1 INTRODUCTION Security analysis involves ranking relative attractiveness of securities while portfolio construction involves selecting the securities for investments and determine the percentage of allocation to each one Managers need to consider that their insights regarding returns/risks Active return is determined by difference in weights between active portfolio and benchmark and expressed mathematically as: ( 𝑅" = $ ∆𝑊' 𝑅' ')* Where: Ri = return of security i ∆𝑊' = active weight = the difference between portfolio weights WPi and the benchmark weights WBi Active returns are generated if: • 2.1 Predictions on return and risk are common to most active investment styles Building Blocks of Active Equity Portfolio Construction Active management is the pursuit of returns in excess of the benchmark, or active return, (adjusted for costs) for an appropriate level of risk • may prove to be inaccurate or affected by unknown events Gains generated overweighting securities which outperform the benchmark are, on average, > losses generated by underweighting securities which outperform the benchmark and Gains generated by underweighting securities which underperform the benchmark are, on average, > losses generated by overweighting securities which underperform the benchmark Fundamentals of Portfolio Construction Rewarded factors: Investment risks (such as market or liquidity risks) for which the investors expect to be compensated by a long-term return premium Sources of active return is the same regardless of whether the manager follows a fundamental/discretionary approach, quantitative/systematic approach, a bottom-up or topdown approach, or a style such as value or growth at reasonable price Proportion of returns sourced from exposure to rewarded factors, alpha and luck with vary among managers and portfolio management approaches Ex post active returns can be decomposed as follows: RA =Σ(βpk − βbk) ´ Fk + (α + ε) Where: βpk = the sensitivity of the portfolio (p) to each rewarded factor (k) βbk = the sensitivity of the benchmark to each rewarded factor Fk = the return of each rewarded factor (α + ε) = return which cannot be unexplained by exposure to rewarded factors The volatility of the components depends on how the manager sizes individual positions Alpha or a is the portfolio’s active return attributable to a manager’s skills (security selection and factor timing) and strategies e is the idiosyncratic return resulting from a random shock or noise or luck (bad/good) It is difficult to isolate these two sources of return Factor methodology has become popular in generating active returns with the growth in hedge funds and disappointing performance of many active managers 2.2 Building Blocks Used in Portfolio Construction 2.2.1) First Building Block: Overweight or Underweight Rewarded Factors Rewarded factors include market, size, value and momentum Most individual securities have a beta > or < to the market factor and non-zero exposure to other factors Managers can add value by over and above the market portfolio by choosing exposures to rewarded risks which differ from those of the market Most managers use narrower market proxies as a benchmark Indices which not include all publicly traded securities have a market beta which differs from Managers willing to create an exposure to rewarded risk, must establish the exposure relative to his or her benchmark to achieve an expected excess return –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Active Equity Investing: Portfolio Construction Reading 29 Reading 29 Active Equity Investing: Portfolio Construction Important points: • • • A size factor of – indicates a large-cap tilt A capitalization-weighted large-cap index has no sensitivity to the value and momentum factors A mid-cap fund/portfolio has a positive exposure to the size factor A portfolio manager can use factors analyze portfolio performance regardless of whether factors are being targeted or she focuses on securities which are believed to be attractively priced Portion of the return not explained by factors includes: • • • Unique skills and strategies of the manager, An incomplete factor model that ignores relevant factors, or Exposure to idiosyncratic risks which either contributed positively or negatively to performance 2.2.2) Second Building Block: Alpha Skills Second building bock and manager’s alpha comprises of two components 1) 2) Skillful timing of exposures to rewarded factors Unrewarded factors or other asset classes (such as cash) Any alpha generated by active managers must be high enough to cover the fees associated with active management Exposure to rewarded factors has become accessible via rules-based indexes Successfully timing this exposure is a source of alpha The following example of provides an illustration: Example: Managers believe their skill partly originates from when rewarded factor returns are less than or greater than their average returns (factor timings): • • Managers with a market beta < (> 1) should outperform the market when market return is negative (positive) Exposure to the market factor can be adjusted and returns timed by investing in securities with a market beta which is > or < There is no consensus on the ability to generate alpha from factor timing Alpha can also be generated by timing exposure to unrewarded factors such as regional exposure, sector exposure, the price of commodities, or security selection FinQuiz.com Thematic exposures not represent rewarded factors but represent a manager’s use of his or her skills to time exposures in the anticipation of reward § Example: While oil is not a rewarded factor, a manager who has a specific view on oil prices and correctly anticipated future oil prices, may alter his exposure to the energy sector in the hope of earning a reward There is little evidence of an ability to consistently time rewarded factors 2.2.3) Third Building Block: Sizing Positions Position