Reading 25 Active Equity Investing: Portfolio Construction
FinQuiz Notes 2 0 2 0
1.
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
2. 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.
Active return is determined by difference in weights
between active portfolio and benchmark and expressed
mathematically as:


=  ∆



Where:
Ri = return of security i
∆ = active weight = the difference between portfolio
weights WPi and the benchmark weights WBi.
Active returns are generated if:
• 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
2.1 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 top-
down 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.
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INTRODUCTION
may prove to be inaccurate or affected by unknown
events.
Predictions on return and risk are common to most
active investment styles.
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 α is the portfolio’s active return attributable to a
manager’s skills (security selection and factor timing)
and strategies. ε 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 <
1 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 do not include all publicly
traded securities have a market beta which differs from
1. 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.
Reading 25 Active Equity Investing: Portfolio Construction
Important points:
• A size factor of – 1 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) Skillful timing of exposures to rewarded factors
2) 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 (> 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 <
1.
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.
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Thematic exposures do 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
Reading 25 Active Equity Investing: Portfolio Construction FinQuiz.com

expertise may increase the likelihood of generating Where:

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.
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

ಲ = the manager’s active risk

Example of independent decision: Overweighting two transfer coefficient of 1)
stocks whose returns are not driven by common factors.

Managers must distinguish between the effective

Practice: Example 1, CFA
number of independent active decisions from the
Curriculum, Volume 4, Reading 25.
nominal number of active decisions when constructing
portfolios.

Expected active portfolio return, E(RA) = √
ಲ 

3. Approaches to Portfolio Construction

Portfolio construction is heavily influenced by a Systematic Strategies Discretionary Strategies

manager’s ability to add value using the building blocks: More likely designed to Search for active returns
extract return premiums by building greater
• Factor exposures from balanced understanding of:
• Timing exposures to known, o firm’s governance
• Position sizing rewarded factors o firm’s business model
• Breadth or depth o the competitive
landscape
The portfolio construction process should reflect o through
manager’s beliefs with respect to the nature of skills in development of
the following areas: better factor proxies
o through successful
timing strategies
• Systematic or discretionary (few factor-based
• Bottom-up or top-down systematic strategies
have integrated this
both are discussed in the sections below. approach)
Incorporate research- Integrate management
Each approach: based rules across a judgment often on a small
• can vary in the extent it is benchmark aware broad universe of subset of securities.
versus benchmark agnostic. securities. Managers may
• is implemented within a framework which o Strategies additionally consider:
specifies acceptable levels of active risk incorporate o financial metrics and
and active share (how similar a portfolio is to management o nonfinancial
its benchmark) relative to a benchmark. judgement to the variables.
extent of strategy
design and
The Implementation Process: The Choice of learning process
3.1 associated with
Portfolio Management Approaches
strategy
3.1.1) Systematic vs. Discretionary implementation
Reduce exposure to Rely on more
The manager’s beliefs regarding the three building idiosyncratic risk & use concentrated portfolios
blocks of portfolio construction need to be examined in broadly diversified reflecting depth of
a systematic and discretionary investment process. portfolios to achieve manager’s insight on the
desired factor exposure company and its
and minimize security- competitive landscape.
specific risk.
Reading 25 Active Equity Investing: Portfolio Construction FinQuiz.com

Systematic Strategies Discretionary Strategies Top-Down Approach Bottom-Up Approach

More adaptable to a Managers use a less concentrated concentrated portfolios
formal portfolio formal approach to portfolios. o Bottom-up stock
optimization process portfolio construction o Top-down picker can run
o Parameters of the sector rotator concentrated
optimization must can run portfolios
be carefully concentrated o Bottom-up value
considered by the portfolios. manager can run
manager o Top-down risk diversified portfolios
allocators can
run diversified
3.1.2.) Bottom-Up vs. Top-Down portfolios

