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2019 Curriculum CFA Program Level III Portfolio Management and Wealth Planning

Active Equity Investing: Portfolio Construction

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Introduction

Active equity investing is based on the concept that a skilled portfolio manager can both identify and differentiate between the most attractive securities and the least attractive securities—typically relative to a pre-specified benchmark. If this is the case, why is a portfolio—a collection of securities—even necessary? Why shouldn’t the portfolio manager just identify the most attractive security and invest all assets in this one security? Or in a long/short context, why not buy the “best” security and sell the “worst” one? Although very simple, this one-stock approach is not likely to be optimal or even feasible. No manager has perfect foresight, and his predictions will likely differ from realized returns. What he predicted would be the “best security” may quite likely turn out not to be the best. Active equity portfolio managers, even those with great skill, cannot avoid this risk. Security analysis is the process for ranking the relative attractiveness of securities, whereas portfolio construction is about selecting the securities to be included and carefully determining what percentage of the portfolio is to be held in each security—balancing superior insights regarding predicted returns against some likelihood that these insights will be derailed by events unknown or simply prove to be inaccurate. 

Active managers rely on a wide array of investment strategies and methodologies to build portfolios of securities that they expect to outperform the benchmark. The challenges faced by active managers are similar whether they manage long-only traditional strategies, systematic/quantitative strategies, or long/short opportunistic strategies. Managers may differ in their investment style, operational complexity, flexibility of investment policy, ability to use leverage and short positions, and implementation methodologies, but predictions about returns and risk are essential to most active equity management styles. 

In Section 2, we introduce the “building blocks” of portfolio construction, and in Section 3, we discuss the different approaches to portfolio construction. In Sections 4 and 5, we discuss risk budgeting concepts relevant to portfolio construction and the measures used to evaluate portfolio risk. Section 6 looks at how issues of scale may affect portfolio construction. Section 7 addresses the attributes of a well-constructed portfolio. Section 8 looks at certain specialized equity strategies and how their approaches to portfolio construction may differ from a long-only equity strategy. The reading concludes with a summary.

Learning Outcomes

The candidate should be able to:

  1. describe elements of a manager’s investment philosophy that influence the portfolio construction process;
  2. discuss approaches for constructing actively managed equity portfolios;
  3. distinguish between Active Share and active risk and discuss how each measure relates to a manager’s investment strategy;
  4. discuss the application of risk budgeting concepts in portfolio construction;
  5. discuss risk measures that are incorporated in equity portfolio construction and describe how limits set on these measures affect portfolio construction;
  6. discuss how assets under management, position size, market liquidity, and portfolio turnover affect equity portfolio construction decisions;
  7. evaluate the efficiency of a portfolio structure given its investment mandate;
  8. discuss the long-only, long extension, long/short, and equitized market-neutral approaches to equity portfolio construction, including their risks, costs, and effects on potential alphas.

Summary

Active equity portfolio construction strives to make sure that superior insights about forecasted returns get efficiently reflected in realized portfolio performance. Active equity portfolio construction is about thoroughly understanding the return objectives of a portfolio, as well as its acceptable risk levels, and then finding the right mix of securities that balances predicted returns against risk and other impediments that can interfere with realizing these returns. These principles apply to long-only, long/short, long-extension, and market-neutral approaches. Below, we highlight the discussions of this reading.

