Monongahela Ap is an equity fund analyst. His manager asks him to evaluate three actively managed equity funds from a single sponsor, Chiyodasenko Investment Corp. Ap’s assessments of the funds based on assets under management (AUM), the three main building blocks of portfolio construction, and the funds’ approaches to portfolio management are presented in Exhibit 1. Selected data for Fund 1 is presented in Exhibit 2.
Exhibit 1
Ap’s Assessments of Funds 1, 2, and 3
Fund | Fund Category | Fund Size (AUM) | Number of Securities | Description |
1 | Small-cap stocks | Large | Small | Fund 1 focuses on skillfully timing exposures to factors, both rewarded and unrewarded, and to other asset classes. The fund’s managers use timing skills to opportunistically shift their portfolio to capture returns from factors such as country, asset class, and sector. Fund 1 prefers to make large trades. |
2 | Large- cap stocks | Large | Large | Fund 2 holds a diversified portfolio and is concentrated in terms of factors. It targets individual securities that reflect the manager’s view that growth firms will outperform value firms. Fund 2 builds up its positions slowly, using unlit venues when possible. |
3 | Small- cap stocks | Small | Large | Fund 3 holds a highly diversified portfolio. The fund’s managers start by evaluating the risk and return characteristics of individual securities and then build their portfolio based on their stock-specific forecasts. Fund 3 prefers to make large trades. |
Exhibit 2
Selected Data for Fund 1
Factor | Market | Size | Value | Momentum |
Coefficient | 1.080 | 0.098 | −0.401 | 0.034 |
Variance of the market factor return and covariances with the market factor return | 0.00109 | 0.00053 | 0.00022 | −0.00025 |
Portfolio’s monthly standard deviation of returns | 3.74% |
Ap learns that Chiyodasenko has initiated a new equity fund. It is similar to Fund 1 but scales up active risk by doubling all of the active weights relative to Fund 1. The new fund aims to scale active return linearly with active risk, but implementation is problematic. Because of the cost and difficulty of borrowing some securities, the new fund cannot scale up its short positions to the same extent that it can scale up its long positions.
Ap reviews quarterly holdings reports for Fund 3. In comparing the two most recent quarterly reports, he notices differences in holdings that indicate that Fund 3 executed two trades, with each trade involving pairs of stocks. Initially, Fund 3 held active positions in two automobile stocks—one was overweight by 1 percentage point (pp), and the other was underweight by 1pp. Fund 3 traded back to benchmark weights on those two stocks. In the second trade, Fund 3 selected two different stocks that were held at benchmark weights, one energy stock and one financial stock. Fund 3 overweighted the energy stock by 1pp and underweighted the financial stock by 1pp.
In Fund 3’s latest quarterly report, Ap reads that Fund 3 implemented a new formal risk control for its forecasting model that constrains the predicted return distribution so that no more than 60% of the deviations from the mean are negative.
Question
Q. Relative to Fund 1, Chiyodasenko’s new equity fund will most likely exhibit a lower:
- information ratio.
- idiosyncratic risk.
- collateral requirement.
Solution
A is correct. As the new fund scales up active risk by doubling active weights, it will face implementation constraints that will prevent it from increasing the weights of many of its short positions. The information ratio (IR) is defined as the ratio of active return to active risk. If there were no constraints preventing the new fund from scaling up active weights, it could scale up active risk by scaling up active weights, proportionally increase active return, and keep the IR unchanged. Implementation constraints experienced by the new fund, however, such as the cost and difficulty in borrowing securities to support the scaled-up short positions, will prevent the active return from proportionally increasing with the active risk. Therefore, the IR would most likely be lower for the new fund than for Fund 1. As the following chart illustrates, as active risk is scaled up, implementation constraints create diminishing returns to scale for active returns, thereby degrading the IR.
Doubt: If the new fund will double its active weights, won’t it reduce the idiosyncratic risk through diversification? In which case, option ‘B’ could also be an answer?
Suppose in the benchmark, security A has a 10% weight. Fund A weighs security A to the tune of 20%. Active Weight = 10%. If Fund A decides to double the active weight to 20%, i.e. weighs security A to the tune of 30%, how does it reduce the idiosyncratic risk through diversification?
Got it, Thank you.
I confused Active Weights with Active Share – now my understanding is that ‘Active Share being increased’ means that the portfolio’s ‘holdings’ differ from the benchmark i.e. the securities chosen are different from the benchmark and the proportion of these securities is being increased. While ‘Active Weight increase’ means the weight of the same securities as the benchmark is being increased.
Is my understanding correct?