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Active equity: Portfolio construction (Components that affect PC and…
Active equity: Portfolio construction
Elements of managers philosophy
Active return
= OW/UW rewarded known risk factors + alpha + luck./noise
Building blocks used in PC
1. OW/UW rewarded factors
Alpha/alternative beta
: exposure to factors that are not consider rewarded factors or factor timing
Position Sizing
: confidence in alpha and factor insight. Factor orientation/stock picking
Breadth of expertise
: success if function of a manager's breadth of experience, # of true independent decisions
Construct active equity portfolio
Top-down
macro factors
factor timing
concentrated with macro fators
diversified OR concentrated security selection
Bottom-up
security specific factors
diversified or concentrated with security selection
Active Share and risk
Active share
0.5x|(wp-wb)|
measures the extent to which number & sizing positions differ from the benchmark
Active risk
affected by degree of the cross-correlation
mgr can control active share but NOT active risk as correlation & variances differ
netflix vs coles AR> Coles vs woolies AR
Risk budgeting
Determine absolute/relative return appropriate to the strategy
Understand each aspect of the strategy contributes to its overall risk
adding new asset with higher covariance, total portfolio risk rises
low risk assets not always reduce portfolio risk
Determine appropriate level of risk
Properly allocate risk among individual positions/factors
Risk measures
Heuristic
limits on exposures factors/currencies
degree of leverage
turnover/trading costs
Formal
VaR, CVaR, active risk, skewness, drawdowns, volatility
requires estimates/prediction of risk
Components that affect PC and market impact
AUM
Position size
Liquidity
Turnover
Portfolio efficiency
Well constructed portfolio:
clear investment philosophy & consistent investment process
risk and structural characteristics as promised
risk efficient delivery methology
reasonable low operating costs given the strategy
low idiosyncratic risk relative to total risk
Long/short portfolios
Long extension
enhanced active equity strategy
130/30 = 130 long, 30 short
allows for greater alpha
more efficient exposure to rewarded factors
Market neutral
hedge out market risk
attempt to match and exactly offset systematic risk
long beta =1, short beta =1.25
pair trading (long strong, short weak)
statistical arb (long underperform, short overperforming)
Benefits
short can reduce market risk
expands benefits of premiums and alpha
greater diversifications
Costs
reduce market premium
leverage active risk
higher implementation costs