Learning objectives: Describe practical issues in portfolio construction, including the determination of an appropriate risk aversion, aversions to specific risks, and proper alpha coverage. Describe portfolio revisions and rebalancing, and analyze the tradeoffs between alpha, risk, transaction costs, and time horizon. Determine the optimal no-trade region for rebalancing with transaction costs. Evaluate the strengths and weaknesses of the following portfolio construction techniques: screens, stratification, linear programming, and quadratic programming. Describe dispersion, explain its causes, and describe methods for controlling forms of dispersion.
Questions:
21.4.1. According to Grinold, typical or illustrative information ratios (IR) include: 0.500 is good, 0.750 is very good and 1.00 is exceptional. In regard to risk aversion, λ, 0.150 is restrained, 0.100 is moderate, and 0.050 is aggressive. Patricia is a manager with a "very good" information ratio of 0.750 and a "moderate" risk aversion of 0.10. If she shifts from this moderate risk aversion to an aggressive risk aversion of 0.050, what is the impact on the optimal level of active risk?
a. No effect
b. Optimal active risk reduces by one-half
c. Optimal active risk Increases by about +41%
d. Optimal active risk doubles
21.4.2. Robert is a value manager who picks among stocks with a relatively low EV/EBIT. However, he observes that these ratios are biased by their industry; for example, homebuilders have much lower ratios than technology companies. How can he neutralize his alphas so they are not biased by industry; that is, how can he achieve alphas that are risk-factor-neutral?
a. If we assume industry is a risk factor, he should forecast the risk factors
b. He can subtract each industry's capitalization-weighted average alpha from his initial alphas
c. He can conduct a three-step screen: rank stocks by alpha, choose the first X stocks, and then equal-weight those stocks
d. His best approach is quadratic programming (QP) with the maximum number of inputs
21.4.3. In the portfolio construction context, where the manager maintains separate accounts for multiple clients, dispersion is "the difference between the maximum return and minimum return for these separate account portfolios."(†) In regard to this type of dispersion, each of the following statements is true EXCEPT which is false?
a. For a given tracking error, more portfolios imply greater dispersion
b. In the presence of nonzero transaction costs, some dispersion is optimal
c. Dispersion is a theoretical measure but not a practical problem because separate accounts are segregated
d. Dispersion is proportional to tracking error where the constant of proportionality is a function of the number of portfolios
Answers here:
(†) Richard Grinold and Ronald Kahn, Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, 2nd Edition (New York: McGraw-Hill, 2000) - Page 385.
Questions:
21.4.1. According to Grinold, typical or illustrative information ratios (IR) include: 0.500 is good, 0.750 is very good and 1.00 is exceptional. In regard to risk aversion, λ, 0.150 is restrained, 0.100 is moderate, and 0.050 is aggressive. Patricia is a manager with a "very good" information ratio of 0.750 and a "moderate" risk aversion of 0.10. If she shifts from this moderate risk aversion to an aggressive risk aversion of 0.050, what is the impact on the optimal level of active risk?
a. No effect
b. Optimal active risk reduces by one-half
c. Optimal active risk Increases by about +41%
d. Optimal active risk doubles
21.4.2. Robert is a value manager who picks among stocks with a relatively low EV/EBIT. However, he observes that these ratios are biased by their industry; for example, homebuilders have much lower ratios than technology companies. How can he neutralize his alphas so they are not biased by industry; that is, how can he achieve alphas that are risk-factor-neutral?
a. If we assume industry is a risk factor, he should forecast the risk factors
b. He can subtract each industry's capitalization-weighted average alpha from his initial alphas
c. He can conduct a three-step screen: rank stocks by alpha, choose the first X stocks, and then equal-weight those stocks
d. His best approach is quadratic programming (QP) with the maximum number of inputs
21.4.3. In the portfolio construction context, where the manager maintains separate accounts for multiple clients, dispersion is "the difference between the maximum return and minimum return for these separate account portfolios."(†) In regard to this type of dispersion, each of the following statements is true EXCEPT which is false?
a. For a given tracking error, more portfolios imply greater dispersion
b. In the presence of nonzero transaction costs, some dispersion is optimal
c. Dispersion is a theoretical measure but not a practical problem because separate accounts are segregated
d. Dispersion is proportional to tracking error where the constant of proportionality is a function of the number of portfolios
Answers here:
(†) Richard Grinold and Ronald Kahn, Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Controlling Risk, 2nd Edition (New York: McGraw-Hill, 2000) - Page 385.