  • The four main building blocks of portfolio construction are the following:
    • Overweight, underweight, or neutralize rewarded factors: The four most recognized factors known to offer a persistent return premium are Market, Size, Value, and Momentum.
    • Alpha skills: Timing factors, securities, and markets. Finding new factors and enhancing existing factors.
    • Sizing positions to account for risk and active weights.
    • Breadth of expertise: A manager’s ability to consistently outperform his benchmark increases when that performance can be attributed to a larger sample of independent decisions. Independent decisions are uncorrelated decisions.
  • Managers can rely on a combination of approaches to implement their core beliefs:
    • Systematic vs. discretionary
      • Systematic strategies incorporate research-based rules across a broad universe of securities.
      • Discretionary strategies integrate the judgment of the manager on a smaller subset of securities.
    • Bottom up vs. top down
      • A bottom-up manager evaluates the risk and return characteristics of individual securities. The aggregate of these risk and return expectations implies expectations for the overall economic and market environment.
      • A top-down manager starts with an understanding of the overall market environment and then projects how the expected environment will affect countries, asset classes, sectors, and securities.
    • Benchmark aware vs. benchmark agnostic
  • Portfolio construction can be framed as an optimization problem using an objective function and set of constraints. The objective function of a systematic manager will be specified explicitly, whereas that of a discretionary manager may be set implicitly.
  • Risk budgeting is a process by which the total risk appetite of the portfolio is allocated among the various components of portfolio choice.
  • Active risk (tracking error) is a function of the portfolios exposure to systematic risks and the level of idiosyncratic, security-specific risk. It is a relevant risk measure for benchmark-relative portfolios.
  • Absolute risk is the total volatility of portfolio returns independent of a benchmark. It is the most appropriate risk measure for portfolios with an absolute return objective.
  • Active Share measures the extent to which the number and sizing of positions in a manager’s portfolio differ from the benchmark.
  • Benchmark-agnostic managers usually have a greater level of Active Share and most likely have greater level of active risk.
  • An effective risk management process requires that the portfolio manager
    • determine which type of risk measure is most appropriate,
    • understand how each aspect of the strategy contributes to its overall risk,
    • determine what level of risk budget is appropriate, and
    • effectively allocate risk among individual positions/factors.
  • Risk constraints may be either formal or heuristic. Heuristic constraints may impose limits on
    • concentration by security, sector, industry, or geography;
    • net exposures to risk factors, such as Beta, Size, Value, and Momentum;
    • net exposures to currencies;
    • the degree of leverage;
    • the degree of illiquidity;
    • exposures to reputational/environmental risks, such as carbon emissions; and
    • other attributes related to an investor’s core concerns.
  • Formal risk constraints are statistical in nature. Formal risk measures include the following:
    • Volatility—the standard deviation of portfolio returns
    • Active risk—also called tracking error or tracking risk
    • Skewness—a measure of the degree to which return expectations are non-normally distributed
    • Drawdown—a measure of portfolio loss from its high point until it begins to recover
    • Value at risk (VaR)—the minimum loss that would be expected a certain percentage of the time over a certain period of time given the modeled market conditions, typically expressed as the minimum loss that can be expected to occur 5% of the time
    • CVaR (expected tail loss or expected shortfall)—the average loss that would be incurred if the VaR cutoff is exceeded
    • IVaR—the change in portfolio VaR when adding a new position to a portfolio
    • MVaR—the effect on portfolio risk of a change in the position size. In a diversified portfolio, it may be used to determine the contribution of each asset to the overall VaR.
  • Portfolio management costs fall into two categories: explicit costs and implicit costs. Implicit costs include delay and slippage.
  • The costs of managing assets may affect the investment strategy and the portfolio construction process.
    • Slippage costs are significantly greater for smaller-cap securities and during periods of high volatility.
    • A strategy that demands immediate execution is likely to incur higher market impact costs.
    • A patient manager can mitigate market impact costs by slowly building up positions as liquidity becomes available, but he exposes himself to greater volatility/trend price risk.
  • A well-constructed portfolio exhibits
    • a clear investment philosophy and a consistent investment process,
    • risk and structural characteristics as promised to investors,
    • a risk-efficient delivery methodology, and
    • reasonably low operating costs.
  • Long/short investing is a compromise between
    • reducing risk and not capturing fully the market risk premium,
    • expanding the return potential from alpha and other risk premiums at the potential expense of increasing active risk, and
    • achieving greater diversification and higher costs and complexity.

3 CE

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