Portfolio construction

1) A fund manager makes the following comment:

“Active management should be easy with the right alphas.”

The manager is most likely:

A
Incorrect because most active managers construct portfolios subject to certain
constraints and therefore active management with the right alphas is not easy to achieve

B
Correct because active managers construct portfolios subject to various constraints, but
these constraints do not make the portfolio less efficient

C
Incorrect because active managers construct portfolios without any constraints and,
therefore, active management with the right alphas is not easy to achieve

D
Correct because most active managers do not take short positions and limit the amount
of cash in the portfolio, thus making the portfolio more efficient

The correct answer is: A).

Most active managers construct portfolios subject to certain constraints – such as restrictions on
short positions, asset coverage, etc. – and, therefore, active management with the right alphas is
not easy to achieve.

2) Which of the following statements is (are) correct?

I. Any complex portfolio construction process can be replaced by a process which first
refines the alphas and uses a simple unconstrained mean/variance optimization to
determine the active positions
II. Simple models are always better than complicated implementation schemes.

A
Both I and II

B
None of the above

C
Only I

D
Only II

The correct answer is: C).

We can replace any portfolio construction process, regardless of its sophistication, that first
refines the alphas and then uses a simple unconstrained mean/variance optimization to
determine the active positions. Not all simple models are better than complicated implementation
schemes. The need for complicated schemes is determined by the reason for the complexity.

3) Which of the approaches explained below can be used to make alphas industry-neutral?
 A
Calculate the capitalization-weighted alpha for each industry, and then subtract the
industry average alpha from each alpha in that industry
B
Calculate the industry average alpha and subtract it from each alpha in that industry
C
Calculate the capitalization-weighted alpha for each industry, and then add the industry
average alpha to each alpha in that industry
D
Calculate the industry average alpha and add it to each alpha in that industry

The correct answer is: A).

A manager can ensure that her portfolios contain no active bets on industries. This generally
means that the alphas are industry-neutral. The steps required to make alphas industry-neutral
are as follows:

1. Segregate the exposures industry wise

2. Calculate the capitalization-weighted alpha for each industry
3. Workout the industry average alpha
4. Subtract the industry average alpha from each alpha in that industry

The alpha obtained is industry-neutral.

4) All the following are procedures for refining alphas, EXCEPT:

A
Scaling

B
Trimming

C
Transformation

D
Neutralization

The correct answer is: C).

There are three procedures for refining alphas:

1. Scaling – Alphas have a natural structure: α = volatility ∗ IC ∗ score. This structure

includes a natural scale for the alphas. Information coefficient (IC) and residual risk
(volatility) for a set of alphas is approximately constant, with the score having a mean of 0
and standard deviation 1 across the set. Hence, the alphas should have mean 0 and
standard deviation, or scale, of Std{α} ∿ volatility ∗ IC.
2. Trimming – Very large positive or negative alphas can have undue influence. A detailed
analysis may show that some of these alphas depend upon questionable data and must
be ignored (set to zero).
3. Neutralization – Alphas can be neutralized with regards to benchmark, cash, industry,
risk factor, etc. For instance benchmark neutralization would mean that the portfolio will
not make any bet on the benchmark.

5) Which of the following statements are accurate?

I. Benchmark neutralization means that the benchmark has zero alpha

 II. Benchmark neutralization means that the optimal portfolio will have a beta of 1

A
None of the above

B
Only I

C
Only II

D
Both I and II

The correct answer is: D).

Benchmark neutralization means that the benchmark has a zero alpha and the optimal portfolio
will have a beta of 1. Benchmark neutralization would mean that the portfolio will not make any
bet on the benchmark.

6) A fund manager makes the following comments:

I. The correct way to compare transactions costs incurred on the annual rate of gain from
alpha and the annual rate of loss from active risk is to amortize the transactions costs
where the rate of amortization depends on the anticipated holding period
II. The annualized transactions cost is the round trip cost divided by the holding period in
years

Which of the fund manager's comments are accurate?

A
Only I

B
Only II

C
Both I and II

D
None of the above

The correct answer is: C).

