Active Equity Investment Portfolio Construction Flashcards
What are the main driver of active return (excess return) ?
Active return are driven by the difference in weights between the active portfolio and the benchmark.
How can a manager conceptually generate active return ?
Strategically adjust active return
Tactically adjust active return
Assuming excessive idiosyncratic risk
Tough IR is very popular for assessing active managers, they seems to be actually alternative beta exposures to rewarded risks.
What is alpha ?
It is the special strategy that is specific to the special skill strategies of the portfolio manager. Skills such as security selection and factor timing.
What are the mains building blocks of a portfolio construction?
Factor weighting
Alpha skills
Position sizing ( concentrated portfolios)
Summary of different approaches
Top down
- Emphasis macro factor -Emphasis macro factor
- Factor timing -Diversified
- Diversified -Concentrated
-Emphasis security -Emphasis security
Specific factor Specific factor
-Diversified -Concentrated
-Factor timing -Factor timing
Bottom up
Elaborate on active shares
If the active shares are 0.5, we can conclude that 50% of the allocation is identical to that of the benchmark and that 50% are not.
There are two sources of active shares
-Including securities in the portfolio that are not in the benchmark
-Holding securities that are in the benchmark but with different weights
Elaborate on active risks
Active risks are affected by the degree of correlation but active shares are not. Active risks are more about concentrated bet (factor or securities).
Elaborate on risk budget
Risk budget is the process by which the total risk appetite of the portfolio is allocated among various components of portfolio choices.
We need to understand:
- Which type of risk measure is the most appropriate for the strategy
- Understand how each aspect of the strategy contributes to the overall risk
- Determine what level of risk budget is appropriate
- Properly allocate risk among individual position factor
What are the sources of absolute risk ?
Additions of a security with a higher covariance with the portfolio increases the risk level.
Replacement of a security with a higher covariance with the portfolio increases the risk level.
What are the sources of relative risk ?
The relative (active) volatility. For instance introducing a low volatility assets within the benchmark against a high volatility index will increase the active risk.
Three scenario that give some insights into practical risk limits.
Portfolio may face implementation constraints that degrade the information ratio if active risk increases beyond specific level.
Portfolio with high absolute risk face limited diversification opportunities, which may lead to a decrease in the Sharpe ratio.
There is a level of leverage beyond which volatility reduces expected compound return.
Elaborate on risk measures
We have formal and heuristic Formal: Volatility Active risk VaR CVaR IVaR Drawdown
A major difference between formal and heuristic is that formal measures require the manager to estimate or predict risk. During stress time, predicted and realized risk can diverge significantly.
How to address trading constraints limits ?
Establish position limits on securities weights
ADV limits
Asianing
Small cap fund with huge AUM may need larger number for securities to work around liquidity constraints. This however comes at the costs of loss of exposure to relevant factors.
Elaborate on
Slippage cost
Volatility trending costs
Unlit venue
Slippage cost is estimated as the difference between the execution price and the midpoint of the bid-ask quote at the time the trade was entered.
Volatility trending costs are the cost of buying in a rising market and selling in a declining market.
Slippage costs are greater than commission costs.
Slippage costs are greater for smaller-cap than for large cap. They are not necessarily greater in EM and may grow during stress time
Things to heed at for smaller funds
For smaller funds with good initial performance, heed at changing strategy as success kicks in and fund grows it might become more difficult to maintain the strategy.
What are the characteristics of a well constructed portfolio ?
- A clear investment philosophy and a consistent investment process
- Risks and structural characteristics as promised to investor
- A risk-efficient delivery method
- Relatively low operating costs given the strategy.
Contrasting 2 products with similar absolute vola, the one with the highest active shares is the better because it leverages on the manager skill to generate alpha.
Elaborate on L/S
L/S can be unconstrained or constrained (L/S long extension) is constrained to have 100 net exposure such as 130% long and 30% short. (L/S long extension) are called enhanced active equity strategies.
What are the merits of long-only investing ?
Long term premium Capacity and scalability Limited legal liability Transactional simplicity Lower mgnt costs
Elaborate on EMN
Assume a fund long with $100 and beta of 1 and a short with $80 beta 1.25. Most EMN are pair trading.
However it is difficult to maintain a zero beta because correlation a continuously shifting.
What are the merits of long/short investing ?
Ability to calibrate exposure factors such as sectors, geography.
Efficient use of leverage and the benefit of diversification
Ability to more fully express short idea than under long only.
Drawback include:
- Short loses when prices go up
- Requires some leverage
- Borrowing cost
- Margin or requirement cost
Assuming the following:
Factors : Market - Size - Value - Momentum
Coeff : 1.080 0.098 –0.401 0.034
Variance 0.00109 0.00053 0.00022 –0.00025
of the market
Portfolio’s monthly standard deviation of returns 3.74%
What’s the portion of total portfolio risk that is explained by the market factor in Fund
The portion of total portfolio risk explained by the market factor is calculated in two steps. The first step is to calculate the contribution of the market factor to total portfolio variance as follows:
1)
CVmarket factor = market Coeff * variance * coeff of factor
(1.0800.001091.080) + ( 1.0800.000530.098) + (1.080–0.4010.00022) + (1.0800.034–0.00025)
CVmarket factor = 0.001223
2)
The second step is to divide the resulting variance attributed to the market factor by the portfolio variance of returns, which is the square of the standard
deviation of returns:
Portion of total portfolio risk explained by the market factor = 0.001223/
(0.0374)^2
Portion of total portfolio risk explained by the market factor = 87%
