanced strategy which is updated on a weekly basis as part of updating the target structure of management portfolio. We post our strategic reports on a quarterly basis. We also publish a new structure of model portfolios in our strategy report for the coming quarter. However, we revise actual model portfolios on a weekly basis and the trend which we post for the Basic Portfolio reflects investment results of the share segment of the Balanced Model Portfolio when the portfolio structure is adjusted on a weekly basis.

The balanced strategy provides for including in the portfolio a bigger share of risky participatory instruments (up to 50% of the portfolio): not only blue chips, but also second-tier shares whose upside potential is strong but involves higher portfolio risks. The return of the balanced portfolio is expected at 23%. The likelihood of a decline in portfolio value is 15%.

It is implied that the optimum investment period is at least a year. The expected portfolio return characterizes return on which investor can count in the event that a certain investment strategy is implemented with 1 year investment horizon. The structure of weekly recommended portfolio updates is available to all Finam clients which use Asset Management and Consulting Management services.

Long-term growth portfolio with quarterly reweighting

The long-term growth strategy is especially risky and presupposes the biggest expected return of all proposed scenarios. This strategy is suitable for investors prepared to assume risks for an indefinite period of time and the entire capital. In the long term, the expected portfolio return will be higher. However, there is a strong likelihood that the value of the investment portfolio will decline. The expected annual return is 42.5% and risks are unlimited.

It is implied that the optimum investment period is at least a year. The expected portfolio return characterizes return on which investor can count in the event that a certain investment strategy is implemented with a 1-year investment horizon. The structure of weekly recommended portfolio updates is available to all Finam clients which use Asset Management and Consulting Management services.

Share segment of Conservative portfolio with quarterly reweighting (Cons-Q)

The balanced strategy presupposes stronger expected return on investments. This provides for including in the portfolio a bigger share of risky participatory instruments: not only blue chips, but also second-tier shares whose upside potential is strong but involves higher portfolio risks. The return of the aggressive portfolio is expected at 23%. The likelihood of a decline in portfolio value is 5%.

It is implied that the optimum investment period is at least a year. The expected portfolio return characterizes return on which investor can count in the event that a certain investment strategy is implemented with 1 year investment horizon. The structure of weekly recommended portfolio updates is available to all Finam clients which use Asset Management and Consulting Management services.

Share segment of Balanced portfolio with quarterly reweighting (Balance-Q)

The balanced strategy presupposes stronger expected return on investments. This provides for including in the portfolio a bigger share of risky participatory instruments: not only blue chips, but also second-tier shares whose upside potential is strong but involves higher portfolio risks. The return of the aggressive portfolio is expected at 23%. The likelihood of a decline in portfolio value is 15%.

It is implied that the optimum investment period is at least a year. The expected portfolio return characterizes return on which investor can count in the event that a certain investment strategy is implemented with a 1-year investment horizon. The structure of weekly recommended portfolio updates is available to all Finam clients which use Asset Management and Consulting Management services.

Share segment of Aggressive portfolio with quarterly reweighting (Agr-Q)

The aggressive strategy presupposes stronger expected return on investments. This provides for including in the portfolio a considerable share of risky participatory instruments: second-tier shares which account for nearly 50% of all portfolio assets. The return of the aggressive portfolio is expected at 32%.

It is implied that the optimum investment period is at least 1 year. The expected portfolio return characterizes return on which investor can count in the event that a certain investment strategy is implemented with a 1-year investment horizon. The structure of weekly recommended portfolio updates is available to all Finam clients which use Asset Management and Consulting Management services.