What is the objective of active equity portfolio construction?
To transform alpha forecasts into an efficient portfolio that maximizes information ratio within given constraints.
List three main portfolio construction methods.
Optimization
Describe the optimization approach.
Uses expected returns
What is a heuristic portfolio?
Built using judgment or simple rules (e.g.
Define risk budgeting.
Allocating total active risk across positions to maximize total IR.
Provide the formula for active share.
AS = ½ Σ|w_p − w_b|.
Provide the formula for tracking error.
TE = σ(R_p − R_b) = √(w’Σw).
Provide the formula for the information ratio.
IR = E[R_p − R_b] / TE.
Explain the relationship between information ratio
skill
What is the impact of tighter portfolio constraints?
Reduces turnover and active risk but also limits alpha potential.
What are typical portfolio constraints?
Sector caps
Explain why transaction costs must be modeled in portfolio construction.
They directly reduce realized IR; ignoring them leads to over-optimistic results.
Describe two ways to control transaction costs in an optimizer.
Add cost penalties or use turnover constraints.
Give the effect of turnover on IR.
High turnover raises costs → lower realized IR.
Compare active share and tracking error.
AS measures holdings deviation; TE measures volatility of active returns.
Interpret a portfolio with low AS and high TE.
Likely uses derivatives or factor tilts rather than stock selection.
Interpret a portfolio with high AS and low TE.
High conviction stock picker with low systematic factor bets.
State the trade-off between alpha concentration and diversification.
Concentration ↑ alpha magnitude but ↑ idiosyncratic risk; diversification smooths IR.
Define alpha diversification.
Combining uncorrelated alpha sources to raise IR via √Breadth relationship.
How does correlation between signals affect realized IR?
If signals correlated (ρ>0)
Explain benchmark mismatch.
Using wrong benchmark creates misleading active risk and IR metrics.
Describe over-optimization.
Excess sensitivity to small input changes causing unstable portfolio weights.
What is the danger of ignoring liquidity in optimization?
Illiquid holdings increase costs and tracking error unpredictably.
What happens if alpha forecasts have estimation error?
Weighting errors cause poor realized performance (garbage-in–garbage-out problem).
