R29 Active Equity Investing: Portfolio Construction

Question 1

R29

Active Return

Answer 1

• The portfolio’s return in excess of the return on the portfolio’s benchmark.
• (R_p-R_b)
• Benefits of active management

Question 2

R29

3 sources of Active Return

Answer 2

1. Strategic or long term exposures to rewarded factors (size,value, growth, market risk (beta))
2. Tactical exposture to mispriced sectors, securities and rewarded factors that generate alpha
3. Idiosyncratic risk - returns generated by luck

Question 3

R29

3 Building Blocks Used in Equity Portfolio Construction

Answer 3

1. Factor Weightings (Active return due to beta differences with portfolio and benchmark). Underweight / overweighting rewarded risk factors.
2. Alpha Skills (factor timing). active returns arising from skillful timing of exposure to rewarded factors, unrewarded factors (e.g. region exposure, industry sector), or even other asset classes (such as cash) constitute a manager’s alpha—the second building block.
3. Position Sizing (diversification vs concentration). The stock picker with high confidence in her analysis of individual securities may be willing to assume high levels of idiosyncratic risk. On the other hand, a manager focused on creating balanced exposures to rewarded factors is unlikely to assume a high level of idiosyncratic risk and is, therefore, quite likely to construct a highly diversified portfolio of individual securities.

• Need to integrate this blocks with breadth of expertise

Question 4

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Fundamental law: expected active portfolio return E(R_A)

Answer 4

E(R_A) = IC√BR_σRATC

where

IC = Expected information coefficient of the manager—the extent to which a manager’s forecasted active returns correspond to the managers realized active returns

BR = Breadth—the number of truly independent decisions made each year. Higher breadth = higher active returns. Looking at multiple factors will lead to higher breadth.

TC = Transfer coefficient, or the ability to translate portfolio insights into investment decisions without constraint (a truly unconstrained portfolio would have a transfer coefficient of 1)

σ_RA = the manager’s active risk

Question 5

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Approaches to Active Equity Portfolio Construction

Answer 5

1. Systematic - following rules. Seek to reduce exposure to idiosyncratic risk and often use broadly diversified portfolios to achieve the desired factor exposure while minimizing security-specific risk. Typically more adaptable to a formal portfolio optimization process.
2. Discretionary -generally more concentrated portfolios, reflecting the depth of the manager’s insights on company characteristics and the competitive landscape.
3. Bottom up - may embrace such styles as Value, Growth at Reasonable Price, Momentum, and Quality.
4. Top Down - contains an important element of factor timing. is Likely to run a portfolio concentrated with respect to macro factor exposures

• Portfolio construction can be seen as an optimisation problem.

Question 6

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Summary of the Different Approaches

Answer 6

Question 7

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Active Risk

Answer 7

• The annualized standard deviation of active returns, also referred to as tracking error (also sometimes called tracking risk).
• Active risk is affected by the degree of cross correlation, but Active Share is not.
• A portfolio manager can completely control Active Share, but she cannot completely control active risk because active risk depends on the correlations and variances of securities that are beyond her control
• The active risk of a portfolio is a function of the variance attributed to the factor exposure and of the variance attributed to the idiosyncratic risk .
• 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 is 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;
• the level of active risk will rise with an increase in factor and idiosyncratic volatility

Question 8

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Active Share

Answer 8

• It measures the extent to which the number and sizing positions in a manager’s portfolio differ from the benchmark.
• 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

• 0.5∑[Weight_portfolio,i−Weight_benchmark,i]
• 1 - active share = % overlap between portfolio and benchmark
• Value from 0 to 1
• Will be 0 when weights in portfolio and benchmark the same
• Will be 1 when weights in portfolio and benchmark are all different

Question 9

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Effective risk management process

Answer 9

1. Determine which type of risk measure is appropriate given the fund mandate.

• Absolute risk measures are appropriate when the investment objective is expressed in terms of total returns (e.g., total volatility of portfolio returns).
• Relative risk measures are appropriate when the investment objective is to outperform a market index.

2. Understand how each aspect of the strategy contributes to overall risk.
   * Does risk come from exposure to rewarded factors or allocations to sectors/securities?
3. Determine what level of risk budget is appropriate.
   * This is the overall level of risk targeted.
4. Properly allocate risk among individual positions/factors.

