Portfolio Management and Risk
Portfolio Management and Risk tests how equity exposures combine and how performance is judged against a benchmark. It covers diversification, beta, active risk, tracking error, factor exposures, and downside measures.
Core rules
- Portfolio expected return is the weighted average of asset expected returns. Portfolio risk depends on weights, volatilities, and correlations; diversification reduces unsystematic risk but not systematic risk.
- Beta measures sensitivity to the market. CAPM expected return = risk-free rate + beta × equity risk premium.
- Active return is portfolio return minus benchmark return. Tracking error is the standard deviation of active returns. Information ratio = active return ÷ tracking error.
- Factor exposures such as value, size, momentum, quality, and low volatility explain returns beyond market beta.
- Risk measures include volatility, beta, VaR, maximum drawdown, and liquidity. VaR is a loss threshold over a horizon at a confidence level, not a maximum loss.
Worked example
A portfolio has 60% in a stock with beta 1.2 and 40% in a stock with beta 0.5. Portfolio beta is 0.60 × 1.2 + 0.40 × 0.5 = 0.92. With a 3% risk-free rate and a 5% equity risk premium, CAPM expected return is 3% + 0.92 × 5% = 7.6%. If the portfolio’s actual expected return is 8.5%, the 0.9% premium may reflect stock-specific views or unmodeled factor exposure, not free alpha.
Traps
Do not assume low correlation eliminates all risk. Do not compare an active return with tracking error from a different period. A high information ratio over a short sample may be luck. Beta is not the same as volatility, and VaR says nothing about losses beyond the threshold.