Top-down approach seeks to understand overall geo- 3.1.3) A Summary of the Different Approaches
political, economic, financial, social, and public policy
environment and project how the expected • Exposure to rewarded factors is achieved
environment will affect (in the order illustrated below): using a bottom-up or top-down approach
• Top-down managers emphasize macro
factors while bottom-up managers
emphasize security-specific factors
Countries
Asset
Sectors Securtities • Top-down managers following a
classes
discretionary approach are more likely to
implement factor timing
• Systematic managers are unlikely to run
concentrated portfolio while discretionary
Bottom-up approach: Develops an understanding of the managers can have concentrated or
environment by evaluating the risk and return of diversified portfolios, depending on their
individual securities. The aggregate of risk & return strategy and portfolio management style.
expectations implies expectations for overall economic • Systematic top-down managers principally
and market environment. emphasize macro factors, factor timing and
have diversified portfolios. Few managers
Top-Down Approach Bottom-Up Approach belong to this category.
Rely on returns from Rely on returns from factors
factors o Emphasize security-
o Emphasize specific factors
macro factors
Investment process Embrace styles as Value,
emphasizes on Growth at Reasonable
factoring timing- Price, Momentum and
managers Quality.
opportunistically shift o Strategies are built
the portfolio to capture around
rewarded and documented
unrewarded factors rewarded 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 Runs diversified or
Reading 25 Active Equity Investing: Portfolio Construction FinQuiz.com

3.1.4) Active Share and Active Risk

 is the variance attributable to idiosyncratic
attributable to factor exposure

The two measures of benchmark-relative risk used to risk

evaluate a manager’s success include active share and
active risk. Managers can increase their active share
A relationship between active share, active risk, and
without necessarily increasing active risk (and vice-
factor exposure can be observed for an unconstrained
versa).
investor.
Calculating active share:
• High net exposure to a risk factor will lead to
a high level of active risk regardless of level
• Active share is easier to calculate than
of idiosyncratic risk
active risk.
• If the factor exposure is fully neutralized,
• Measures the extent to which the number
active risk is entirely attributed to active
and sizing positions in a manager’s portfolio
share
Active share = ∑ 
  , 
differ from the benchmark
 • Active risk attributed to active share will be
•
 
, 
 smaller if number of securities is large or
average idiosyncratic risk is small.
where n = total number of securities in • Level of active risk will rise with an increase in
portfolio and benchmark factor and idiosyncratic volatility
• The two sources of active share are:
o Including securities in the portfolio Note:
not in the benchmark
o Holding securities in the portfolio
• Active risk increases when a portfolio
which are in the benchmark but at
becomes more uncorrelated with its
different weights
benchmark.
• If two portfolios are managed against the
• A closet indexer advertises itself as being
same benchmark but one has fewer
actively managed but is substantially similar
securities (is more concentrated), this
to an index fund in its exposures
portfolio will have a higher active share
• Managers have full control of their active
share A manager can increase his degree of control over the
• Active share is not affected by efficiency of level of active share and/or active risk by decreasing
diversification security concentration.

A fund with an active share of 0.25 would be considered

Calculating active risk:
• Active risk is a complicated calculation
• Like active return, active risk depends on
difference between security weights held in
the portfolio and benchmark
• Two measures of active risk:
o Realized active risk: actual, historical
standard deviation between
portfolio return and benchmark
return
o Predicted active risk: relies on
forward-looking estimates of
variances and correlations
• Variance-covariance matrix is important in
the calculation of active risk
• Active risk is affected by degree of cross
correlation but active share is not
• Active risk depends on correlation and
covariances which are beyond the control
more expensive relative to a fund with an active share of
0.75 if both charge the same fees.
Practice: Example 2, CFA
Curriculum, Volume 4, Reading 25.
The Implementation Process: The Objectives
3.2
and Constraints
A common objective function in portfolio management
is to maximize risk-adjusted return.
• If risk is being measured by predicted active
risk, then the objective function involves
maximizing the information ratio.
• If risk is being measured by predicted
portfolio volatility, then the objective function
involves maximizing the Sharpe ratio.

Active risk formula: ಲ 

of the manager
• Typical constraints include limits on:

  ∑        

• Geographic
•
  ∑       is the variance
Where: Sector
• Industry
Reading 25 Active Equity Investing: Portfolio Construction
• Single-security exposures
• Transaction costs
• Minimum market capitalization for a security
or entire portfolio
Other constraints may be specified in terms of a
maximum price-to-book ratio.
Constraints may be specified relative to the benchmark
or without regard to it.
Objectives and constraints of systematic managers are
explicitly specified while those of discretionary managers
are less explicitly specified.
Objectives and constraints can be stated in absolute
terms or relative to a benchmark.
Some optimization approaches specify their objectives in
terms of risk metrics such as portfolio volatility, downside
risk, maximum diversification and drawdowns. These
approaches do not integrate an explicit expected return
component but implicitly create an exposure to risk
factors.
Note: Any objective function which focuses on
minimizing/managing risk will select low-beta or value
securities.
Objective functions which creates an exposure to
rewarded factors:
1 1 1
  
