Equity R18

Question 1

3 building blocks of active return

Answer 1

Factor exposure (differ from benchmark)

Alpha skills - timing of rewarded/unrewarded factors. Identifying mispricings

Position Sizing

Question 2

Fundamental law of active management

Answer 2

E(R) (Or Information Ratio) = Information Coefficient * √Breadth * Transfer Coefficient

Where
Breadth = # of decisions made
IC = (2 * Proportion of Correct Calls) - 1

Question 3

Distinguish between Active Share and Active Risk

Answer 3

Active share:
measures degree to which number of positions and sizing differ from benchmark

AS = 1/2 * Σ (Wp - Wb)

Falls between 0 and 1, the lower the AS the more similar it is to the benchmark

Active Risk: (also called tracking error)
Standard deviation of the active return (portfolio return - benchmark return)

Active risk has two sources: Active factor exposure (active beta) and idiosyncratic risk from concentrated positions

Question 4

Contributions to portfolio variance (Risk Budgeting):

1) Contribution of asset to portfolio’s absolute variance

2) Contribution of factor to portfolio’s absolute variance

3) Contribution of asset to portfolio’s relative variance

Question 5

Discuss risk measures incorporated in equity portfolio construction

Answer 5

Heuristic - arbitrary position limits

Formal - statistical measures like VaR

Question 6

Discuss how AUM, position sizing, liquidity and turnover affect portfolio construction

Answer 6

Market impact costs are more with higher AUM, higher turnover and lower liquidity

Smallcap funds often limit their AUM for this reason

Question 7

Evaluate the efficiency of a portfolio structure given its investment mandate

Question 8

Discuss the long-only, long extension, long/short, and equitized market-neutral
approaches to equity portfolio construction