The rebalancing of a portfolio incurs transaction costs at that point in time. To contrast
transactions costs incurred at that time with alphas and active risk expected over the next year,
there has to be a rule to allocate the transactions costs over the one-year period. We must
amortize the transactions costs to compare them to the annual rate of gain from the alpha and
the annual rate of loss from the active risk. The rate of amortization will depend on the
anticipated holding period.

The annualized transactions cost is the round trip cost divided by the holding period in years.

7) A fund manager desires an active risk of 5%. If the information ratio of the portfolio is 0.5, then
the active risk aversion parameter is:
A
0.5

B
5

C
0.05

D
0.005

The correct answer is: C).

The relation between active risk, information ratio, and active risk aversion is as follow:

λa = IR / (2 * ψp)

λa = 0.5 / (2 * 0.05 * 100) = 0.05

8) A fund manager makes the following comments:

I. A high aversion to specific risk reduces bets on any particular stock

II. In the case of multiple portfolios, aversion to specific risk can reduce dispersion

Which of his comments is (are) accurate?

The correct answer is: C).

Specific risks arise from bets of specific assets. A high aversion to specific risk reduces bets on
any one stock. For managers, of multiple portfolios, aversion to specific risk can help reduce
dispersion. This will push all those portfolios toward holding the same stocks.

9) If a portfolio is optimal, then:

I. The marginal contribution to value added for a stock should be less than the purchase
cost
II. The marginal contribution to value added for a stock should be more than the purchase
cost
III. The marginal contribution to value added must be greater than the negative of the sales
cost
IV. The marginal contribution to value added must be less than the negative of the sales cost

The correct answer is: A).

If the portfolio is optimal then, marginal contribution to value added for a stock should be
less than the purchase cost and must be greater than the negative of the sales cost.

9) The following are techniques for portfolio construction, EXCEPT:

A
Linear programming

B
Polynomial programming
C
Screens

D
Stratification

The correct answer is: B).

Linear programming, quadratic programming, screens, and stratification are techniques for
portfolio construction.

10) All the following statements regarding the screen technique are correct, EXCEPT:

A
It is easy to understand with a clear link between cause and effect

B
Wild estimates of positive or negative alphas will alter the result

C
It is easy to computerize

D
It enhances the alphas by concentrating the portfolio in the high-alpha stocks

The correct answer is: B).

The screen technique depends solely upon ranking, hence wild estimates of positive or negative
alphas will not alter the result.

11) All the following are shortcomings of screen technique, EXCEPT:

A
It ignores all information in the alphas apart from rankings

B
It does not protect against biases in the alphas

C
It may result in more risky portfolios

D
It is hard to code

The correct answer is: D).

The first step in building a portfolio by utilizing the screen technique usually begins with ranking
the stocks by alpha. The simplicity in its implementation is one of the advantages of the screen
technique, which also makes its coding easy.

12) All the following are advantages of the stratification technique over the screen technique,
EXCEPT:

A
It ignores biases in the alphas across categories

B
The portfolio has a representative holding in each category
C
It reduces transaction costs

D
It is more transparent and easy to code

The correct answer is: C).

In the screen and stratification techniques, transaction costs are limited by controlling turnover
through judicious choice of the size of the buy, sell and hold lists. Hence, none of the techniques
results in the reduction of transactions costs.

31) All the following statements regarding the linear programming technique are true, EXCEPT:
A
It characterizes stocks along dimensions of risk

B
It can easily produce portfolios with a pre-specified number of stocks

C
It is possible to set up a linear program with explicit transaction costs, a limit on turnover,
and upper and lower position limits on each stocks

D
Its objective is to maximize the portfolio’s alpha less transaction costs, while remaining
close to benchmark portfolio in the risk control dimensions

The correct answer is: B).

The linear programming has difficulties producing portfolios with a pre-specified number of
stocks.

14) All the following statements regarding quadratic programming are true, EXCEPT:

A
It includes the linear program as a special case

B
It considers only two elements – risk and transactions costs

C
It requires a large number of inputs

D
The use of a large number of inputs increase the noise in the portfolio construction
process

The correct answer is: B).