sizing concerns balancing manager’s confidence in alpha and factor insights while mitigating idiosyncratic risks While position sizing affects alpha and factor insights, its greatest influence is on idiosyncratic risk A manager can achieve exposure to a factor or set of factors with greater success if concentrated portfolios are used Level of idiosyncratic risk and the potential impact of luck on performance is greater in a concentrated portfolio vs a portfolio comprising many securities Note: In concentrated portfolios, volatility of active returns attributable to idiosyncratic risks is greater There are greater deviations between realized portfolio returns and expected returns A manager’s belief regarding skills level will determine degree of portfolio concentration: § § Factor-oriented managers: o Set up and balance exposure to rewarded factors o Targets specific exposure to factors and maintains a diversified portfolio to minimize idiosyncratic risk Stock-picker: o Believes he is skilled at forecasting security-specific performance o Expresses his forward-looking views using a concentrated portfolio, assuming a high level of idiosyncratic risk 2.2.4) Integrating the Building Blocks: Breadth of Expertise Sources of a manager’s active returns include: § § § Exposure to rewarded risks Timing of exposures to rewarded factors Position sizing and its implications for idiosyncratic risk A manager’s success in combining these three sources is a function of a manager’s breadth of expertise Broader Active Equity Investing: Portfolio Construction Reading 29 expertise may increase the likelihood of generating consistent, positive active returns Fundamental law of active management: Confidence in a manager’s ability to outperform his benchmark increases when that performance is attributed to a larger sample of independent (or uncorrelated) decisions Example of independent decision: Overweighting two stocks whose returns are not driven by common factors Managers must distinguish between the effective number of independent active decisions from the nominal number of active decisions when constructing portfolios FinQuiz.com Where: IC – Expected information coefficient of the manager – extent to which the manager’s forecasted active returns correspond to the manager’s realized active returns BR – Breadth – the number of truly independent decisions made annually TC – Transfer coefficient – or the ability to translate portfolio insights into investment decisions without constraints (a truly unconstrained portfolio would have a transfer coefficient of 1) 𝜎01 = the manager’s active risk Practice: Example 1, CFA Curriculum, Volume 4, Reading 29 Expected active portfolio return, E(RA) = 𝐼𝐶√𝐵𝑅𝜎01 𝑇𝐶 Approaches to Portfolio Construction Portfolio construction is heavily influenced by a manager’s ability to add value using the building blocks: • • • • Factor exposures Timing Position sizing Breadth or depth Systematic Strategies More likely designed to extract return premiums from balanced exposures to known, rewarded factors The portfolio construction process should reflect manager’s beliefs with respect to the nature of skills in the following areas: • • Systematic or discretionary Bottom-up or top-down both are discussed in the sections below Each approach: • • 3.1 can vary in the extent it is benchmark aware versus benchmark agnostic is implemented within a framework which specifies acceptable levels of active risk and active share (how similar a portfolio is to its benchmark) relative to a benchmark The Implementation Process: The Choice of Portfolio Management Approaches 3.1.1) Systematic vs Discretionary The manager’s beliefs regarding the three building blocks of portfolio construction need to be examined in a systematic and discretionary investment process Incorporate researchbased rules across a broad universe of securities o Strategies incorporate management judgement to the extent of strategy design and learning process associated with strategy implementation Reduce exposure to idiosyncratic risk & use broadly diversified portfolios to achieve desired factor exposure and minimize securityspecific risk Discretionary Strategies Search for active returns by building greater understanding of: o firm’s governance o firm’s business model o the competitive landscape o through development of better factor proxies o through successful timing strategies (few factor-based systematic strategies have integrated this approach) Integrate management judgment often on a small subset of securities Managers may additionally consider: o financial metrics and o nonfinancial variables Rely on more concentrated portfolios reflecting depth of manager’s insight on the company and its competitive landscape Active Equity Investing: Portfolio Construction Reading 29 Systematic Strategies More adaptable to a formal portfolio optimization process o Parameters of the optimization must be carefully considered by the manager Discretionary Strategies Managers use a less formal approach to portfolio construction 3.1.2.) Bottom-Up vs Top-Down Top-down approach: seeks to understand overall geopolitical, economic, financial, social, and public policy environment and project how the expected environment will affect (in the order illustrated below): Top-Down Approach concentrated portfolios o Top-down sector rotator can run concentrated portfolios o Top-down risk allocators can run diversified portfolios Asset classes Sectors Securtities • • • Bottom-up approach: Develops an understanding of the environment by evaluating the risk and return of individual securities The aggregate of risk & return expectations imply expectations for overall economic and market environment Top-Down Approach Rely on returns from factors o Emphasize macro factors Investment process emphasizes on factoring timingmanagers opportunistically shift the portfolio to capture rewarded and unrewarded factors o May embrace same