Advanced Portfolio Management - Book Review
No unexamined portfolio is worth investing
I wrote a long thread on Twitter reviewing Advanced Portfolio Management: A Quant’s Guide for Fundamental Investors by Giuseppe Paleologo. See below:
Review
As Paleologo says in the book, “there is no master theory yet of portfolio management.” Before this one, there were no books offering a methodical, practical framework of portfolio management, yet hundreds, even thousands, on how to pick stocks. That’s a shame. While portfolio management’s importance is widely recognized, most of the equity industry still uses simple heuristics to size positions, limit risks, and understand performance. This book is a step in the right direction towards a more rigorous approach.
You don’t need access to a risk model or anything fancy to get value out of this book. Whether you’re a obsessed retail trader managing your own book, a small L/S fund, or a big LO, it will help you think more clearly about how to take your good ideas and put them together in a way that makes you more money and be able to survive any market environment.
Favorite Quotes
Below are some of my favorite quotes from the book. This is barely scratching the surface of the book contents, and I would reference the Twitter thread, or better yet, buy the book if you want more.
The Prime Directive, in almost everything, is to survive.
Chapter 3 - A Tour of Risk and Performance
It’s alpha that will pay your salary. Beta, on the other hand, can get you fired.
It is the job of the fundamental analyst to predict forward-looking alpha values based on deep fundamental research. The ability to combine these alpha forecasts in non-trivial ways from a variety of sources and to process large number of unstructured data is a competitive advantage of fundamental investing, and one that will not go away soon.
A deep value investor with little quantitative training may answer that risk is the “possibility of a permanent loss of capital,” which sounds great until you try to determine what “permanent loss of capital” means.
Risk is associated to the probability of losses large enough to disrupt our ability to invest.
Chapter 5 - Understand Factors
If a factor model is the skeleton of the market, then the factors are the large muscles of body. They literally move the markets. You may want to give them a name, and know how they do it.
The benefit of factor-based approach is that its returns aren't conflating returns of several factors.
Chapter 6 - Use Effective Heuristics for Alpha Sizing
Portfolio construction is a competitive advantage for quant managers, if not the competitive advantage. Fundamental investors do not trade every second thousands of stocks; does it matter for them? The answer is yes, enormously. It is not sufficient to have great ideas.
Chapter 7 - Manage Factor Risk
If you are a fundamental investor, factor returns are the cross-currents that can wreak your portfolio.
The larger the ratio between realized returns for high-conviction stocks and low-conviction ones, the more concentrated the portfolio can be. We call this the Conviction Profitability Ratio or CPR. You may be surprised to know that for most PM’s it is one or less, and that even the best PM’s dont exceed 2.
Chapter 8 - Understand Your Performance
No unexamined portfolio is worth investing. In order to become a better portfolio manager, you want to understand how much of your past performance is due to luck vs. skill (factor PnL vs. idiosyncratic PnL), and how selection, sizing and timing contribute to your performance.
The simple fact is that factors can find infinite ways to mar your performance, but cannot tell you how to be profitable.
Idiosyncratic PnL = selection PnL + sizing PnL + timing PnL
Identifying trends in a stock’s return is a long-term, strategic skill; timing a stock’s return is inherently a short-term, tactical skill.
There is anecdotal evidence that PM's have at best very little timing skill, moderately-positive-to-moderatively-negative sizing skill, and primarily selection skills.
The power of diversification is great. It is not a skill: it is a skill multiplier.