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seeks to maximize exposure to securities with specific
characteristics.
When an explicit objective function is not used, heuristic
methodologies can be considered to determine security
weighting in a portfolio. Examples include:
• Identify securities with desired characteristics
and weigh them relative to their scoring on
these characteristics
• Identify securities with desired characteristics
and weigh them per their ranking or risk on
these characteristics
A formal optimization process allocates risk more
efficiently compared to alternative methodologies. The
constraints and objective function will be reflective of a
manager’s philosophy and style. For example,
• Stock pickers will have fewer constraints on
security weights compared to multi factor
managers seeking to minimize idiosyncratic
risks
• A sector rotation manager will have more
permissive constraints with respect to sector
concentration compared to value
managers.
  !"#$  %&'$&


3 3 3
Practice: Example 3 & 4, CFA
 Curriculum, Volume 4, Reading 25.

Where Sizei, Valuei, Momentumi are standardized proxy

measures of Size, Value and Momentum for security i.

The optimization process of discretionary managers

often relies on an implicit return-to-risk objective and

4. Allocating the Risk Budget

Risk budgeting: The process of allocation portfolio risk

among its constituents. An effective risk management
process requires the portfolio manager to do the
following:
• Determine which risk measure is appropriate
for the manager’s strategy
• Understand how each aspect of the strategy
contributes to its overall risk
o Understand what drives a portfolio’s
risk and ensuring the portfolio has the
right kind of specific risks.
• Determine the appropriate level of risk
budget
• Properly (& efficiently) allocate risk among
individual positions/factors
4.1 Absolute vs. Relative Measures of Risk
The choice between absolute and relative risk is driven
by the mandate of the manager and investor goals. For
example, if the mandate is to outperform a benchmark
index, the manager will focus on active risk.
Managers who feel that benchmark-relative constraints
inhibit their portfolio’s ability to realize its full potential
can rely on:
• absolute risk measures – Portfolio risk must
remain at or below predefined risk threshold
and the manager can freely construct the
portfolio without considering benchmark
characteristics.
Reading 25 Active Equity Investing: Portfolio Construction FinQuiz.com

• relative risk measure – measures with wide )*%#$ ,%-.%#
% /"-
"'0  !
bands around target implies a benchmark-
relative approach with freedom to diverge
from benchmark characteristics
A manager’s chosen risks should be related to his
perceived skills.
4.1.1) Causes and Sources of Absolute Risks
Total portfolio risk rises when a (n):
• new security which has a higher covariance
(due to higher variance or higher correlation)
than most of the existing securities is added
to a portfolio and
• existing security is replaced by another which
has a higher covariance with the portfolio.
The above fundamental principles also work in reverse.
Total portfolio variance (Vp) = ∑ ∑ ( ( 
(CVi) = ∑ ( (   ( 
Contribution of each asset to total portfolio variance
where:
xj = the asset’s weight in the portfolio
Cij = the covariance of returns between asset i and asset
)$
 !"- 1   2  !"-3 


If the manager’s portfolio is the market portfolio,
variance of portfolio would be explained by a beta of 1
to the market factor and idiosyncratic risks would be
diversified. As one moves away from the market
portfolio, portfolio variance is explained by other factors
exposures and other risks unexplained by factors.
4.1.2) Causes and Sources of Relative/Active Risk
Relative risk is important for managers concerned about
their performance relative to a benchmark. A measure
of relative risk is variance of portfolio’s active returns
(AVp):
!   4(  ) 5(  ) 

 
 
where:
xi = the asset’s weight in the portfolio
bi = the benchmark weight in asset i
RCij = the covariance of relative returns between asset i
and asset j
%'-
%' %. "0 "** % ,%-.%#
% "0
/ -$-' 
j
Cip = the covariance of returns between asset i and the
portfolio
Note: Assets in a portfolio can represent sectors,
countries, or pools of assets representing risk factors
(Value versus Growth, Small versus Large)
Example: An asset comprises three assets – A, B and C.
The contribution of asset A to total portfolio variance is
determined as follows:
Weight of Asset A × Weight of Asset A × Covariance of
Asset A with Asset A
+ •
Weight of Asset A × Weight of Asset B × Covariance of
Asset B with Asset A
+ o Introducing a low volatility asset to a
Weight of Asset A × Weight of Asset C × Covariance of
Asset C with Asset A
= Asset A’s contribution to total portfolio variance
A manager should aim to minimize risks attributed to
sources which are not related to his perceived skills.
Therefore, absolute portfolio variance comprises: 1)
variance attributed to factor exposures (and related to
manager’s skills) and 2) variance unexplained and is
expressed as:
!  4(  ) 5(  ) 

