Active Equity Investing: Core reading: Q no 14: page 453
The new Heydon Quant Fund will use a factor-based strategy. Nowacki assembles a large dataset with monthly standardized scores and monthly returns for the strategy to back-test a new investment strategy and calculates the information coefficient. FS(t) is the factor score for the current month, and FS(t + 1) is the score for the next month. SR(t) is the strategy’s holding period return for the current month, and SR(t + 1) is the strategy’s holding period return for the next month.
Knight foresees a possible scenario in which the investment universe for the Heydon Quant Fund is unchanged but a new factor is added to its multifactor model. Knight asks Nowacki whether this scenario could affect the fund’s investment-style classifications using either the returns-based or holdings-based approaches.
Q. The most appropriate response to Knight’s question regarding the potential future scenario for the Heydon Quant Fund is:
- only the returns-based approach.
- only the holdings-based approach.
- both the returns-based approach and the holdings-based approach.
Solution
C is correct. Because the Heydon Quant Fund would be changing its factor model by adding a new factor, the correlations of the fund’s returns with the factors would likely change and the returns-based style would change. Even though the investment universe is unchanged, the portfolio holdings would likely change and the holdings-based style classification would also be affected.
Query:-
Sir,
I am not able to understand why HOLDING BASED APPROACH will be affected. The answer has not explained this properly. Can you help?
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