Active equity investing may reflect a variety of ideas about profitable investment opportunities. However, with regard to how these investment ideas are implemented—for example, how securities are selected—active strategies can be divided into two broad categories: fundamental and quantitative. Fundamental research forms the basis of the fundamental approach to investing. Although it can be organized … Read more
The construction of an index starts with the method of identifying stocks to include; this method can be exhaustive (every stock in a defined universe; e.g., the CRSP U.S. Total Market Index) or selective (a subset of stocks within a universe; e.g., the S&P 500 Index or the Dow Jones Industrial Average [DJIA]). Methods of index-weighting include (1) market-cap … Read more
Benefits of Long-Only Investing Long-term risk premiums, such as the market risk premium, are earned by investors going net long securities. The capacity and scalability of a long-only strategy is set by the liquidity of the underlying securities. Capacity of short-selling strategies is set by the availability of securities to borrow to facilitate short-selling. This means the capacity of long/short strategies … Read more
A well-constructed portfolio should deliver the characteristics promised to investors in a cost-efficient and risk-efficient way. The 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. Funds aiming to deliver different required characteristics will … Read more
Risk budgeting is a process by which the total risk appetite of the portfolio is allocated among the various components of portfolio choice. An effective risk management process requires that the portfolio manager do the following: Determine which type of risk measure is most appropriate to her strategy. Absolute risk measures are appropriate when the investment … Read more
Investment approaches can also vary according to whether the manager is highly benchmark-aware or is benchmark-agnostic (i.e., pays little attention to the benchmark). Each manager will specify the acceptable levels of deviation from the benchmark, and quantify this deviation in terms of Active Share and active risk. Active Share and active risk do not always move in tandem. A manager can pursue … Read more
A manager’s portfolio construction process should reflect her beliefs with respect to the nature of her skills in each of these areas. The majority of investment approaches can be classified as either systematic or discretionary – the degree to which a portfolio construction process is subject to a set of predetermined rules or is left to … Read more
Integrating the Building Blocks: Breadth of Expertise A manager may be more or less successful at combining these three sources of return into a portfolio. Success is a function of a manager’s breadth of expertise. Broader expertise may increase the manager’s likelihood of generating consistent, positive active returns. where IC = Expected information coefficient of the … Read more
Investors who pursue active management are looking to generate portfolio returns in excess of benchmark returns (adjusted for all costs) for an appropriate level of risk. The excess return—also called active return (RA)—of an actively managed portfolio is driven by the difference in weights between the active portfolio and the benchmark. The three main building … Read more
The active return (RA)—of an actively managed portfolio is driven by the difference in weights between the active portfolio and the benchmark: where: Ri = the return from security i ΔWi = the active weight, the difference between portfolio and benchmark weight, for security i Conceptually, a manager can generate active returns by strategically adjusting the active weights of the … Read more