Handbook of Finance: Investment Management and Financial Management

Chapter 27. Portfolio Construction with Active Managers: An Integrated Approach

VINEET BUDHRAJA

Senior Research Analyst, Citi Alternative Investments

RUI J. P. DE FIGUEIREDO, JR., PhD

Associate Professor, Haas School of Business, University of California at Berkeley

JANGHOON KIM, CFA

Research Analyst, Citi Alternative Investments

RYAN MEREDITH, CFA, FFA

Senior Research Analyst, Citi Alternative Investments

Abstract: Alpha, or skill-based return, is a critical component of most investors' portfolios. Investors collectively spend enormous time and energy identifying active managers that can generate alpha and ultimately improve portfolio performance. Unfortunately, even if investors can identify managers who can generate positive alpha, these managers present a number of challenges from a portfolio construction standpoint. These challenges include short track records, biases in reported returns, and dynamic investment strategies. Most standard asset allocation approaches fail to deal with these challenges in a holistic fashion and are not very useful for helping investors determine allocations across active managers. Investors instead need new forecasting and optimization tools to deal with the portfolio construction difficulties that active managers present. Such tools have the potential to dramatically improve portfolio performance in practice, as compared to more traditional portfolio construction techniques.

Keywords: alpha, asset allocation, benchmark, beta, core satellite, forecast risk, ...