Buying High Return Low Volatility Technology Stocks

Abstract

ABSTRACT. Technology stocks provide higher returns but can be associated with high levels of volatility. This occurs are technologies go in and out of fashion, which impacts future profits and stock prices. This paper introduces the concept of Risk Weighted Alpha, which identifies stocks that have outperformed over a long period of time and there is usually a tendency for such stocks to keep growing further. When this trend breaks then this method also advises to keep reducing the weight of these stocks within the portfolio. As an example, the NASDAQ 100 index stocks are analysed to understand how the Risk Weighted Alpha method can be applied. Results show that the Risk Weighted Alpha portfolio delivered three times higher return than the NASDAQ 100 index with the same level of systematic risk.JEL Codes: R53; H54Keywords: indexation; portfolio theory; portfolio construction; stock selection; fundamental indexation and alpha1. IntroductionTechnology companies like Apple, Intel, Google and IBM for example have had exponential growth in stock prices over the years. However, there are numerous companies that have fallen over, especially during the dotcom bubble in 2001-02. So, how do you pick companies that will grow overtime? This paper takes the example of the NASDAQ 100 index to analyze companies that have grown and are expected to keep growing over time compared to those that have not performed. Before we move is discussion further, we need to realize that the NASDAQ 100 is a market capitalization based index. This means that the stocks that form the NASDAQ 100 index are the biggest companies in terms of market capitalization or value that are listed on this index. NASDAQ is primarily an index that lists technology related companies in the United States. Most major indexes like the Dow Jones Industrial Average, SP 2008; 2010) have provided the fundamental indexation method that utilizes five fundamental factors: revenue, sales, cash flow, employment and book value, in order to develop the index weighting of stocks. They argue that the fundamental index is a more efficient indexation method compared to the market capitalization weighted index method. Researchers (Kaplan 2008, Hemminki et al. 2008, Hsu et al. 2006, Blitz et al. 2008, Estrada 2006, Chen et al. 2007, Siegel 2006, Mar et al. 2007, Mar et al. 2009, Blitz et al. 2010 and Basu and Forbes 2013) argue that the evidence is inconclusive if the fundamental index method is actually more efficient than the market capitalization method and if it then this is mainly due to the value and small cap bias in the fundamental index method.An alternative to the market cap and fundamental indexation methods are the equal weighted and risk weighted indexes. Equal weighted indexes as suspected weight each stock with equal weight in the index and are seen to be profit taking indexes because over time they reduce the weight of the stocks that have increased in value and increase the weight of stocks that have decreased in value (Bemartzi and Thaler 2001, Winde liff and Boyle 2004 and DeMiguel et al, 2007). As a result, these indexes are seen to have a high tracking error to market cap based indexes and require frequent index rebalancing. There are a variety of risk weighted index methods that have been developed, which are the minimum variance (MV), equally weighted portfolio, maximum Sharpe ratio (MSR), most diversified portfolio (MDP), equally-weighted risk distribution (ERC) portfolio and semi-variance portfolio (Demey et al. 2010).While, risk weighted methods reduce risk through diversification, they also reduce the overall return. …