security characteristics sought by bottom-up managers o May raise cash opportunistically when overall view of the market is unfavorable Managers likely to run portfolios concentrated with macro factors Runs diversified or Bottom-Up Approach Rely on returns from factors o Emphasize securityspecific factors Embrace styles as Value, Growth at Reasonable Price, Momentum and Quality o Strategies are built around documented rewarded factors Runs diversified or Bottom-Up Approach concentrated portfolios o Bottom-up stock picker can run concentrated portfolios o Bottom-up value manager can run diversified portfolios 3.1.3) A Summary of the Different Approaches • Countries FinQuiz.com • Exposure to rewarded factors is achieved using a bottom-up or top-down approach Top-down managers emphasize macro factors while bottom-up managers emphasize security-specific factors Top-down managers following a discretionary approach are more likely to implement factor timing Systematic managers are unlikely to run concentrated portfolio while discretionary managers can have concentrated or diversified portfolios, depending on their strategy and portfolio management style Systematic top-down managers principally emphasize macro factors, factor timing and have diversified portfolios Few managers belong to this category Reading 29 Active Equity Investing: Portfolio Construction 3.1.4) Active Share and Active Risk The two measures of benchmark-relative risk used to evaluate a manager’s success include active share and active risk Managers can increase their active share without necessarily increasing active risk (and viceversa) attributable to factor exposure 𝜎E3 is the variance attributable to idiosyncratic risk A relationship between active share, active risk, and factor exposure can be observed for an unconstrained investor Calculating active share: • • • • • • • Calculating active risk: • • • • • • • • Active share is easier to calculate than active risk Measures the extent to which the number and sizing positions in a manager’s portfolio differ from the benchmark * Active share = ∑C')*5𝑊𝑒𝑖𝑔ℎ𝑡;? stock’s average daily volume, asset prices will be affected The impact will be greater as the difference between the two increases Funds with a focus on large-cap stocks can support a higher level of AUM relative to funds focused on small-cap stocks To mitigate market impact costs, small-cap funds should limit AUM, hold a more diversified portfolio, limit turnover, or devise a suitable trading strategy Slippage costs can be implemented using a strategic approach with smaller AUM managers having an advantage in this respect Slippage costs may result from the opportunity cost of not being able to implement the strategy as assets grow: • • Investors who select a fund for its strategy and implementation approach should be informed about any changes to the approach or managers should limit size of fund assets If the strategy cannot be scaled for a larger AUM, resulting from the introduction of a new product, the product delivered to clients may be different from the strategy which investors thought they were investing in Active Equity Investing: Portfolio Construction Reading 29 A study by Frazzini, Israel, and Moskowitz concluded that value strategies could support significant scale while scaling up size and short-term reversal led to a steeper decline in performance and higher tracking error FinQuiz.com Practice: Example 7, CFA Curriculum, Volume 4, Reading 29 It is important that investors monitor a strategy’s capacity by the observing evolving portfolio characteristics and portfolio turnover The Well-Constructed Portfolio A well-constructed portfolio should deliver results consistent with an investor’s risk and return expectations A well-constructed portfolio possesses: • • • • Investors and managers may seek different characteristics in a well-structured portfolio At a minimum, well-structured portfolios should deliver promised characteristics in a cost- and risk-efficient way In well-constructed portfolios, investors seek risk exposures that are aligned with investor expectations and constraints and low idiosyncratic risk (unexplained) relative to total risk: • • 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 given the strategy The risk-efficiency of a portfolio should be judged in the context of the investor’s total portfolio The diversification effect of each manager’s portfolio on the total investor’s portfolio should be considered when determining the well-structured portfolio Practice: Example 8, CFA Curriculum, Volume 4, Reading 29 If two products are comparable with respect Long/Short, Long Extension, and Market-Neutral Portfolio Construction Long/Short, long extension and market neutral strategies can be used to exploit both positive and negative insights on stock performance Long/short strategies: • • • o constrained long/short strategies committed capital is levered to exploit positive and negative insights have a typical net exposure of 100% like the long-only portfolio o for example, long exposure = 130% and short exposure = 30% long and short positions may be related or unrelated Market-neutral strategies: • can include long-extension and marketneutral products and are unconstrained: they can lever both positive and negative insights Long extension strategies: • • to factor exposures, the product with the lower absolute and active risk is preferred (assuming similar costs) If two products have similar absolute and active risks and costs, and managers have similar alpha skills, the product having a higher active share is preferred because it leverages the manager’s alpha skills and increases expected return • 8.1 constructed to ensure portfolio exposures to a wide variety of risk factors is zero may be neutralized against a wide variety of other risk factors The Merits of Long-Only Investing The decision to pursue a long-only strategy is based on the following