Financial Risk Manager Part 2
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In constructing an equity portfolio using mean/variance optimization as instructed by the portfolio manager, what specific procedures should analysts follow to effectively implement this strategy? This includes conducting alpha analysis to determine expected returns, adjusting these alphas to conform with the portfolio's constraints, excluding any extreme alpha values that could skew results, and removing any biases or undesirable bets to ensure a robust portfolio construction.
In constructing an equity portfolio using mean/variance optimization as instructed by the portfolio manager, what specific procedures should analysts follow to effectively implement this strategy? This includes conducting alpha analysis to determine expected returns, adjusting these alphas to conform with the portfolio's constraints, excluding any extreme alpha values that could skew results, and removing any biases or undesirable bets to ensure a robust portfolio construction.
Explanation:
The correct answer is B, Neutralization. Neutralization is a process used in alpha analysis to remove biases or undesirable bets from the alphas. It involves adjusting the alphas so that the benchmark has a zero alpha, which means the alphas are centered around the benchmark. This can also be extended to make the alphas cash-neutral, meaning they won't lead to any active cash position. Furthermore, neutralization can be applied against risk factors, ensuring that the alphas only reflect information on factors the manager can forecast, along with specific asset information. Once neutralized, the alphas of the risk factors will be zero. This allows the manager to avoid making active bets on industries or size factors, which may not be in line with their investment strategy. The other options, Stratification, Scaling, and Trimming, are not suitable for the task of refining alphas to be neutral as they serve different purposes in portfolio construction and analysis.