40 (PM) - Analysis of Active Portfolio Management

Question 1

What should an appropriate benchmark have?

Answer 1

1. Be representative of the investment universe from which the active manager may choose.
2. Be replicable at low cost.
3. Have weights that are available beforehand (ex-ante), and benchmark returns that can be obtained promptly afterwards (ex-post)

Question 2

How does active management seek to add value?

Answer 2

Outperforming a passively managed benchmark portfolio.

Question 3

Active Return

Answer 3

Value added by active management. Can be measured as ex-ante or ex-post.

Question 4

What is the difference between ex-ante and ex-post?

Answer 4

Ex-Ante - Based on expectations of returns.

Ex-Post - Based on after-the-fact actual/realized returns.

Question 5

Active Weight

Answer 5

The difference between a security’s weight in an actively managed portfolio and its weight in the benchmark portfolio. This determines the amount of value added.

Question 6

What do all active weights in a portfolio sum to?

Answer 6

They must sum to zero. Securities can be overweighted and have a positive active weight relative to the benchmark. They can also be underweighted and have negative active wight relative to the benchmark.

Question 7

What are the two different methods of measuring a portfolio’s risk-adjusted returns?

Answer 7

1. Sharpe Ratio
2. Information Ratio

Question 8

Sharpe Ratio

Is the Sharpe ratio affected by having leverage in the portfolio?

Answer 8

Excess return per unit of risk.

No, Sharpe ratio is unaffected by the addition of leverage in a portfolio.

Question 9

Information Ratio

Is the IR affected by having leverage in the portfolio?

Answer 9

Active return to the standard deviation of active returns (i.e. active risk/benchmark tracking risk).

Yes. Leverage lowers active return (because its measured against a non-cash benchmark with no leverage) while active risk would not change much, resulting in a likely lower information ratio.

Question 10

Active risk

Answer 10

The standard deviation of active returns

Question 11

Closet index fund

Answer 11

A fund that is purported to be actively managed but in reality closely tracks the underlying benchmark index.

Sharpe Ratio - Similar to that of benchmark
Information Ratio - Very low. After fees, it is often negative.
Active Risk - Very low

Question 12

How is the information ratio helpful in manager selection and choosing active portfolio risk?

Answer 12

Manager Selection - An investor will choose the active manager with the highest information ratio regardless of their risk aversion. This is the optimal active portfolio an investor can choose from regardless of their risk tolerance. The reason is that the portfolio with the highest information ratio will also be the portfolio with the highest Sharpe ratio.

Active Portfolio Risk - An investor will combine the optimal active portfolio with the benchmark to create a suitable level of optimal risk based on risk preferences.

Question 13

What are the three components of the information ratio?

Answer 13

1. Information coefficient - Measure of manager’s skill. Can be ex-ante or ex-post.
2. Breadth = Number of independent active bets.
3. Transfer coefficient - The degree of constraints on a manager’s active portfolio

Question 14

For an unconstrained portfolio, what is the transfer coefficient?

For a constrained portfolio, what is the transfer coefficent?

Answer 14

Unconstrained: TC = 1

Constrained: TC = <1

Question 15

What is a constrained portfolio?

Answer 15

Any active portfolio that is constrained to an extent on what they can do (e.g. take short positions, etc.)

Question 16

What can the information coefficient be used as?

Answer 16

Market timing

Question 17

What are the strengths and limitations of the fundamental law of active management?

Answer 17

Strengths - Can be used to evaluate market timing, security selection, and sector rotation strategies.

Limitations
1. Bias in measurement of the ex-ante information coefficient (i.e. manger skill)
2. Lack of true independence while measuring the breadth of an active strategy.

Question 18

What are the two parts of active return?

Answer 18

1. Asset allocation return
2. Security selection return