considerations: Reading 29 Active Equity Investing: Portfolio Construction A Long-term risk premiums An investor’s motivation to be long-only is based on the belief that there is a positive long-run premium earned from bearing market risk Alternatively, investors may believe that risk premiums may be earned from other risk sources such as Size, Value or Momentum and investors must own securities with these risk exposures, over time, to capture return premiums Note: Cyclicality of size, value, and momentum factors means that the expected positive risk premium over the long-term may not offset potential risk of market declines or other reversals Investors may resort to short-selling some securities B Capability and scalability Long-only investing, particularly focused on large-cap stocks, offers greater investment capacity compared to other approaches Large institutional investors such as pensions funds face no effective capacity constraints when relying on longonly, large-cap investing Long-only strategies focusing on illiquid and smaller stocks or which employs a strategy that involves high portfolio turnover, face capacity constraints The capacity of short-selling strategies is limited by the securities available for borrowing C Limited legal liability Common stocks are limited liability financial instruments – the floor is equal to zero and the maximum amount of loss for an investor = investment amount Long-only investing establishes a floor on maximum loss Naked short-selling: Involves the short-selling of tradeable securities without borrowing it first or ensuring it can be borrowed Short-sellers have an unlimited loss exposure As stock price increases, investors lose money and there is no limit on potential price increase This is a high risk strategy In long-only investing, buying and selling stocks are straight-forward, intuitive transactions Short-selling transactions are more complex Investors need to find shares to borrow – some stocks are difficult to borrow while others are hard to locate and cost of borrowing these shares may be high Collateral should also be provided by short-sellers Many countries mandate regulated investment entities to employ a custodian for all transactions The involvement of a custodian will require forming complicate three party agreements between the fund, prime broker and custodian to govern buying and selling of securities and for collateral management When a custodian is not used, investors are exposed to counterparty risk and collateral is held in a general operating account of prime broker If the prime broker goes bankrupt, the collateral can vanish Operational risk is greater with long/short investing F Management costs Long-only investing is less expensive in terms of management fees and from an operational perspective Long-short investing is many time more expensive Types of long/short products include active extension (charge management fees ranging from 0.5% to 1.5%), market neutral and directional strategies (charge hedge fund fixed fees of 1%-2% and performance fees of 20% G Personal ideology Some investors prefer long-only investing for ideological reasons and believe that short-selling strategies which directly gain from the loss of others are morally wrong Other investors believe short-selling requires greater expertise which they not have while others argue that short-selling requires significant leverage which may be too risky for their risk appetite 8.2 Long/Short Portfolio Construction Investors may prefer long/short strategies because: Long/short strategies are less risky than long- or short-only strategies • D Regulatory • Some countries ban short-selling while other temporarily ban or have restricted short-selling Many countries that allow short-selling prohibit or restrict naked short-selling E Transactional Complexity FinQuiz.com • conviction of negative views can be more strongly expressed when short-selling is permitted short-selling can help reduce exposures to sectors, regions, general market movements and allows investors to focus on their unique skill set full extraction of benefit of risk factors requires a long/short approach Implementation of long/short strategies varies with intended purpose: Active Equity Investing: Portfolio Construction Reading 29 • • • position weights can be negative weights are not necessarily constrained to sum to as with a long-only approach aggregate exposure can be less than Absolute exposure = absolute value of longs – absolute value of shorts Net exposure = Longs + absolute value of shorts Equal risk premium products, which seek to extract risk premiums from rewarded factors across asset classes, may use long/short strategies Managers using this approach employ long and short positions and leverage (or deleveraging) to arrive at the most efficient combination of rewarded factors Long/short managers define their exposure as part of the portfolio construction process All strategies must establish parameters regarding desired levels of gross and net exposures 8.3 Long Extension Portfolio Construction Long extension strategies represent a hybrid of long-only and long/short strategies They are also often called enhanced active equity strategies 8.4 Market-Neutral Portfolio Construction Represents a specialized form of long/short portfolio construction Market-neutral strategies are used by investors who want to remove effects of general market movements and focus on their return-forecasting skills This strategy can be risky if stocks prices rise as investors lose out on the opportunity However, such strategies bring diversification to an overall portfolio and help to partially offset losses when prices decline Market-neutral portfolio construction aims to match and offset systematic risks of long positions with those of short positions Targeted beta of the portfolio should be zero when beta is used as a systematic risk measure A market-neutral strategy is expected