Active Equity Investing: Portfolio Construction

Question 1

Define the source of active return that can be generated from a manager

Answer 1

1. Strategically adjusting active weight of the portfolio to rewarded factors.
2. Tactically adjusting active weights from the portfolio using the manager skills to benefit from mispriced opportunities from rewarded factors, sector or security selection.
3. Assuming excessive idiosyncratic risk that may result in lucky or unlucky returns.

Question 2

Identify the building blocks of equity portfolio construction

Answer 2

1. Factor weighting (Overweight/underweight rewarded factors)
2. Alpha skills
3. Position sizing

(Note : There a fourth building block, breath of expertise, that is really important to glue all the three buildings block together.)

Question 3

Identify the conclusion that can be made regarding the composition of active return

Answer 3

1. High net exposure to risk factor will increase the level of active risk
2. Portfolio with no net factor exposure will attribute all the active risk to active share
3. Active risk is inversely proportional to the number of securities in the portfolio
4. Active risk increase when the exposure to idiosyncratic risk/ factor risk increase.

Question 4

If we have 3 assets in a portfolio, how do we calculate the absolute contribution of assets A to the portfolio variance

Answer 4

W of Assets A * W assets A * Correlation of A and A
+
W of Assets A * W assets B* Correlation of A and B
+
W of Assets A * W assets C * Correlation of A and C

= Contribution of Assets A to portfolio variance

Question 5

Explain heuristic risk constraints

Answer 5

Based on experience or general ideas of good practice. Exemple would be to limit the leverage to a certain level, limit exposure to individual position, sector or region, etc.

Question 6

Explain Formal risk constraints

Answer 6

Often statistical. Require the need to forecast return distribution. Exemple include limits on volatility, active risk, drawdown, VAR.

Question 7

Define Slippage cost

Answer 7

Difference between the execution price and the midpoint of the quoted market bid/ask spread

Question 8

Define long extension portfolios related to long/short portfolio construction

Answer 8

long/short strategies typically constrained to have a net exposure of 100%. For example, a long extension portfolio might have a long position of 130% and a short position of 30% (referred to as a 130/30 fund)

Question 9

Define Market neutral portfolio related to long/short portfolio construction

Answer 9

Aim to remove market exposure through their long and short exposures. A simple example would be a fund that is long $200 million of assets with a market beta of 0.9 and short $150 million of assets with a market beta of 1.2, giving a net market beta of zero.

Question 10

Identify the benefits of long/short portfolio

Answer 10

1. Greater ability to express negative ideas than a long-only strategy. The most negative position a long-only manager can take is to not hold a security, meaning that maximum underweighting a long-only manager can take is set by the weight of the security in the benchmark. A long/short manager is not constrained in this way because they can short securities. This will increase the information ratio because lower constraints will increase the transfer coefficient of the manager (TC, measuring their ability to translate insights into investment decisions, as seen earlier in the fundamental law of active management).
2. Ability to use the leverage generated by short positions to gear into high-conviction long ideas.
3. Ability to remove market risk and act as a diversifying investment against other strategies.
4. Greater ability to control exposure to risk factors. Because most rewarded factors (size, value, momentum, etc.) are obtained through a long/short portfolio, being able to short sell allows managers to better control their exposure to these factors.

Question 11

Identify Drawbacks of long/short strategies

Answer 11

1. Unlike a long position, a short position will cause the manager to suffer losses if the price of the security increases. This means potential losses are unlimited because security prices are not bounded above. It also means the manager is reducing long-term exposure to the market risk premium.
2. Some long/short strategies require significant leverage, which magnifies losses as well as gains.
3. The cost of borrowing securities can become too high, particularly for securities that are difficult to borrow.
4. Losses on the short position will increase collateral demands from stock lenders, particularly if leverage has been used. This may force the manager to liquidate positions at unfavorable prices. The manager may also be vulnerable to a short squeeze, where a sudden rise in the price of a heavily-shorted security forces short sellers to cover positions, buy back shares and potentially force the share price higher. Lenders of securities could also recall shares at inopportune times causing disruption to the manager’s strategy.