Active Equity Investing: Portfolio Construction

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Graphs, charts, tables, examples, and figures are copyright 2018, CFA Institute.
Reproduced and republished with permission from CFA Institute. All rights reserved.
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 Introduction and Contents
1. Introduction
2. Building Blocks of Active Equity Portfolio Construction
3. Approaches to Portfolio Construction
4. Allocating the Risk Budget
5. Additional Risk Measures used in Portfolio Construction and Monitoring
6. Implicit Cost-Related Considerations in Portfolio Construction
7. The Well-Constructed Portfolio
8. Long/Short, Long Extension and Market-Neutral Portfolio Construction

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2. Building Blocks of Active Equity Portfolio Construction
Active return is driven by difference in weights
between active portfolio and benchmark

Active manager will generate positive return if:

Gains generated by Losses generated by

• Overweighting securities that • Underweighting securities that
outperform the benchmark and
• Underweighting securities that
> outperform the benchmark and
• Overweighting securities that
underperform the benchmark underperform the benchmark

1. Fundamentals of Portfolio Construction

2. Building Blocks Used in Portfolio Construction

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 2.1 Fundamentals of Portfolio Construction
Active returns can be generated by:
1. Strategically adjusting exposures to rewarded Rewarded risks or rewarded factors
risks which are different from benchmark
2. Tactically adjusting active weights of securities Alpha
based on skills and experience
3. Assuming excessive idiosyncratic risk Luck

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 2.2 Building Blocks Used in Portfolio Construction
Breadth of Expertise
Factor Weighting Alpha Skills Position Sizing

Overweight, underweight or neutralized rewarded factors

Factors known to offer a persistent return premium: market, size, value, momentum

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 Breadth of Expertise
Factor Weighting Alpha Skills Position Sizing

Successfully time exposure to

• Rewarded factors
• Unrewarded factors
• Markets
• Securities

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 Breadth of Expertise
Factor Weighting Alpha Skills Position Sizing

Position sizing: large positions in a few stocks versus small positions in many stocks

Position sizing will be influenced by

• Investment approach
• Level of confidence in analytical work

Tradeoff between confidence in alpha skills and idiosyncratic risk

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 Breadth of Expertise
Factor Weighting Alpha Skills Position Sizing

Fundamental law of active management

Ability to consistently outperform the market is based on the number of independent decisions.

Manager IC Breadth Active Risk TC Expected active return

A 0.2 20 4% 0.6
B 0.2 40 4% 0.6

“Success is not achieved by being right all the time but, rather, by being right
often through small victories achieved consistently over long periods.”

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Overall, Proteus has integrated all the primary dimensions of the investment process.
Rewarded factors: Proteus recognizes the existence of rewarded factors, and it has significantly enhanced its measures of Quality, Value,
and Momentum over time.
Alpha skills: Given the commercial success of Proteus as a firm, we might safely assume that there is an alpha component in the process.
Position sizing: Position size limits are integrated into the investment process to ensure diversification limits idiosyncratic risks.
Breadth of expertise: Proteus has 20 years of experience refining and improving an investment process based on a consistent investment
philosophy.

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 3. Approaches for Portfolio Construction
Portfolio construction is based on a manager’s ability to add value using
• Factor exposures
• Timing
• Position sizing
• Breath or depth

1. The Implementation Process: The Choice of Portfolio Management Approaches

2. The Implementation Process: The Objectives and Constraints

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 3.1 The Choice of Portfolio Management Approaches
Managers rely on a combination of approaches to implement their core beliefs
• Systematic versus discretionary
• Bottom-up versus top-down
• Benchmark aware versus benchmark agnostic

Systematic Discretionary
Balanced exposure to know, rewarded factors Depth of understanding of a firm
Better factor proxies
Timing strategies
Research-based rules across a universe of securities Integrate judgement of manager across a smaller set of
securities
Integrate non-financial variables
Broadly diversified portfolios to reduce exposure to More concentrated portfolios reflecting insight of
idiosyncratic risk manager
Adaptable to a formal portfolio optimization process Less formal approach to portfolio construction