Quadratic programming explicitly considers each of the three elements – risk, transaction costs,
and alpha.

15) Which of the following statements is (are) INCORRECT?

 I. Quadratic programming does not include all the constraints and limitations one finds in a
linear program
II. Errors in the estimation of co-variance lead to ineffective implementation of portfolio
construction technique
III. The lack of precision in the estimate of correlations is a problem in the ordinary
estimation of portfolio risk
IV. The portfolio optimizer selects a portfolio with higher active risk
V. A
VI. I and IV
VII. B
Only I
VIII. C
Only IV
IX. D
I, II and IV

The correct answer is: A).

Quadratic programming can include all the constraints and limitations one finds in a linear
program. Errors in estimation of co-variance or correlations can lead to an ineffective
implementation of the portfolio construction technique. The portfolio optimizer selects a
portfolio with lower active risk. Hence, statements I and IV are incorrect.

16) All the following statements regarding dispersion are true, EXCEPT:

A
Client-driven dispersion can be controlled by the manager

B
Separate accounts with the same factor exposures and beta can still exhibit dispersion

C
Dispersion is a measure of how an individual client’s portfolio may differ from the
manager’s reported composite return

D
If transactions costs were zero, dispersion would disappear

The correct answer is: A).

Client-driven dispersion, such as restriction in the use of futures contracts, are completely
beyond the manager’s control.

17) Dispersion is caused by all the following, EXCEPT:

A
Different betas and factor exposures

B
The number of stocks the portfolios have in common

C
Identical holdings in each portfolio

D
The overall number of portfolio under management

The correct answer is: C).

Dispersion will disappear if the holdings in each account are identical because the returns from
all these accounts will be identical.

17) Why do managers find certain levels of dispersion optimal?

A
It results in higher average returns

B
It remains constant over time

C
Transactions cost incurred to reduce dispersion is very low

D
It does not affect the average returns

The correct answer is: A).

For securities, the higher the standard deviation, the greater the dispersion of returns and the
higher the risk associated with the investment. As described by modern portfolio theory (MPT),
volatility creates risk that is associated with the degree of dispersion of returns around the
average.

18) The convergence of dispersion depends upon all of the following, EXCEPT:

A
The type of alphas in the strategy

B
The number of stocks in the portfolio

C
The transaction costs

D
The portfolio construction methodology

The correct answer is: B).

The convergence of dispersion depends upon the type of alphas in the strategy, transaction
costs, and the portfolio construction methodology.

19) Which of the following statements is (are) correct?

I. If alphas and risk stay absolutely constant over time, then dispersion will never disappear
II. For a given tracking error, more portfolios lead to less dispersion
III. Higher transactions costs result in more tracking error
IV. Dual-benchmark optimization reduces dispersion but at the cost of return

A
I and II

B
Only IV
C
I, III and IV

D
I, II and IV

The correct answer is: C).

For a given tracking error, more portfolios lead to more dispersion. Hence, statement II is
incorrect while all other statements are correct.

20) Which of these is not a method of refining alphas?

A
Trimming

B
Interpolation

C
Scaling

D
Neutralization

The correct answer is: B).

The three methods of refining alphas include trimming, scaling and neutralization. Trimming
involves removing extreme values while scaling is performed to make the alphas have the proper
scale for the portfolio construction process. The removal of biases from alphas is known as
neutralization.

21) A portfolio manager’s strategy for constructing a portfolio consists of first ranking stocks in
order of alpha and then picking the top ten stocks from this list and constructing an equally
weighted portfolio with them. The manager is most likely employing which of these portfolio
construction techniques?

A
Stratification

B
Linear programming

C
Quadratic programming

D
Screens

The correct answer is: D).

22) There are four commonly used classes of portfolio construction techniques. These include,

 Screens: which involves simple ranking of the assets and composing an equal weighted
or capitalization-weighted portfolio.
 Stratification: builds on the screens method by ensuring that each category of assets is
present in the portfolio.
 Linear programming: is used to choose a portfolio that closes resembles the benchmark
portfolio using stratification based on industry characteristics.
 Quadratic programming: this technique models alpha, risk and transaction costs and can
also incorporate constraints.