R25: Active Investing - Portfolio Construction Flashcards
What are the sources of active return?
- Strategic AA
- Tactical AA
- Idiosyncratic risk
What is the Fundamental Law?
Ra=IC×TC×/BR×SDa
Breadth of expertise: confidence in a manager’s ability to outperform a benchmark increases when that performance is driven by a large number of independent decisions.
Factor weighting: regression analysis will determine the factor sensitivities of the benchmark. From here we can tilt the portfolio.
Alpha skills: zero sum game before fees. Exposure to known reward factor is not alpha, but timing of the exposure is.
Position sizing: balance between managers’ confidence in their factor weighting and alpha generation vs Idiosyncratic risk.
What’s an active share? Formula?
Extent to which weights differ from benchmark. Easy for PM to control.
0.5×sum of absolute difference in weights
What’s the active risk?
SD of active return. Much harder to manage since requires knowledge/estimations of correlations and covariance. In general, high active risk = high active share, but not always.
Two sources:
- Active factor exposure (active beta)
- Idiosyncratic risk from concentrated positions (variance from both the skill and luck of the manager)
Name the type of strategy for each TE figure:
<1%, 2-4%, 7-10%, 15%
Tracker/closet tracker
Multi-factor portfolio
Stock rotator
Concentrated stock picker
What are the two risk budgeting approaches?
- How much a security contributes to a portfolio’s overall risk.
- Multi-factor modelling to measure contribution to portfolio variance from relevant risk factors.
What are the constraints with portfolio construction?
- Heuristics
- Formal
What are the types of VaR?
CVaR (expected shortfall, weighted average of extreme losses in the tail beyond VaR cut-off point)
IVaR
MVaR
What are the characteristics of a well-constructed portfolio?
- Cleae investment policy and consistent investment process
- Risk characteristics as expected by investors
- Risk-efficient delivery methodology
- Reasonably low operating costs
Low active risk.
All else being equal, higher active share preferable (this form of leverage enhances alpha and so returns)
What are the advantages of long/short over long-only?
- Easier to express negative views
- Create a bespoke net exposure
- Long extension approach
- Pairs trading
- Factor-based investing - better control risk factor exposures
- Ability to gear into high-conviction long positions
What are the disadvantages of long/short vs long-only?
- Potential unlimited losses
- Cost of borrowing a security
- Collateral requirements
- Transactional complexity
- Negative beta
- Increases active risk
- Potential high leverage for market-neutral funds
What are the implicit cost-related considerations?
Market impact (change in price): Available liquidity, urgency of trade, trades that contain info (large order)
Slippage (executed price vs midpoint of b/o when trade first entered):
Market impact costs and trend costs, large sell order over multiple days, minimise through unlit venues, higher for small-cap stocks and large trades
What is the impact of subbing highly correlated stocks?
Will likely create some active share but limited effect on active risk
Pearson IC vs Spearman Rank IC
Pearson IC is sensitive to outliers. Suggests negative relationship between earnings yield and subsequent stock performance.
Spearman Rank IC is more robust. Suggests earnings yield has a relatively strong predictive power related to the subsequent stock performance.
What are the characteristics of a multi-factor portfolio?
Low single-security risk contribution, significant sector deviations despite high diversificstion, low TE, high active share.
