Financial Risk Manager Part 2
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The equity mutual fund’s risk audit committee is currently evaluating a new portfolio construction strategy proposed by a recently appointed portfolio manager. This manager has received capital to manage and has the autonomy to select and implement the portfolio construction techniques they deem appropriate. However, it is a mandatory requirement that any chosen method adheres to the firm's pre-defined key risk control objectives. Which of the following portfolio construction methods accurately reflect their effectiveness in managing risk within the portfolio construction process?
The equity mutual fund’s risk audit committee is currently evaluating a new portfolio construction strategy proposed by a recently appointed portfolio manager. This manager has received capital to manage and has the autonomy to select and implement the portfolio construction techniques they deem appropriate. However, it is a mandatory requirement that any chosen method adheres to the firm's pre-defined key risk control objectives. Which of the following portfolio construction methods accurately reflect their effectiveness in managing risk within the portfolio construction process?
Explanation:
The correct answer is A. Quadratic programming allows for risk control through parameter estimation but generally requires many more inputs estimated from market data than other portfolio construction techniques do. Quadratic programming is a sophisticated method that involves estimating volatilities and pair-wise correlations between all assets in a portfolio. This process is powerful for risk control but also introduces the potential for noise and poor calibration due to the large number of inputs and the imperfect nature of market data. The other options are incorrect for the following reasons:
B is incorrect because the screening technique aims for risk control by including a sufficient number of stocks that meet certain parameters and by avoiding concentration in any particular stock. However, it does not necessarily select stocks evenly across sectors and can overlook entire sectors or classes of stocks if they do not meet the screening criteria, making risk control in screening processes limited.
C is incorrect because stratification involves categorizing stocks, such as by economic sectors, and implementing risk control by ensuring that the weighting in each sector matches the benchmark weighting. It does not allow for the selective overweighting or underweighting of specific categories.
D is incorrect because linear programming does not necessarily aim to select the portfolio with the lowest level of active risk. Instead, it seeks to improve upon stratification by introducing additional dimensions of risk control and ensuring that the portfolio closely matches the benchmark across all these dimensions.