Portfolio Construction Approaches

Investment approaches can be categorized as:

• Systematic or discretionary.
• Bottom-up or top-down.

$$ \textbf{Systematic vs. Discretionary} \\ \small{\begin{array}{l|l} \textbf{Systematic} & \textbf{Discretionary} \\ \hline {\text{The objective of systematic strategies is} \\ \text{to construct portfolios whose returns are} \\ \text{derived from a balanced exposure to} \\ \text{known, rewarded factors.} } & { \text{Discretionary strategies search for active} \\ \text{returns by gaining a deeper} \\ \text{understanding of a company’s} \\ \text{governance, business model, and} \\ \text{competitive landscape, or by developing} \\ \text{better factor proxies or by using clever} \\ \text{timing. }} \\ \\ { \text{Research-based rules are usually used} \\ \text{across a wide spectrum of securities in} \\ \text{systematic strategies.}} & {\text{Factor timing is a challenging task, and} \\ \text{only a few factor-based systematic} \\ \text{strategies incorporate factor timing.} }\\ \\ {\text{In systematic strategies, idiosyncratic risk} \\ \text{is minimized through broad} \\ \text{diversification of portfolios to achieve the} \\ \text{desired exposure while minimizing} \\ \text{idiosyncratic risk.}} & {\text{Discretionary strategies use more} \\ \text{judgment, usually on a smaller number of} \\ \text{securities. While a discretionary value} \\ \text{manager might also rely on financial} \\ \text{metrics, more leeway is assigned to the} \\ \text{manager to weigh the hard data and} \\ \text{interpret its usefulness. The use of} \\ \text{nonfinancial variables such as the quality} \\ \text{of management, the competitive} \\ \text{landscape, and the pricing power of the} \\ \text{firm, is also more common in} \\ \text{discretionary approaches.}}\\ \\ {\text{Adaptability into a formal portfolio} \\ \text{optimization process is more important in} \\ \text{systematic processes. The systematic} \\ \text{manager must carefully consider the rules} \\ \text{of the construction. What function is} \\ \text{being used? Will elements be} \\ \text{incorporated into the function or into the} \\ \text{constraints?}} & {\text{The manager’s insights about company} \\ \text{characteristics and the competitive} \\ \text{landscape are reflected in discretionary} \\ \text{strategies, which tend to have more} \\ \text{concentrated portfolios.}} \\ & { \text{The portfolios of discretionary managers} \\ \text{are often built on a less formal basis,} \\ \text{using securities that they consider to be} \\ \text{attractive, within the constraints of an} \\ \text{agreed-upon risk profile. }} \end{array}} $$

$$ \textbf{Bottom-Up vs. Top-Down} \\ \underline{\small{\textbf{Top-down}}} \\ \small{\begin{array}{l|l|l|l} { \text{S} \\ \text{y} \\ \text{s} \\ \text{t} \\ \text{e} \\ \text{m} \\ \text{a} \\ \text{t} \\ \text{i} \\ \text{c} } & { { \bullet \text{Emphasizes known macro factors}} \\ { \bullet \text{Factor timing possible} }\\ { \bullet \text{Diversified}} \\ { \bullet \text{Formal portfolio optimization used}} \\ { \bullet \text{Few managers exist} }\\ { \bullet \text{Emphasizes security-specific factors}} \\ { \bullet \text{No factor timing}} \\ { \bullet \text{Diversified}} \\ { \bullet \text{Formal portfolio optimization used}} } & { { \bullet \text{Emphasizes macro rewarded factors}} \\ { \bullet \text{Factor timing heavily used}} \\ { \bullet \text{Can be diversified or concentrated}} \\ { \bullet \text{Less formal construction process}} \\ { \bullet {{ \text{Emphasizes security-} \\ \text{specific characteristics} \\ \text{or factors} } }} \\ { \bullet { \text{Potential factor timing.}} } \\ { \bullet { \text{Diversified across broad} \\ \text{universe or concentrated} \\ \text{on smaller number of} \\ \text{securities} } } \\ { \bullet { \text{Less formal construction}}} } & { \text{D} \\ \text{i} \\ \text{s} \\ \text{c} \\ \text{r} \\ \text{e} \\ \text{t} \\ \text{i} \\ \text{o} \\ \text{n} \\ \text{a} \\ \text{r} \\ \text{y}} \\ \end{array} } \\ \overline{\small{ \textbf{Bottom-up }}} \\ $$

