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.