where RCij = the covariance of relative returns between
asset i and j
Note:
• Depending on the composition of the
benchmark, a lower risk asset could increase
active risk while a higher risk asset might
reduce it.
When allocating among countries, sectors,
securities, and other factors the following
principles hold:
benchmark within a portfolio
benchmarked against a high
volatility index will increase active
risk.
o Introducing a high volatility asset
may reduce active risk if the asset
has a high covariance with the
benchmark.
4.2 Determining the Appropriate Level of Risk
Examples of risk targets for different mandates:
• Market neutral hedge fund targets an
Reading 25 Active Equity Investing: Portfolio Construction FinQuiz.com

absolute risk of 10%
• Long-only equity manager targets an active
risk of < 2% (a closet indexer)
• Long-only equity manager targets an active
risk of 6-10% (benchmark agnostic)
• Benchmark-agnostic manager targets an
absolute risk equal to 85% of index risk
Scenario 3: Leverage and its implications for risk:
There is a level of leverage beyond which volatility
reduces expected compounded returns.
Expected geometric return = expected arithmetic return
when there is no leverage:

Rg = Ra – σ2/2
The appropriate level of absolute or relative risk is a
function of manager’s:
where:
Rg = expected compounded/geometric asset return
• investment style and Ra = expected arithmetic/periodic return
• his/her conviction in the ability to add value. σ = expected volatility

Three scenarios which give insight into practical risk limits:
Scenario 1: Implementation constraints:
These constraints degrade a portfolio’s information ratio
if active risk increases beyond a certain level.
Example:
The inclusion of the cost of funding will decrease active
returns and result in a faster decline of the Sharpe ratio.
In this case, volatility will remain proportional to the cost
of funding.
If realized volatility is greater than expected, the
combined impact of volatility and leverage on
compounded return would be greater.

Consider two managers with the same information ratio Note: The Sharpe and information ratios do not always
but different levels of active risk. Manager can tolerate decrease following a rise in active risk, absolute risk or
higher risk and so increases active risk to match that of leverage. A reasonable increase in the latter three
Manager B. measures may lead to an increase in expected
compounded return.
• In the absence of constraints and costs,
manager can increase risk by scaling up 4.3 Allocating the Risk Budget
active weights which proportionally
increases active returns. Information ratio is
A manager can determine the contribution of each
unchanged
factor to the portfolio’s variance or active variance by
• In the presence of constraints and costs,
understanding position sizing and covariance.
leveraging the active risk will not
proportionally increase returns.
The decomposition of the sources of realized risk will help
o If short-selling is prohibited, he may
determine whether the risk budget has been used
be unable to increase underweights
effectively.
o If leverage is prohibited, he may be
unable to increase overweights
A fund’s strategy and style will dictate much of the
o If some securities have poor liquidity,
structure of its risk budget.
leveraging these position may be
imprudent and impact trading costs.
When evaluating an investment manager, the asset
o If policy restricts maximum position
owner needs to understand the drivers of active risk that
sizes, manager may not be able to
can lead to differences in realized returns over time.
scale up active risk

Scenario 2: Limited diversification opportunities: Practice: Example 5, CFA

Curriculum, Volume 4, Reading 25.
Portfolios with high absolute risk targets face limited
diversification opportunities which may lead to a
decrease in Sharpe ratio