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 Top-Down versus Bottom-Up
Top-Down Bottom-Up
Starts with analysis of macro-economic, geo-political, Starts with detailed analysis of specific securities
social and public policy environment
Emphasis on macro factors Emphasis on security-specific factors
Emphasis on factor timing May embrace styles such as: value, growth at
reasonable price, momentum and quality
Capture returns from rewarded and un-rewarded
factors

Likely to have concentration of macro factor exposures Less likely to have concentration of macro-factor
exposures
Can be diversified or concentrated in terms of Can be diversified or concentrated in terms of
securities securities

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 Approaches and Their Use of Building Blocks
Top-Down
Systematic and Top-Down Discretionary and Top-Down
• Emphasizes macro factors • Emphasizes macro factors
• Factor timing • Factor timing

Discretionary
Systematic

• Diversified • Diversified or concentrated depending on strategy and

Systematic and Bottom-Up
• Emphasizes security-specific
factors
• No factor timing
• Diversified
style
Discretionary and Bottom-Up
• Emphasizes security specific characteristics or factors
• Potential factor timing
• Diversified or concentrated depending on strategy and
style

Bottom-Up

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 Active Share and Active Risk (1/2)
Active Share
Active Share measures extent to which number
and sizing of positions in benchmark differ from
portfolio
Not impacted by correlations
Portfolio manager has complete control
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Active Risk
Realized active risk is the realized standard
deviation of the active return
Predicted active risk requires forward-looking
estimates of correlations and variances
Higher correlations → higher active risk
Portfolio manager does not have complete
control
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 Active Share and Active Risk (2/2)
• High net exposure to risk factor → high level of active risk

• If factor exposure is neutralized, active risk will be due to

Active Share

• Active risk attributed to Active Share will be smaller if

▪ Number of securities is large and/or
▪ Average idiosyncratic risk is small

• Level of active risk will rise with an increase in

▪ Factor volatility High Concentrated
▪ Idiosyncratic volatility Concentrated Stock Picks

Active Share
Diversified Factor Bets
Factor Neutral Factor Bets
and Diversified
Stock Picks

Closet indexing

Low Pure indexing

Low High
Active Risk
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Example 2: Portfolio Construction – Approaches and Return Drivers

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Example 2: Portfolio Construction – Approaches and Return Drivers

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Example 2: Portfolio Construction – Approaches and Return Drivers

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Example 2: Portfolio Construction – Approaches and Return Drivers

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3.2 The Implementation Process: Objectives and Constraints
Portfolio construction can be thought of as an optimization problem

Typical objective function: maximize risk-

adjusted return such as information ratio or
Sharpe ratio

Possible constraints:
• Limits on geographic, sector, industry and
single-security exposures
• Limits on exposure to specific factors
• Limits on transaction costs

Objectives can be specified in terms of:

Heuristic methodologies:
Risk metrics
Identify securities based on desired characteristics
Rewarded factors
• weight based on score or
• weight based on rank

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Manager Description Sensitivity to risk Security Idiosyncratic
factors concentration risk
Cohen Rewarded factors
Palmer Sector performance
Christopher Stock picker

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 Implementation Approach

Security Selection Approach

Portfolio Concentration

Objective Function

Constraints

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 4. Allocating the Risk Budget
Risk budgeting is a process by which the total risk appetite of a portfolio is allocated across various
components of the portfolio

An effective risk management process requires a portfolio manager to:

• Determine which type of risk measure is most appropriate given the strategy
• Understand how each aspect of the strategy contributes to its overall risk
• Determine what level of risk budget is appropriate
• Properly allocate risk among individual positions/factors

1. Absolute vs. Relative Measures of Risk

2. Determining the Appropriate Level of Risk

3. Allocating the Risk Budget

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 4.1 Absolute vs. Relative Measures of Risk
Portfolio management orientation Appropriate risk measure Low risk – High risk
Performance measured relative to index focus Active risk Low bands – wide bands
Performance measured in absolute terms Volatility of returns Low volatility – high volatility

Risks should be related to perceived skills

• Market timers
• Sector rotators
• Multi-factor managers

Need to understand the generic drivers of:

• Absolute portfolio risk
• Relative portfolio risk

Portfolio risk is also impacted by position sizing and by covariance of assets/factors with portfolio.