The above diagram compares two investment strategies: Bottom-Up and Top-Down, in the context of Systematic and Discretionary approaches. In the Systematic approach, Bottom-Up emphasizes known macro factors, allows factor timing, is diversified, uses formal portfolio optimization, has few managers, and emphasizes security-specific factors. In contrast, Top-Down in the Discretionary approach emphasizes macro rewarded factors, heavily uses factor timing, can be diversified or concentrated, has a less formal construction process and emphasizes security-specific characteristics or factors.

In summary, the diagram compares two different investment strategies, each with its own set of characteristics. The Bottom-Up approach is more focused on security-specific factors, while the Top-Down approach emphasizes macro rewarded factors. The Systematic approach is more formal and optimized, while the Discretionary approach is less formal and more flexible.

The Implementation Process: The Objectives and Constraints

Portfolio construction involves two components: an optimization process and a set of constraints that govern this process. These constraints can be expressed either relatively or absolutely, as demonstrated in the example below:

$$ \small{\begin{array}{l|c|c} & \underline{\textbf{Absolute Framework}} & \underline{\textbf{Relative Framework}} \\ & \textbf{Maximize Sharpe} & \textbf{Maximize Information} \\ & \textbf{Ratio} & \textbf{Ratio} \\ \hline \underline{\textbf{Constraint}} & & \\ \hline {\textbf{Individual security} \\ \textbf{weights (w)}} & w \le 5\% & \mid w_p – w_b \mid \le 5\% \\ \hline \bf{\text{Sectors weights (S)}} & S \le 20\% & \mid S_p – S_b \mid \le 10\% \\ \hline \bf{\text{Portfolio volatility } (\sigma)} & \sigma_p \lt 0.8 \sigma_b & — \\ \hline \bf{\text{Active risk } (A_r)} & — & A_r \le 5\% \\ \hline {\textbf{Weighted average} \\ \textbf{capitalization (CaP)}} & \text{CaP} \ge 30bn & \text{CaP} \ge 30bn \end{array}} $$

Where:

\(P\) = Portfolio metric.

\(B\) = Benchmark metric.

• In the absolute approach, the goal is to maximize the Sharpe ratio, while in the relative approach, the aim is to maximize the information ratio.
• In the absolute approach, individual positions are restricted to a maximum of 5%, and no single sector can exceed 20%. In the relative approach, security weights must stay within \(\pm 5\%\) of their index weight, and sector weights should remain within \(\pm 10\%\) of the index weights.
• The absolute approach uses a portfolio volatility limit set at 80% of the estimated benchmark volatility, whereas the relative approach incorporates a 5% active risk limit and maintains the same capitalization constraint.
• Managers can also combine relative and absolute constraints, such as limiting differences from a benchmark while enforcing specific security limits.

Other Approaches to Optimization

• Setting objectives based on risk.
• Maximizing exposure to factors that yield positive returns.
• Maximizing exposure to securities with specific characteristics a discretionary manager defines.
• Utilizing heuristic methods like ranking securities based on desired characteristics, such as a low price-to-book ratio.

Question

Maximizing the information ratio is a characteristic of which of the following frameworks for specifying objectives and constraints?

1. Absolute.
2. Relative.
3. A and B.

Solution

The correct answer is B.

The information ratio focuses on comparing portfolio performance to a benchmark. In this context, it aligns more with the relative framework (answer B) for specifying objectives and constraints.

To understand this, consider the information ratio formula:

$$ \text{Information Ratio} = \frac { (\text{Portfolio Return} – \text{Benchmark Return}) }{ \text{Tracking Error} } $$

A and C are incorrect. This formula explicitly measures how a portfolio performs relative to a specific benchmark, emphasizing the relative aspect. In contrast, the absolute framework (answer A) typically evaluates the portfolio independently of external benchmarks, like the Sharpe Ratio, which compares a portfolio’s excess return to its own volatility. Therefore, the information ratio is more suitable for the relative framework.

Reading 26: Active Equity Investing: Portfolio Construction

Los 26 (b) Discuss approaches for constructing actively managed equity portfolios