Equity Portfolio Construction and Analysis
Core concepts
Equity construction starts with a benchmark choice and an active-risk budget. Candidates must understand the spectrum from passive (index replication, full replication versus sampling) through enhanced indexing to active management, and the trade-off between tracking error and potential alpha. Style classifications - value versus growth, market cap, sector - drive benchmark selection and performance attribution.
Portfolio construction tools include screening, optimization, and risk-factor models. Concentration limits, liquidity, and turnover costs matter. Analysis covers valuation metrics (P/E, P/B, dividend yield, free cash flow yield), quality and profitability measures, and the decomposition of returns into allocation, selection, and interaction effects. Multi-factor models explain returns through exposures such as size, value, momentum, and quality.
Traps
- Confusing active share with tracking error; high active share does not imply high tracking error.
- Attributing all excess return to selection when sector allocation drove it.
- Ignoring transaction costs and capacity in high-turnover strategies.
- Assuming a style label is stable; style drift changes the benchmark comparison.
Worked example
A portfolio returned 9% while its benchmark returned 8%. Sector allocation contributed +0.4% and security selection +0.6%. The sum is +1.0%, matching the excess return. If interaction effects are present, reconcile them explicitly rather than forcing the numbers into allocation and selection alone.
Rule of thumb: define the benchmark first, size active risk deliberately, and always decompose excess return into allocation, selection, and interaction before judging skill.