Markowitz efficient frontier demonstrates a concave

relationship between return and risk. Expected returns
increase with risk but at a declining rate.
Reading 25 Active Equity Investing: Portfolio Construction
5. Additional Risk Measures Used in Portfolio Construction and Monitoring
5.1 Heuristic Constraints
Risk constraints imposed during the portfolio construction
process may be formal or heuristic.
Heuristic constraints are controls imposed on portfolio
composition through some exogenous classification
structure. These constraints are based on experience or
practice and can be used to limit:
• exposure concentrations by sector, security,
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; and
• other attributes related to an investor’s core
concerns
Risk heuristics can be used to limit unknown or
unexpected risks, a major managerial concern such as:
• A single position is limited to the lesser of:
o Five times the weight of the security
in the benchmark or
o 2%
• The portfolio must have a weighted average
capitalization < 75% of the index
• The portfolio may not size positions such that
it exceeds two times the average daily
trading volume of the past three months.
• The portfolio’s carbon footprint must be
restricted.
The above constraints can limit active manager’s ability
to exploit their insights into expected returns but may
also safeguard against overconfidence.
Managers who manage portfolio risk using a bottom-up
process rely on heuristic characteristics to express their
risk objectives. The portfolio construction process ensures
that this heuristic risk is achieved.
Continuous monitoring is necessary to determine
whether an evolution of market prices causes heuristic
risk to be breached. Managers will impose constraints on
heuristic characteristics of the portfolio even if formal
statistical measures of risk are used. For example:
constraints on allocations to securities and sectors or for
international mandates. Managers will low-volatility
mandates will also impose such constraints to limit
idiosyncratic risk.
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FinQuiz Notes 2 0 2 0
5.2 Formal Constraints
Formal risk measures are statistical in nature and related
to the portfolio returns distribution.
Formal risk measures include:
• Volatility
• Active risk
• Skewness etc.
A key difference between formal and heuristic risk
measures: managers are required to estimate/predict
risk. For portfolio construction, forward-looking view of risk
and active risk required and if realized risk varies from
expected risk, actual portfolio performance can differ
significantly from expectations.
Different ways of using formal risk constraints:
In systematic strategies: formal risk constraints may be
applied as part of the portfolio optimization process
In discretionary strategies: used as part of a feedback
mechanism to determine whether portfolio will remain
within predefined risk tolerance limits following the
proposed change
All risk measures (formal or heuristic) can be expressed in
absolute or relative terms. In many cases, a portfolio
imposes both formal and heuristic portfolio constraints.
5.3 The Risks of Being Wrong
The consequences of being wrong about risk
expectations is more severe when a strategy is
leveraged.
Example: A hedge fund owned a two times levered
portfolio of highly rated mortgage-related securities. The
prices of these securities declined sharply following
concerns related to the economy and market liquidity
even though the securities were not materially exposed
to subprime mortgages. The presence of leverage and
price declines forced managers to sell their positions
before price recovery.
Effective risk management requires managers to
consider the fact that unexpected volatility could
negatively affect an investment strategy. Spikes in
volatility can be sector specific. Risk constraints may be
tightened in more volatile periods to protect against
excessive variability.
Reading 25 Active Equity Investing: Portfolio Construction
Statistical risk measures used in portfolio construction
depend on management style.
Example: Long/short managers with a neutral market
exposure and exposure to other risk factors target
volatility within a pre-defined range.
For portfolios comprising limited number of securities,
formal risk measures will be less appropriate because
estimation errors in parameters will be greater.
Measures of portfolio risk must be relevant to the nature
and objective of the portfolio mandate.
Formal risk measures are not often outlined in the
investment policy statement even if managers are using
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these measures. This is because it may be difficult to
measure and forecast such risk measures as volatility and
value at risk. Such risk measures are usually expressed as
a soft target by managers.
If restrictions imposed by an active manager are too
tightly anchored to the benchmark index, the resulting
portfolio may too closely resemble benchmark
performance.
Practice: Example 6, CFA
Curriculum, Volume 4, Reading 25.
Reading 25 Active Equity Investing: Portfolio Construction
6. Implicit Cost-Related Considerations in Portfolio Construction
A manager needs to consider both explicit and implicit
costs in the portfolio construction approach. Assets
under management (AUM) will drive position size.
Position size and liquidity of the securities will affect the
turnover which can be sustained at an acceptable level
of costs.
Portfolio management should balance the costs and
benefits of portfolio turnover.
Implicit Costs – Market Impact and the
6.1 Relevance of Position Size, Assets under
Management, and Turnover
The price movement (or market impact) resulting from a
security sale/purchase can erode alpha. A manager’s
investment approach and style will influence the extent
to which he/she is exposed to market impact costs.
Key points on market impact costs:
• Market impact costs will be higher when
managers require:
o immediacy in execution
o higher portfolio turnover
• Manager who believes her investment
insights will be rewarded over time can slowly
build up positions with the availability of
liquidity and mitigate market impact costs in
the process.
• Trades containing information are sensitive to
market impact costs
• Assets under management, portfolio
turnover, and liquidity of underlying assets
affect potential market impact costs.
A manager’s strategy and feasibility of implementing it
should be consistent:
• A high turnover strategy with a significant
allocation to smaller securities will reach a
level of AUM at which the strategy becomes
difficult to implement.
• Managers targeting a low level of
idiosyncratic risk is likely to have more
securities and smaller and could therefore
support a higher level of AUM.
6.2 Estimating the Cost of Slippage
Slippage is the difference between the execution price
and midpoint of the bid and ask quotes at the time the
trade was first entered. It includes the effect of both
volatility/trend costs (costs of buying in a rising market
and selling in a declining market) and market impact.
FinQuiz.com
Slippage costs are relevant to orders executed in a
single trade.
When a trade is executed in increments, market impact
costs for later trades do not account the impact of
earlier trades on subsequent execution prices.
Two ways to conceal trade size:
1. breaking a large trade into smaller pieces or
2. trading in unlit venues such as dark pools
and crossing networks in which traders can
trade anonymously with each other.
Based on studies, small-cap have had higher effective
trading costs than large-cap stocks and illiquidity can be
very cyclical, increasing prior to the beginning of a
recession and decreasing towards the end of the
recession.
Key points:
• A given trading volume causes a larger price
move for a less liquid asset.
• If trade size > 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.
Reading 25 Active Equity Investing: Portfolio Construction FinQuiz.com

