Portfolio Design

Advanced concepts in stock investment portfolio design.  Fundamentals, technical analysis and many other related topics are discussed.

Capital Strength Stock Portfolio Part 2 - The Ranking System

This is the second part of a three part tutorial on how to design a capital strength portfolio based on the First Trust Capital Strength ETF. Part 1 was dedicated to the construction of the custom stock universe. Part 2 deals with the stock ranking system, which will be used to rank the stocks according  to lowest three month and one year volatility. Part 3 will complete the portfolio design that implements the FTCS reconstitution, rebalancing, and industry weighting rules.

Stock analysis tools provided by Portfolio123.

In Part 1 of this tutorial, the majority of the First Trust Capital Strength ETF (Symbol: FTCS) stock selection requirements were implemented in the custom universe shown below.

Custom stock universe constructed in Part 1 of the Capital Strength Stock Portfolio tutorial

Noticeably absent from the custom stock universe is the requirement for selection of the 50 lowest volatility stocks. The 3-month and 1-year volatility rules were left out deliberately due to complications with the overall portfolio design. If the stock selection were whittled down to the 50 holdings within the stock universe, then the portfolio would not be able to accommodate the requirement for a maximum of 30% allocation to any one industry (sector in GICS terminology).  The requirement is for a 50 stock portfolio, if the portfolio starts with 50 stocks then it wouldn't be able to discard stocks due to an overweight industry.

Instead, the 3-month and 1-year minimum volatility rules are put into the ranking system. Then the portfolio buy rules get to decide which of the 95 stocks from the custom universe should make up the final selection of 50 stocks, based on the industry weighting and volatility ranking.

So lets get started by creating a new ranking system. From the Portfolio123 TOOLS pull-down menu, select RANKING -> Systems.

Selecting ranking systems from the TOOLS pull-down menu

The list of existing ranking systems will be displayed on the screen.  At the top left of the window, select New -> Stock Ranking System

Selecting a new stock ranking system

Enter a name for the new ranking system then click SAVE.

Naming and saving the ranking system

An empty ranking system with the assigned name will be shown on the screen. Select ADD NODE and from the pull-down menu select Stock Formula

Selecting a new Stock Formula node to be added

Now the first volatility rule can be entered.  Select Lower values for the ranking direction. This means that lower volatility stocks will be ranked higher than high volatility stocks. Enter a label for the 3-month volatility and then enter the formula PctDev(63,1) as shown below. Click on ADD to insert the node into the ranking system.

Entering data for the 3-Month Volatility stock formula node

Percent deviation (PctDev) is the Portfolio123 formula for standard deviation expressed as a percentage of the underlying price.  The percentage normalizes the output, an important consideration when ranking stocks. If the standard deviation wasn't normalized then apples would be ranked against oranges. 63 represents the number of unit time periods that will be used for the calculation. 63 days is equivalent to 3 months. Each unit time period is specified to be 1 trading day by the second parameter of PctDev.

Now, without leaving the ADD NODE tab modify the label and formula as shown below. The new formula is for the 1-year volatility. Note that there are approximately 252 trading days in one year. Click on ADD again.

Adding the 1-Year Volatility stock formula node

The ranking system now has two nodes as shown below.

Screenshot of the final ranking system, Don't forget to Save!

The weighting for each node is listed as 0%.  Since they are both 0%, they are equally weighted and there is no need to modify the weights to add up to 100%.

The last step is to save the ranking system. Please do that now by clicking on Save. Otherwise, your efforts could be lost.

Part 2 of this tutorial, the ranking system design, is now complete.  Part 1 went through the process of creating the custom stock universe. Part 3 will describe the construction of the overall portfolio, including buy/sell rules for rebalancing and industry weighting.