How does a manager’s deliberate increase in tracking risk limit his/her ability to take advantage of his/her investment insights?
I just can’t find the link between the tracking risk, the long-only constraint that it is implicit, and the “smaller portion of the manager’s insight is translated into the portfolio”?
“The problem is that as an investor increases a portfolio’s tracking risk, the long-only constraint increasingly limits the portfolio manager from taking full advantage of her investment insights”
(Level III 2012 Volume 4 p. 284).
“IC falls because a smaller portion of the manager’s insight is translated into the portfolio…”
Long-only limits the manager from taking full advantages of of her investment insights means if they have a -ve view on the stock, then can avoid it. Suppose that stock has 4% weight in the index by not using the particular stock in your portfolio you only -4% weight to it. (Since you are not allowed to short the stock & have more negative weight). Stock can be overweighted to any value but can only be underweighted to the tune of its weight in index.
Investors increasing the tracking risk means that investor is moving further away from the index because he has better views/insights about the stocks & looking to capture value by under/over weighting stock. But the cost is higher tracking risk relative to the index.
Information coefficient (means what you know about the given investment…basically knowledge) falls because your knowlegde is constrained as discussed above.
Had you been following long-short strategy you would have been able to apply your skills more.
Long only bounds the allocation weight on the left side I.e. at 0 . This means you cannot use the full range of weights -1 to +1 . If your estimations are right , you should be able to make more alpha by weighting at the most appropriate level over the full range
Long only - means the maximum negative constraint that may be applied to any asset class if you do not like it, e.g. is 0. (do not invest).
To increase Tracking risk - you would stop investing on some portion of the benchmark you do not like, and go and invest 100% in something that you liked. Your tracking risk is at its highest. But what you really wanted to do was to do a negative weight on your overvalued asset (sell it short) and a > 100% weight on your Undervalued asset (kind of buy it with leverage).
however if you thought the stock was overvalued - you would like to “Short it” - say invest a -30% in it, and go 130% on some other stock you liked (because it was undervalued).
If that were allowed (and it is not in the Long only constraint) If the Shorted stock fell - you would gain. But now in the long only constraint - you cannot gain from a fall in price of the shorted stock - since you do not have a position in it.
that’s why the extension to Long only - Short extension strategy comes in to play??
Most common 120/20, where you short the stock within the given portfolio (assuming few of the stock which you own are overvalued) or outside the portfolio. Resulting in the same or different net beta.
Yah , I meant the exact question typed out because i don’t have the books on me, i figured that was implied. I remember this question from last year though and I think you may be getting caught up in the details… the point is to know that you cannot double alpha by doubling active risk in a long only portfolio. If they didn’t spell out the long only constraint or infer it in some way beyond just stating it’s a pension, I find that to be a bogus question.
Just remeber, long only means doubling active risk does not double alpha because there is only one alpha, the long side.
“1) Long-only limits the manager from taking full advantages of of her investment insights means if they have a -ve view on the stock, then can avoid it. Suppose that stock has 4% weight in the index by not using the particular stock in your portfolio you only -4% weight to it. (Since you are not allowed to short the stock & have more negative weight). Stock can be overweighted to any value but can only be underweighted to the tune of its weight in index”
Actually the stock can only be overweighted by 1-index weight in the extreme case that the portfolio only held the one stock.
Yoko Suzuki manages an enhanced index portfolio benchmarked to the index for Kyushu Motors’ pension fund. The strategy has a target alpha of 1.5 percent annually with an annualized active risk of 2 percent. Her client is quite pleased that the portfolio has met its stated objective for the last five years. Kyushu’s other investment managers have not done so well against their objectives, however, and the pension fund now suffers from a large shortfall between its assets and liabilities. To make up this shortfall, Kyushu asks her to double the portfolio’s active risk with the intention of doubling the alpha as well. How should Suzuki respond to this suggestion?
“Kyushu, you ignorant slut! doubling your active risk does not necessarily double your active return. As you increase your active risk (especially in a long only constraind portfolio) your increase in active return would most likely decrease, causing your information ratio to decline as well.”
Well, i don’t know my man… i think they should have clearly specified the long-only constraint or this question is another fail by the CFA IMO. Yes, the pension is underfunded so you arguably can’t take much risk, but that doesnt mean you can’t short certain securities here and there AFAIK. I guess maybe the unspoken intent is that a pension fund thats underfunded can’t risk a short squeeze?
I don’t think any index is ever long short , so if they’re tracking the index , their fund is long only . So they cannot double their alpha , because they’re constrained on the left side ( i.e. min weight = 0)
ENHANCED index, which is an index where the weights are changed depending on the PM’s view, and as far as i know a negative weight is totally within their mandate unless specified otherwise.
you are right , Investopedia says short is possible and even preferred by enhanced indexing managers.
So I can’t think of any reason why they couldn’t achieve double alpha by increasing tracking error , except to say enhanced indexing is not quite active management , so probably short is done very opportunistically , and not on all stock viewpoints