Question 10

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Causes and Sources of Absolute Risk

Answer 10

• The contribution of an asset to total portfolio variance is equal to the product of the weight of the asset and its covariance with the entire portfolio
• CV i= ∑ = x_ix_jC_ij = x_iC_ip

_{xj = the asset’s weight in the portfolio}

_{Cij = the covariance of returns between asset i and asset j}

_{Cip = the covariance of returns between asset i and the portfolio}

• _{“assets” might also be sectors, countries, or pools of assets representing risk factors (Value versus Growth, Small versus Large)}

Question 11

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Causes and Sources of Relative/Active Risk

Answer 11

• Relative risk becomes an appropriate measure when the manager is concerned with her performance relative to a benchmark.
• The contribution of each asset to the portfolio active variance (CAV_i) is:

CAV_i = (x_i−bi)RC_ip

_{xi = the asset’s weight in the portfolio}

_{bi = the benchmark weight in asset i}

_{RCij = the covariance of relative returns between asset i and asset j}

• Adding up the contributions for active variance (CAVi) for all assets in the portfolio produces the variance of the portfolios active return.
• Can be done on a factor level

Question 12

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Risk Constraints

Answer 12

• Heuristic Constraints e.g. portfolio must have a weighted average capitalization less than 75% of that of the index; portfolio’s carbon footprint must be limited to no more than 75% of the benchmark’s exposure.
• Formal Constraints e.g Volatility, Active risk, VaR, Skewness, Drawdowns.

Question 13

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Long-Only Investing

Answer 13

• Can take long positions
• choice of whether to pursue a long-only strategy or some variation of a long/short strategy is likely to be influenced by several considerations:

1. Long-term risk premiums
2. Capacity and scale (the ability to invest assets, liquidity)
3. Limited legal liability and risk appetite. Long only will only lose the amount invested. Short sellers losses can be unlimited - stock could go up indefinetly
4. Regulatory constraints. Some countries ban short selling.
5. Transactional complexity. Long -only transactions simple.
6. Management costs. Long-only is less expensive.
7. Personal ideology - morally wrong to short? Unwilling to use risk.

Question 14

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Long-Short Investing

Answer 14

• Net exposure is 0
• Equal number of long and short positions

Question 15

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Long Extension Portfolio Construction

Answer 15

• A hybrid of long-only and long/short strategies.
• A 130/30 strategy builds a portfolio of long positions worth 130% of the wealth invested in the strategy—that is, 1.3 times the amount of capital. At the same time, the portfolio holds short positions worth 30% of capital
• This strategy offers the opportunity to magnify total returns
• Could also lead to greater losses if the manager is simultaneously wrong on both his long and short picks.
• Beta not zero - more equal to 1.

Question 16

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Market-Neutral Portfolio Construction

Answer 16

• Dollar neutral is not the same thing as market neutral, because the economic drivers of returns for the long side may not be the same as the economic drivers for the short side.
• True market-neutral strategies hedge out most market risk
• A simple example of zero-beta investment would be a fund that is long $100 of assets with a Market beta of 1 and short $80 of assets with a Market beta of 1.25
• The main constraint is that in aggregate, the targeted beta(s) of the portfolio be zero.
• Seek to remove major sources of systematic risk from a portfoli
• Use of pairs trading or statistical arbitrage
• Market-neutral strategies have two inherent limitations:

1. It is no easy task to maintain a beta of zero
2. Market-neutral strategies have a limited upside in a bull market unless they are “equitized.” Some investors, therefore, choose to index their equity exposure and overlay long/short strategies.

Question 17

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Benefits of Long/Short Strategies

Answer 17

• Ability to more fully express short ideas than under a long-only strategy
• Efficient use of leverage and of the benefits of diversification
• Greater ability to calibrate/control exposure to factors (such as Market and other rewarded factors), sectors, geography, or any undesired exposure (such as, perhaps, sensitivity to the price of oil)
• Short positions can reduce market risk.
• Shorting potentially expands benefits from other risk premiums and alpha.

Question 18

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Drawbacks of Long/Short Strategies

Answer 18

• Unlike a long position, a short position will move against the manager if the price of the security increases.
• Long/short strategies sometimes require significant leverage. Leverage must be used wisely.
• The cost of borrowing a security can become prohibitive, particularly if the security is hard to borrow.
• Collateral requirements will increase if a short position moves against the manager. In extreme cases, the manager may be forced to liquidate some favorably ranked long positions (and short positions that might eventually reverse) if too much leverage has been used. The manager may also fall victim to a short squeeze. A short squeeze is a situation in which the price of the stock that has been shorted has risen so much and so quickly that many short investors may be unable to maintain their positions in the short run in light of the increased collateral requirements.
• Lender can call back shares at any time
• Shorting may amplify the active risk.
• Short positions might reduce the market return premium.
• There are higher implementation costs and greater complexity associated with shorting and leverage relative to a long-only approach.

Question 19

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Slippage

Answer 19

• Slippage is the difference between execution price and mid point of the bid and ask quotes
• Slippage costs usually more important than commission costs
• slippage costs greater for small cap than large cap
• slippage costs not necessarily greater in emerging markets
• Slippage costs can vary over time, especially when market volatility is higher.