Why not always buy the highest valued shares?

PrefBlog Reader Drew asked on the Comments and Requests: HIMIPref thread:

Thanks for the response. One of the reasons for my question is that I noticed recently that HIMIPref gives high valuation scores to a couple of the operating retractibles, specifically those of GWO and MFC, but instead of recommending them for purchase it recommends a perpetual issue with a lower valuation score. I do own several split share issues but no operating retractibles. Is it likely that HIMIPref is recommending the lower valuation issue due to overall portfolio risk considerations?

Well, I responded on the wrong thread, initially, but I’ll reprint it here:

 There are a number of possibilities:

(i) It may be due to weight constraints set in your constraints specifications file. It is possible to set this file such that, for instance, you would hold only perpetuals.

(ii) More likely, it is due to the relative riskDistance between the various issues. Essentially, the valuation pick-up is divided by the risk distance and it is this value that must exceed the hurdle in order for the trade to be recommended. The risk distance between a perpetual and another perpetual will normally be greater than that between a perpetual and a retractible.
The concept of risk distance was introduced on the basis that issues are more easily compared the more similar they are. In other words, you can discriminate more easily between two high quality perpetual issues than you can between a hiqh quality perpetual and a low quality split share. The second trade will have a higher risk distance than the first; the second may well have a higher raw valuation pick-up but a lower trade score.
In the “Issue Method” of trade evaluation, this concept is used by the system in an effort to ensure that each individual trade, once recommended, has an equal chance of being profitable.
In the “Portfolio Method”, risk distance is measured from the pre-trade portfolio to the index and then from the post-trade portfolio to the index, in an effort to ensure that a portfolio mis-match of risk characteristics from the index is justified by excess expected return.

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