Well-Constructed Portfolio
A well-constructed portfolio is a strategic assembly of investments designed to meet the risk and return expectations of investors. It doesn’t guarantee an excess return over the benchmark, particularly in the short term. However, it is structured to deliver the risk characteristics that the portfolio manager has committed to the investors.
Key Characteristics of a Well-Constructed Portfolio
- Clear investment philosophy and consistent investment process: This could be a focus on value investing, growth investing, or a blend of both.
- Risk and structural characteristics as promised to investors: For instance, a portfolio promising low volatility should not be heavily invested in high-risk assets.
- Risk-efficient delivery methodology: This involves the strategic allocation of assets to balance risk and return.
- Reasonably low operating costs given the strategy: This includes management fees, transaction costs, and other expenses associated with the portfolio.
A well-constructed portfolio should align risk exposures with investor expectations and constraints, and the idiosyncratic risk (unexplained) should be low relative to the total risk. If two products have comparable factor exposures, the one with lower absolute volatility and lower active risk is likely to be preferred, assuming similar costs. If two products have similar active and absolute risks, similar costs, and the managers have similar alpha skills, the product with a higher Active Share is preferable. This is because it leverages the alpha skills of the manager and is expected to yield higher returns.
The “risk efficiency” of any given portfolio approach should be evaluated in the context of the investor’s total portfolio. The active risk of a concentrated stock picker should be higher than that of a diversified factor investor, and the concentrated stock picker may have a lower information ratio. However, both managers could be building a well-structured portfolio relative to their mandate. It’s crucial to consider the diversification effect of a manager’s portfolio on the investor’s total portfolio to arrive at an appropriate solution.
Practice Questions
Question 1: A portfolio manager is designing a well-constructed portfolio. They believe in a clear investment philosophy, consistent investment process, risk-efficient delivery methodology, and reasonably low operating costs. However, they are unsure about the risk and structural characteristics. If the manager wants to ensure that the portfolio delivers the risk characteristics as promised to the investors, which of the following should they consider?
- Substantial diversification
- High-conviction, less diversified strategy
- Either substantial diversification or high-conviction, less diversified strategy, depending on the investors’ requirements
Answer: Choice C is correct.
The portfolio manager should consider either substantial diversification or a high-conviction, less diversified strategy, depending on the investors’ requirements. The choice between these two strategies depends on the risk tolerance and investment objectives of the investors. Substantial diversification can help to reduce the risk of the portfolio by spreading investments across a wide range of assets. This can help to ensure that the portfolio delivers the risk characteristics as promised to the investors. On the other hand, a high-conviction, less diversified strategy can potentially deliver higher returns, but it also comes with higher risk. If the investors have a high risk tolerance and are seeking higher potential returns, then this strategy may be appropriate. Therefore, the portfolio manager should consider the investors’ requirements when deciding on the risk and structural characteristics of the portfolio.
Choice A is incorrect. Substantial diversification alone may not ensure that the portfolio delivers the risk characteristics as promised to the investors. While diversification can help to reduce risk, it may not be suitable for all investors. For example, investors with a high risk tolerance may prefer a less diversified, high-conviction strategy that has the potential for higher returns.
Choice B is incorrect. A high-conviction, less diversified strategy alone may not ensure that the portfolio delivers the risk characteristics as promised to the investors. While this strategy can potentially deliver higher returns, it also comes with higher risk. Therefore, it may not be suitable for all investors, particularly those with a low risk tolerance.
Question 2: The “risk efficiency” of any given portfolio approach should be evaluated in the context of the investor’s total portfolio. The active risk of a concentrated stock picker should be higher than that of a diversified factor investor, and the concentrated stock picker may have a lower information ratio. However, both managers could be building a well-structured portfolio relative to their mandate. Based on this information, which of the following statements is most likely to be true?
- The active risk of a diversified factor investor should be higher than that of a concentrated stock picker.
- The concentrated stock picker cannot build a well-structured portfolio relative to their mandate.
- The active risk of a concentrated stock picker should be higher than that of a diversified factor investor.
Answer: Choice C is correct.
The active risk of a concentrated stock picker should be higher than that of a diversified factor investor. Active risk, also known as tracking error, is a measure of the risk in an investment portfolio that is due to active management decisions. A concentrated stock picker, who makes specific bets on individual stocks, is likely to have a higher active risk than a diversified factor investor, who spreads investments across a broad range of factors. This is because the concentrated stock picker’s portfolio is more likely to deviate significantly from the benchmark due to the specific risks associated with the individual stocks selected. On the other hand, a diversified factor investor’s portfolio is likely to be more closely aligned with the benchmark due to the broad diversification across factors, resulting in a lower active risk.
Choice A is incorrect. The statement that the active risk of a diversified factor investor should be higher than that of a concentrated stock picker contradicts the information provided. As explained above, a diversified factor investor is likely to have a lower active risk due to the broad diversification across factors.
Choice B is incorrect. The statement that the concentrated stock picker cannot build a well-structured portfolio relative to their mandate is incorrect. The question statement clearly states that both managers could be building a well-structured portfolio relative to their mandate. The structure of a portfolio is determined by the manager’s investment strategy and mandate, and a concentrated stock picker can certainly build a well-structured portfolio that aligns with their specific investment strategy and mandate.
Glossary
- Value factor: A strategy that chooses stocks that are trading for less than their intrinsic values.
- Active Share: A measure of the percentage of stock holdings in a manager’s portfolio that differ from the benchmark index.
- Drawdown: The peak-to-trough decline during a specific recorded period of an investment, fund or commodity.
- Return on Equity (ROE): A measure of financial performance calculated by dividing net income by shareholders’ equity.
- Debt-to-Equity Ratio (D/E): A financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets.
- Earnings Variability: The inconsistency in a company’s earnings over a certain period of time.
Portfolio Management Pathway Volume 1: Learning Module 3: Active Equity Investing: Portfolio Construction;
LOS 3(j): Evaluate the efficiency of a portfolio structure given its investment mandate