EV - R25 Active Equity Investing: Portfolio Construction

Question 1

Generate active return

Answer 1

1. strategically adjusting the active weights of the securities to create long term exposures to rewarded risks that are different from those of his benchmark
2. tactically adjusting the active weights of the securities using his skills and expertise in identifying mispricing in securities, sectors, rewarded risks, and so on to generate alpha that cannot be explained by long term exposure to rewarded risks
3. assuming excessive idiosyncratic risk that may result in lucky or unlucky returns

Question 2

Portfolio construction building block

Answer 2

1. Rewarded factor weightings
2. Alpha skills
3. position sizing
4. breath of expertise

Question 3

Portfolio construction building block - rewarded factor weightings

Answer 3

over/under rewarded factors

Question 4

Portfolio construction building block - alpha skills

Answer 4

• timing the exposure would be a source of alpha
• can also be generated from timing exposure to unrewarded factors, such as regional exposure, sector exposure, and price of commodities, or even security selection
• or even timing other asset classes (such as cash)

Question 5

Portfolio construction building block - Sizing positions

Answer 5

It is about balancing managers’ confidence in their alpha and factor insights while mitigating idiosyncratic risk.
Manager’s choice with respect to the position sizing is influenced by her investment approach and the level of confidence in her analytic work. Higher confidence, willing to assume high levels of idiosyncratic risk, which is consistent with her emphasis on the “a + e’ part of equation on page 463 #2

Question 6

Portfolio construction building block - breath of expertise

Answer 6

The important of breath of expertise is implicit in the fundamental law of active management, which implies that confidence in a manager’s ability to outperform his benchmark increases when that performance can be attributed to a large sample of independent decisions

E(Ra) = IC * SQR (BR) * Active Risk a * TC

Question 7

Approach to portfolio construction - systematic vs discretionary

Answer 7

Systematic strategies -

1) to be designed around the construction of portfolios to seeking to extract return premiums from a balanced exposure to known, rewarded factors;
2) typically incorporate research-based rules across a broad universe of securities;
3) it seeks to reduce exposure to idiosyncratic risk and often use broadly diversified portfolios to achieve the desired factor exposure while minimizing securities specific riks;
4) also typically more adaptable to a formal portfolio optimization process

Discretionary strategies -

1) search for active returns by building a great depth of understanding of a firm’s governance, business model, and competitive landscape, through the development of better factor proxies
2) integrated the judgement of the manager, on a smaller subset of securities
3) generally more concentrated portfolio, reflecting the depth of the manager’s insights on company characteristics and the competitive landscape
4) use a less formal approach to portfolio construction, building a portfolio of securities deemed attractive

Question 8

Active Share

Answer 8

• Active Share - measures the extent to which the number and sizing positions in a manager’s portfolio differ from the benchmark
• Active share = 1/2 sum of 1 to n (weight portfolio - weight benchmark)
• Active share calculation involves no statistical analysis or estimation, there are only two sources of active share: 1) including securities in the portfolio that are not in the benchmark; 2) holding securities in the portfolio that are in the benchmark but at weights different than the benchmark weights
• if two portfolios are managed against the same benchmark, the portfolio with fewer securities will have a higher level of active share than the highly diversified portfolio. A portfolio manager has complete control over his active share because he determines the weights of the securities in his portfolio

Question 9

Active Risk

Answer 9

• Like active share, active risk depends on the differences between the security weights in the portfolio and the security weights in the benchmark
• there are two different measures of active risk: 1) one is realized active risk, which is the actual historical standard deviation between the portfolio return and the benchmark return
• the variance-covariance matrix of returns is very important in the calculation of active risk. Active risk is affected by the degree of cross-correlation but the active share is not. Active share is not concerned with the efficiency of diversification.