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 Causes and Sources of Absolute Risk

Action Portfolio Risk

Add new asset which has higher covariance with portfolio than most current securities Rises
Replace existing security with higher covariance security Rises

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Exhibit 11: Absolute Risk Factor Attribution, Feb 1990 – Dec 2016

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 Causes and Sources of Relative/Active Risk
One measure of relative risk: variance of portfolio’s active return
Each asset has a contribution to the portfolio’s active variance

Active Risk Factor Attribution, Feb 1990 – Dec 2016

Can’t assume that low risk asset

will reduce active risk

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 4.2 Determining the Appropriate Level of Risk
The appropriate level of absolute or relative risk is subjective and depends on

• Manager’s investment style

• Manager’s conviction in his ability to add value

• Risk appetite

Examples of risk targets for different mandates

• Market-neutral hedge fund targeting an absolute risk of 10%

• Long-only equity manager targeting an active risk of less than 2%

• Long-only manager targeting an active risk of 6% - 10%

• Equity manager targeting an absolute risk equal to 85% of the index risk

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 Practical Risk Limits
• Implementation constraints

• Limited diversification
opportunities

• Leverage and implications

for risk
“Leverage eventually leads to a reduction of expected compounded return in a multi-period setting”

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 4.3 Allocating the Risk Budget
Allocation of the risk budget depends on style and strategy

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 5. Additional Risk Measures Used in Portfolio
Construction and Monitoring

1. Heuristic Constraints

2. Formal Constraints

3. The Risks of Being Wrong

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 5.1 Heuristic Constraints
Heuristic constraints may impose limits on:

• exposure concentrations by security, sector, industry, or geography

• net exposures to risk factors, such as beta, size, value, and momentum

• net exposures to currencies

• degree of leverage

• degree of illiquidity

• turnover/trading-related costs

• exposures to reputational and environmental risks, such as actual or potential carbon emissions

• other attributes related to an investor’s core concerns

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 5.2 Formal Constraints
Formal risk measures are often statistical and directly linked to portfolio returns.
• Volatility is the standard deviation of portfolio returns.
• Active risk is the standard deviation of the differences between a portfolio’s returns and its benchmark’s returns.
• Skewness is a measure of the degree to which return expectations are non-normally distributed.
• Drawdown measures the portfolio loss from its high point until it begins to recover.
• VaR is the minimum loss that would be expected a certain percentage of the time over a specific period of time.
• CVaR is the average loss that would be incurred if the VaR cutoff is exceeded.
• IVaR is the change in portfolio VaR when adding a new position to a portfolio.
• MVaR reflects the effect of a very small change in the position size.

Formal measures require managers

to estimate or predict risk.

A given portfolio can have both formal

and heuristic constraints.

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 5.3 The Risks of Being Wrong

The consequences of being wrong can be significant

Leverage magnifies the consequences

Volatility can be controlled by using short-term

bonds

Statistical risk measures depend on manager’s style

and strategy

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6. Implicit Cost-Related Considerations in Portfolio Construction
Two categories of portfolio management costs
• Explicit costs: brokerage fees, etc.
• Implicit costs: market impact resulting from purchase or sale of a security;
includes delay and slippage

Smaller funds might pay more explicit costs but less implicit costs

Benefits of post-trade risk/return position must justify the cost of getting there

1. Implicit Costs – Market Impact and the Relevance of Position Size, Assets
under Management, and Turnover

2. Estimating the Cost of Slippage

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6.1 Implicit Costs – Market Impact and the Relevance of
Position Size, Assets under Management and Turnover

