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Reading 1CFA L3 PCFull chapter

Active equity portfolio construction

In this chapter: Approaches: top-down vs bottom-up · Style classification (value, growth, blend) · Portfolio construction methods (concentrated, diversified, factor-based) · Long-only vs market-neutral

~3 min readLayer 4 · Professional CertificationsFree

Once you have an active strategy, how do you build the portfolio? CFA L3 tests aligning approach with investment philosophy and managing risk.

Foundation

Approaches: - **Top-down**: macro/sector → individual securities. Asset-allocation-driven. Quant-friendly. - **Bottom-up**: stock-by-stock fundamental analysis. Aggregates to portfolio. Style classification (Morningstar 9-box): - Value / Blend / Growth on horizontal. - Large / Mid / Small cap on vertical. Construction methods: - **Concentrated**: 20-40 stocks, high active share, high tracking error. - **Diversified**: 60-100 stocks, lower TE. - **Factor-based**: tilt to value, momentum, quality, low-volatility. - **Long-short**: 130/30, market-neutral, equity long-short. Key portfolio metrics: - Active share = Σ |w_p – w_b| / 2. >60% = active. - Tracking error (TE). - Information ratio (IR) = α/TE.

Deep Dive

Risk budgeting: - Total active risk decomposed into systematic (factor) + idiosyncratic (security-specific). - Concentrated portfolio: more idiosyncratic risk. - Factor-based: more systematic factor risk. Long-only constraint: limits how negative an underweight can be (can't go below 0%). For small-cap underweights in benchmarks like Russell 2000, this binds heavily. 130/30 strategy: - 130% long, 30% short. - Net market exposure 100%. - Higher TE than long-only because shorts add active bets. - Improves transfer coefficient (constraints relaxed). Market-neutral: - Long and short balanced; near-zero market beta. - Pure alpha extraction. - Requires careful pair construction and risk management.

Advanced

L3 essay: "Critique manager X's portfolio construction approach for client Y." Key factors to evaluate: - Alignment with mandate. - Active share consistency with claimed approach. - Concentration risk. - Factor exposures intentional or hidden. - Liquidity matched to client redemption needs. Factor crowding: when many managers tilt same factor, returns compress. Watch for risk-on regimes where factor risk concentrates.

Regulatory references
  • CFA Institute PM curriculum
  • SEBI MF Regulations
Common mistakes & pitfalls
  • Mistaking style drift for active management.
  • Confusing tracking error with active share.
  • Ignoring liquidity in concentrated portfolios.

Frequently asked

High active share = high alpha?
Necessary, not sufficient. You can have high active share and bad picks. But low active share + high fees = mathematical underperformance.
Can long-only managers be truly market-neutral?
No. Without shorts, can't fully hedge market beta. Approximate with low-beta longs + cash, but residual market exposure remains.

Practice questions

Click each question to reveal the answer and explanation.

Q 1
Active share measures:
  1. (a)Returns
  2. (b)How different portfolio is from benchmark
  3. (c)Trading volume
  4. (d)Fees
Correct: (b) How different portfolio is from benchmark
Active share = how different portfolio composition is from benchmark. Higher = more active.
Q 2
Concentrated portfolio typically has:
  1. (a)Lower idiosyncratic risk
  2. (b)Higher idiosyncratic risk
  3. (c)No factor risk
  4. (d)Zero TE
Correct: (b) Higher idiosyncratic risk
Fewer stocks → more security-specific risk. Concentrated = stock-picking bet.
Q 3
In 130/30 strategy:
  1. (a)130% long only
  2. (b)130% long, 30% short, net 100%
  3. (c)Cash position
  4. (d)30% leverage
Correct: (b) 130% long, 30% short, net 100%
130/30: 130% long + 30% short = 100% net market exposure with extra active bets.
Q 4
Long-only constraint hurts most for:
  1. (a)Large-cap underweights
  2. (b)Small-cap underweights (can't go very negative)
  3. (c)Cash position
  4. (d)Currency
Correct: (b) Small-cap underweights (can't go very negative)
Small benchmark weight → max underweight is small. Long-only binds.
Q 5
Factor crowding leads to:
  1. (a)Higher returns
  2. (b)Compressed factor returns
  3. (c)Lower volatility
  4. (d)No effect
Correct: (b) Compressed factor returns
When many funds chase same factor, returns compress.
Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.