Question 10

Relationship between active risk, active share, and factor exposure for an unconstrained investor, assuming a single factor model, they found (Sapra and Hujan 2013)

Answer 10

• high net exposure to a risk factor will lead to a high level of active risk, irrespective of the level of idiosyncratic risk
• if the factor exposure if fully neutralized, the active risk will be entirely attributed to active share
• the active risk attributed to active share will be smaller if the number of securities is large and or average idiosyncratic risk is small, and
• the level of active risk will rise with an increase in factor and idiosyncratic volatility

Question 11

Top-down and bottom-up portfolio management approach and how they relate to two of the building blocks: rewarded factors and alpha

Answer 11

Factor exposure:

• bottom-up managers look at characteristics of securities to build their portfolios. the factor exposure inherent in their portfolio may be intentional, or it may be a by-product of their security selection process
• top-down managers articulate a macro view of the investment universe and build a portfolio emphasizing the macro factors that reflect those views. Although their macro views could then be translated into security views using a bottom-up approach, their performance will likely be dominated by their macro-level factor exposures

Alpha:
The alpha of bottom-up managers is most likely attributable to their security selection skills
some portion of their active returns can also be explained through exposure to rewarded factors.
Top-down manager alphas are largely derived from factor timing.

Question 12

Implementation process: objectives and constraints - absolute framework and relative framework

Answer 12

Absolute framework

• objective: maximize Sharpe ratio
• constraints:
  1) individual security weights (w) less equal to 2%
  2) sector weights (S) less equal to 20%
  3) portfolio volatility < 0.9 of the estimated benchmark volatility and imposes a minimum weighted average security capitalization of $20bn

Relative framework

• objective: maximize information ratio
• constraints:
  1) individual security: a security must remain within +-2% of index weight |Wp-Wb|<=2%
  2) sector weight must remain within +-10% of the index weights |Sp-Sb|<=10%
  3) relative approach imposes a 5% active risk limit and same capitalization constraint

Question 13

Risk Measure - Volatility

Answer 13

the standard deviation of portfolio returns

Question 14

Risk measure - active risk

Answer 14

the standard deviation of the differences between a portfolio’s return and its benchmark’s return. also called tracking error or tracking risk

Question 15

Risk measure - skewness

Answer 15

a measure of the degree to which return expectations are non-normally distributed.

Question 16

Risk measure - drawdown

Answer 16

measures the portfolio loss from its high point until it begins to recover

Question 17

Risk measure - VaR

Answer 17

the minimum loss that would be expected a certain percentage of the time over a specific period of time given the modeled market conditions. it is typically expressed as the minimum loss that can be expected to occur 5% of the time

Question 18

Risk measure - CVaR

Answer 18

the average loss that would be incurred if the VaR cutoff is exceeded. it is also sometimes referred to as the expected tail loss or expected shortfall. it is not technically a VaR measure

Question 19

Risk measure - IVaR

Answer 19

the change in the portfolio VaR when adding a new position to a portfolio, thereby reducing the position size of current positions

Question 20

Risk measure - MVaR

Answer 20

the effect of a vary small change in the position size. in a diversified portfolio, marginal VaR may be used to determine the contribution of each asset to the overall VaR

Question 21

Long/short - benefits

Answer 21

• short positions can reduce market risk
• shorting potentially expands benefits from other risk premiums and alpha
• the combination of long and short positions allows for a great diversification potential

Question 22

Long/short - costs

Answer 22

• short positions might reduce the market return premium
• shorting may amplify the active risk
• there are higher implementation costs and greater complexity associated with shorting and leverage relative to a long only approach

Question 23

Absolute risk

Answer 23

the total volatility of portfolio returns independent of a benchmark. it is the most appropriate risk measure for portfolios when an absolute return objective

Question 24

Well constructed portfolio processes

Answer 24

• a clear investment philosophy and a consistent investment process
• risk and structural characteristics as promised to investors
• a risk efficient delivery methodology
• reasonably low costs given the strategy

Question 25

Well constructed portfolio

Answer 25

Would be looking for risk exposures that are aligned with investor expectations and constraints and low idiosyncratic risk relative to total risk
if two products have comparable factor exposures, the product with a lower absolute volatility and lower active risk will likely be preferred (assuming similar costs).
if two products have similar active and absolute risks, the portfolios have similar cost, and the alpha skills of the managers are similar, the product having a higher active share is preferred, because it leverages the alpha skills of the manager and will have higher expected returns.
finally, the risk efficiency of any given portfolio approach should be judged in the context of the investor’s total portfolio. the active risk of a concentrated stock picker should be higher than that of a diversified factor investor, and the concentrated stock picker may have lower information ratio

Question 26

Long only investing is influence by few factors

Answer 26

• long risk premiums
• capacity and scale: long only investing, particularly strategies that focus on large cap stocks, generally offers greater investment capacity than other approaches
• limited legal liability and risk appetite
• regulatory
• transactional complexity
• management costs
• personal ideology