A study by Frazzini, Israel, and Moskowitz concluded that

value strategies could support significant scale while
Practice: Example 7, CFA
scaling up size and short-term reversal led to a steeper
Curriculum, Volume 4, Reading 25.
decline in performance and higher tracking error.

It is important that investors monitor a strategy’s capacity

by the observing evolving portfolio characteristics and
portfolio turnover.
7. 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:
• 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.
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.
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.
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.

In well-constructed portfolios, investors seek risk

Practice: Example 8, CFA
exposures that are aligned with investor expectations
Curriculum, Volume 4, Reading 25.
and constraints and low idiosyncratic risk (unexplained)
relative to total risk:
• If two products are comparable with respect

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

Long/Short, long extension and market neutral strategies o long and short positions may be
can be used to exploit both positive and negative related or unrelated
insights on stock performance.
Market-neutral strategies:
Long/short strategies:

• constructed to ensure portfolio exposures to

• can include long-extension and market-
a wide variety of risk factors is zero
neutral products and
• may be neutralized against a wide variety of
• are unconstrained: they can lever both
other risk factors
positive and negative insights.

Long extension strategies: 8.1 The Merits of Long-Only Investing

• constrained long/short strategies The decision to pursue a long-only strategy is based on

• committed capital is levered to exploit the following considerations:
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%
Reading 25 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 long-
only, 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.
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
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 do 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:
• 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:
Reading 25 Active Equity Investing: Portfolio Construction
• position weights can be negative
• weights are not necessarily constrained to
sum to 1 as with a long-only approach
• aggregate exposure can be less than 1
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.
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
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:
• 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 25 Active Equity Investing: Portfolio Construction FinQuiz.com

cases can arise:

Limitations of market-neutral strategies: o Manager may be forced to liquidate
favorably ranked long positions if too
1. Correlations between exposures are much leverage is used
constantly changing and not all risks can be o Manager may fall victim to a short
efficiently hedged. squeeze: managers are unable to
2. Have a limited upside potential in bull market maintain short positions as the
unless they are equitized by choosing to security which has been shorted has
index the equity exposure and overlay risen so much and so quickly.
long/short strategies.
The higher the short-selling in a portfolio, the greater the
amount of collateral required. Short-selling is a
8.5 Benefits and Drawbacks of Long/Short Strategies
compromise between return impacts, sources of risk, and
costs.
As stated above long/short strategies offer the following
benefits: Benefits Costs
Short positions can Short positions might
• Ability to more fully express short ideas than mitigate market risk reduce market premium
under a long-only strategy Shorting expands Shorting may amplify
• Efficient use of leverage and of the benefits benefits from other risk active risk
of diversification premiums and alpha
The combination of There are higher
An additional benefit is offered which is that they offer long and short positions implementation costs and
greater ability to control exposure to factors (such as allows for a greater greater complexity
Market and other rewarded factors), sectors, geography diversification potential associated with shorting
or any undesired exposure. and leverage relative to
the long-only approach.
A long/short manager has more flexibility in adjusting his
level of market exposure to reflect his view of current Practice: Example 9, CFA
market opportunities while a long-only manager will be Curriculum, Volume 4, Reading 25.
constrained within a range:

• To increase beta, long-only managers will Practice: End of Chapter Questions

own high-beta stocks or use financial
leverage
• To decrease beta, long-only managers will
own low-beta stocks or increase cash
holdings
from CFA Institute’s Curriculum
and FinQuiz Question-bank (Item-
sets + Questions)

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