to generate a positive information despite eliminating a portfolio’s market exposure seeks to eliminate risk The objective of the strategy is to neutralize risk which the manager has no comparative advantage in forecasting to focus on his/her specific skills Characteristics of market-neutral strategies: The ‘130/30’ strategy: • Long position = 130% of the wealth invested in a strategy Short position = 30% of capital Resulting gross leverage = 160% • Benefits of the strategy: • • • • • • The short positions are funding long positions and resulting gross leverage allows for greater alpha and more exposure to rewarded factors Theoretically, the strategy allows investors to benefit from positive and negative company insights This strategy is particularly attractive for investors seeking returns in low interest environments Investors can express the strength of their positive and negative views more symmetrically – Investors can size an underweight in line with stock expectations This contrasts to long-only strategy where a security can be underweighted to the extent of its weight in the benchmark index Drawback of the 130/30 approach is that it can lead to greater losses if manager is simultaneously wrong regarding long and short positions FinQuiz.com Less volatile than long-only strategies as they seek to remove major sources of systematic risk Often considered absolute return strategies because they employ a fixed-income benchmark Have a low correlation with other strategies May serve more of a diversification role than a return-seeking role Pairs trading: Investor goes long one security in an industry and short another security in the same industry in an attempt to exploit mispricing Statistical arbitrage: A quantitatively oriented form of pairs trading which uses statistical technique to identify two securities which have a high historical correlation with each other • When price correlation of securities temporarily deviates from long-term average, manager will go long the underperforming stock and short the outperforming stock When prices converge to long-term average as forecasted, manager will close the trade and realize a profit Other variations: Managers may rely on portfolios constructed using systematic multi-factor models and buy (sell) most (least) favorably ranked securities Constraints may be imposed on long and short positions to keep gross at net exposures at desired levels Reading 29 Active Equity Investing: Portfolio Construction Limitations of market-neutral strategies: 8.5 Correlations between exposures are constantly changing and not all risks can be efficiently hedged Have a limited upside potential in bull market unless they are equitized by choosing to index the equity exposure and overlay long/short strategies Benefits and Drawbacks of Long/Short Strategies As stated above long/short strategies offer the following benefits: • • Ability to more fully express short ideas than under a long-only strategy Efficient use of leverage and of the benefits of diversification An additional benefit is offered which is that they offer greater ability to control exposure to factors (such as Market and other rewarded factors), sectors, geography or any undesired exposure A long/short manager has more flexibility in adjusting his level of market exposure to reflect his view of current market opportunities while a long-only manager will be constrained within a range: • • To increase beta, long-only managers will own high-beta stocks or use financial leverage To decrease beta, long-only managers will own low-beta stocks or increase cash holdings Note: Total portfolio risk in a long-only portfolio is dominated by market risk, which is a long-only factor All other factors (size, value, and momentum) can be thought of as long/short portfolios The ability to tilt a portfolio in favor of these factors or diversify efficiently across factors is structurally restricted in long-only portfolios Reduction of overall risk and distribution of risk sources is efficiently achieved using short-selling Risks of short-selling: • • • • Short positions will move against the investor if security price increases Long/short strategies may require significant leverage Borrowing the security may be costly especially if it is hard to find Collateral requirements increase if a short position moves against the manager Two FinQuiz.com cases can arise: o Manager may be forced to liquidate favorably ranked long positions if too much leverage is used o Manager may fall victim to a short squeeze: managers are unable to maintain short positions as the security which has been shorted has risen so much and so quickly The higher the short-selling in a portfolio, the greater the amount of collateral required Short-selling is a compromise between return impacts, sources of risk, and costs Benefits Short positions can mitigate market risk Shorting expands benefits from other risk premiums and alpha The combination of long and short positions allows for a greater diversification potential Costs Short positions might reduce market premium Shorting may amplify active risk There are higher implementation costs and greater complexity associated with shorting and leverage relative to the long-only approach Practice: Example 9, CFA Curriculum, Volume 4, Reading 29 ... –––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz. com All rights reserved –––––––––––––––––––––––––––––––––––––– FinQuiz Notes Active Equity Investing: Portfolio Construction Reading 29 Reading 29 Active Equity Investing:... resemble benchmark performance Practice: Example 6, CFA Curriculum, Volume 4, Reading 29 Active Equity Investing: Portfolio Construction Reading 29 Implicit Cost-Related Considerations in Portfolio... both charge the same fees Practice: Example 2, CFA Curriculum, Volume 4, Reading 29 The Implementation Process: The Objectives and Constraints 3. 2 A common objective function in portfolio management