Liquidity

Trade Size /
Market Impact Turnover Costs
Daily Volume

Immediacy

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 AUM and Portfolio Construction Decisions

As a fund grows the opportunity set Capitalization and Trading Volume of Russell 1000 Companies
reduces

Only 35% of the companies in the Russell

1000 have an average trading volume over
$100 million

For a $5 billion fund a 2% position means

$100 million

Constraint: position size should be less

than 10% of daily trading volume
This further limits the opportunity set

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 6.2 Estimating the Cost of Slippage
Slippage: difference between execution price and midpoint of the bid and ask quotes at the time the
trade was first entered

Slippage costs are usually more important than commission costs.

Slippage costs are greater for smaller-cap securities than for large-cap securities.

Slippage costs are not necessarily greater in emerging markets.

Slippage costs can vary substantially over time, especially when market volatility is higher

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Example 7: Issues of Scale

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Example 7: Issues of Scale

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 7. The Well-Constructed Portfolio
“A well-constructed portfolio should deliver results consistent with investors’ risk and return
expectations.”

Portfolio should have:

• a clear investment philosophy and a consistent investment process

• risk and structural characteristics as promised to investors

• a risk-efficient delivery methodology

• reasonably low operating costs given the strategy

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8. Long/Short, Long Extension, and Market-Neutral
Portfolio Construction

1. The Merits of Long-Only Investing

2. Long/Short Portfolio Construction
3. Long Extension Portfolio Construction
4. Market-Neutral Portfolio Construction
5. Benefits and Drawbacks of Long/Short Strategies

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 8.1 The Merits of Long-Only Investing
• Long-term risk premiums

• Capacity and scalability

• Limited legal liability

• Regulatory

• Transactional complexity

• Management costs

• Personal ideology

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 8.2 Long/Short Portfolio Construction
• Long/short portfolios have both long and short positions
▪ Positions can be negative and are not constrained to sum 1
▪ Net exposure versus gross exposure

• Many reasons for long-short strategies

▪ Negative views can be expressed through short positions
▪ Short selling can help reduce exposures
▪ Fully extracting benefits of risk factors requires long/short approach

• Many different styles

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 8.3 Long Extension Portfolio Construction
• Hybrid of long-only and long/short strategies

• Also called “enhanced active equity” strategies

• Example: 130/30 strategy

• Leverage by taking short positions in overpriced securities

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 8.4 Market-Neutral Portfolio Construction
• Specialized form of long/short portfolio construction

• Dollar neutral portfolio: dollars invested in long positions = dollars invested in short positions

• Market neutral portfolio: exposure to market is cancelled out

▪ Long $100 of assets with Market beta of 1 and short $80 of assets with Market beta of $1.2
▪ Pairs trading (statistical arbitrage)

• Two inherent limitations

▪ Not easy to maintain a beta of zero
▪ Market-neutral strategies have limited upside in a bull market

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 8.5 Benefits and Drawbacks of Long/Short Strategies
Benefits
• 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, sectors, geography, or any undesired exposure.

Risks
• 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.
• 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.
• Manager may fall victim to a short squeeze.

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Benefits
Short positions can reduce market risk
Shorting potentially expands benefits from
other risk premiums and alpha
Costs
Short positions might reduce the market
return premiums
Shorting may amplify the active risk

The combination of long and short positions Short positions have relatively high
allows for a greater diversification potential implementation costs

Short positions are relatively complex to

establish

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 Summary
• Elements of investment philosophy that influence the portfolio
construction process

• Approaches for constructing actively managed equity portfolios

• Active Share versus active risk

• Application of risk budgeting concepts in portfolio construction

• Limits on risk measures affect portfolio construction

• Impact of AUM, position size, market liquidity, and portfolio turnover

• Efficiency of a portfolio structure

• Long-only, long extension, long/short, and equitized market-neutral

approaches

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