Active Equity Investing: Portfolio Construction

Good ideas do not guarantee a good portfolio: the way positions are sized, the risk they consume, the liquidity of the holdings and the structure of the fund decide how much of a manager's skill reaches the client. This module links philosophy to construction, measures active share and active risk, applies risk budgeting, assesses capacity, and compares long-only, long extension and market-neutral structures.

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What you will learn

1. Explain how a manager's investment philosophy and the building blocks of active return (factor exposures, alpha skill, position sizing and breadth) drive portfolio construction.

Four building blocks: rewarded factor tilts, alpha skill, position sizing and breadth.
Fundamental law: IR is approximately TC x IC x square root of breadth; constraints reduce the transfer coefficient.
Systematic vs discretionary, bottom-up vs top-down, benchmark-aware vs benchmark-agnostic shape the portfolio.
Active return = sum of active factor exposures x factor returns + security-selection residual.
A stock picker whose active return comes mainly from factor tilts is not delivering what the philosophy promises.

2. Distinguish active share from active risk, calculate both, and relate them to a manager's strategy.

Active share = half the sum of absolute weight differences; for long-only portfolios it equals the sum of overweights.
Active risk depends on correlations and factor exposures, not only on weight differences.
Active variance = factor variance + idiosyncratic variance.
High AS + moderate TE: diversified stock picker; high AS + high TE: concentrated; low AS + high TE: factor bettor; low AS + low TE: closet indexer.
Compare active share only against the same benchmark; neither measure proves skill.

3. Apply risk budgeting, contributions to risk and limits on risk measures when building an active equity portfolio.

Contribution to variance = weight x covariance with the portfolio; contributions sum to total variance.
Risk share can differ sharply from capital share: volatile, correlated positions consume more risk.
Check the level of risk, its sources and its concentration against the philosophy.
Heuristic limits (position, sector, holdings caps) are simple; formal limits (tracking error, factor caps, VaR) need a model.
For independent managers or sleeves, total active risk = square root of the sum of (weight x tracking error) squared.

4. Evaluate how assets under management, position size, liquidity and turnover affect a strategy's efficiency and capacity.

Market impact rises with order size relative to volume, so larger AUM erodes net alpha.
Growing AUM forces larger positions, more names or more liquid stocks: each has a cost.
Days to liquidate = position / (participation rate x ADV); the same rule sets capacity.
High-turnover, small-cap and emerging-market strategies have the lowest capacity.
Illiquid holdings hurt remaining investors when redemptions come; closing a strategy protects them.

5. Compare long-only, long extension, long/short, market-neutral and equitized market-neutral structures, including the costs and risks of shorting and leverage.

Long-only: maximum underweight equals the stock's benchmark weight, which limits negative views.
130/30: net exposure 100%, gross exposure 160%, beta near 1; negative views can be fully expressed.
Market-neutral: net beta about zero, return = long/short spread + cash; equitized adds index futures for market return.
Shorting costs: borrow fees, dividends on borrowed shares, recalls, squeezes, margin calls and unlimited loss.
Choose the structure from the manager's short-side skill, the client's risk tolerance and whether beta is wanted.

Module at a glance

Active return comes from factor tilts, alpha skill, position sizing and breadth; IR is approximately TC x IC x the square root of breadth.
Active share = half the sum of absolute weight differences; active risk depends on correlations and factor bets.
Use active share and tracking error together to spot closet indexers and concentrated stock pickers.
Contribution to risk = weight x covariance with the portfolio; spend the risk budget where the manager has skill.
For independent managers, total active risk = square root of the sum of (weight x tracking error) squared.
Capacity = participation x ADV x days / weight for the least liquid holding; growth erodes net alpha.
130/30 keeps net exposure at 100% with gross 160%; equitized market-neutral adds index futures to a neutral long/short book.

This free module has 5 lessons, 18 practice questions with full explanations and 1 essay case with a model answer.

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