Reading 25: Active Equity Investing: Portfolio Construction Flashcards
Active Strategy
Managers with fewer positions are more likely to be focussed on risk management and are therefore behaving in a risk-efficient manner. All else equal, portfolios with a higher active share are preferable since these portfolios will benefit most from the alpha skills of the managers and should therefore have higher expected returns.
Formal Risk Constraints
Formal risk constraints are linked to expected return distribution, unlike heuristics, and therefore require forward looking risk estimates. Heuristics are both on experience and perceived good practises and require little analyses. Formal are conditional VAR, incremental VAR, marginal VAR (impact of very small change in position size).
Idiosyncratic Risk
Comes from large concentrated portfolio and is random risk that is not explained. Single stock pickers will have more of this. Fundamental stock-picking managers are likely to hold fewer positions since they generate few high-conviction ideas through time consuming research, hence are likely to be the least diversified and have the highest contribution to active return from idiosyncratic risk factors.
Multi Factor Products
They are diversified across factors and securities and typically have high active share but have reasonably low active risk (tracking error), often in the range of 3%. Most multi-factor products have a low concentration among securities in order to achieve a balanced exposure to risk factors and minimize idiosyncratic risks.
Well-Constructed Portfolio
Should have low idiosyncratic risk (unexplained) relative to total risk. With comparable factor exposures, the portfolio with lower active risk and absolute volatility is preferred, assuming similar costs. If all are equal then you would prefer the portfolio with higher active share. Achieve risk exposure with fewer securities. Managers can be combined to create overall equity allocation.
Long-Only Strategy
Long-only investing generally offers greater investment capacity than other approaches, particularly when using strategies that focus on large-cap stocks. There will be lower effective capacity constraints. Captures long term risk premiums, set by liquidity of underlying (more capacity than shorts that are based on capacity to borrow security), limited legal liabilities (security can only fall to zero value), some countries ban short selling, less transactionally complex, lower costs, personal ideology (ethics of benefiting from shorts).
Sources of Active Return
Long term exposure to rewarded factors (is transparent and doesn’t require lots of skill); alpha, which is tactical exposure to misplaced securities (mangers skill), idiosyncratic risk.
Building Blocks of Portfolio Construction
Factor weightings: taking exposure to rewarded risks that differ from benchmark, not considered alpha, sensitivity to beta factors.
Alpha skill: factor timing to outperform.
Sizing positions: impacts all three sources of active risk but the main one is idiosyncratic. Smaller positions in greater number of securities will diversify away idiosyncratic risk = lower volatility.
Systematic Vs Discretionary
Systematic follows a set of rules and uses more formal portfolio optimisation. It will be more diversified compared to discretionary typically.
Active Share
Measures the degree to which the weightings of the manager deviate from the benchmark. Scaled between 0-1, if manager holds stocks not in the benchmark their active share will be 1. (1 - Active Share) can be interpreted as the overlap. If two portfolios have same securities in the benchmark, the portfolio with fewer securities will have higher concentration and higher active share.
Active Risk
Tracking error, standard deviation of active returns. If a security is added that has low correlation with the others active risk will increase. Active share is not affected by this cross-correlation. High net exposure to risk factors leads to higher active risk. No net exposure will have active risk attributed entirely to active share.
Risk Budgeting
Total risk of a portfolio is allocated to constituents of the portfolio in most efficient manner.
Causes & Sources of Risk
Can be absolute where weights or betas are used or can be relative where active weights and active return correlations are used. The sum of all contributions of each security to portfolio variance equals total portfolio variance. For relative, cash has very low correlations to other sectors, so including cash can increase active risk.
Market Impact Costs
Implicit costs due to price movements. More common with large AUM, smaller caps, high portfolio turnover, shorter investment horizons, high information trades (signals). Measured by slippage (difference between execution price and midpoint of bid-ask spread at time of trade). Slippage is higher than explicit costs, greater for small caps, not necessarily greater in emerging markets, higher in times of volatility.
Long/Short Portfolios
Gross exposure is the long exposure plus the short exposure. Net exposure is the different between the two.
Long extensions are contained to net exposure of 100%, so can include 100% long and 30% short.
Market neutral removes market exposure through long and short exposures giving Beta of one, lower correlation with other strategies and lower volatility (can use pairs trading through statistical arb).
