Portfolio construction and risk budgeting - Constraints risk...

Learning Outcomes

This article explains the core elements of portfolio construction within a risk‑budgeting framework, focusing on how constraints, risk targets, and position sizing shape investment decisions and exam solutions. It clarifies the different types of constraints—liquidity, regulatory, tax, legal, mandate-based, and position limits—and shows how each one narrows the feasible opportunity set and influences asset allocation and security selection. It explains how to define and interpret absolute, relative, and qualitative risk targets, link them to investor objectives, and translate them into practical risk limits such as volatility, tracking error, and value-at-risk. It describes and compares major position-sizing approaches, including fixed weights, risk parity, volatility targeting, and maximum single-position or sector limits, emphasizing how they convert abstract risk budgets into concrete portfolio weights. It highlights the way constraints, risk targets, and position sizing must be integrated and monitored over time to maintain compliance, control concentration risk, and ensure that active bets remain intentional. It also prepares you to diagnose constraint or risk-budgeting issues in exam vignettes and justify recommended portfolio adjustments clearly and concisely.

CFA Level 2 Syllabus

For the CFA Level 2 exam, you are expected to understand the principles and application of portfolio risk budgeting and construction, with a focus on the following syllabus points:

• Explaining common portfolio constraints such as liquidity, regulation, tax, legal, and client mandates
• Defining and setting quantitative and qualitative risk targets linked to investment objectives
• Identifying and comparing position sizing methods within risk budgeting frameworks
• Describing how constraints, risk targets, and position sizing interact in the portfolio construction process
• Discussing the implications of constraints and risk budgeting for the implementation and monitoring of investment strategies

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following constraints would most likely affect both asset allocation and the choice of individual securities?
   1. Taxation
   2. Liquidity
   3. Regulatory restrictions
   4. All of the above

2. What is the main purpose of setting a risk target in the portfolio construction process?

3. A portfolio manager is restricted to a maximum 7% position in any single security. What type of portfolio constraint is this?

4. Briefly explain the difference between absolute and relative risk budgets.

Introduction

Portfolio construction requires careful balancing of return objectives and risk exposures. Success in the CFA exam, and in practice, depends on understanding how constraints, risk targets, and position sizing act as a basis for risk budgeting within the investment process. This article examines the interplay among these key portfolio design elements, providing definitions, methods, and practical examiner-focused examples.

Key Term: Constraint
A rule or requirement that limits or guides investment actions, such as asset class exposure limits, liquidity rules, regulatory guidelines, or client-imposed restrictions.

Key Term: Risk Target
A quantitative or qualitative goal specifying desired risk characteristics of a portfolio, often expressed as volatility, tracking error, or value-at-risk.

Key Term: Position Sizing
The process of determining the amount of capital allocated to individual assets or positions, based on risk and portfolio guidelines.

Key Term: Risk Budgeting
The allocation of allowable risk across a portfolio, strategies, or positions to ensure total risk remains within target levels.

Portfolio Constraints

Constraints shape the design and monitoring of investment portfolios. Some are externally imposed (legal, regulatory), while others arise from investor preferences or policy.

Types of Constraints

• Liquidity: Limits minimum cash balances or maximum investment in illiquid assets to ensure the ability to meet spending obligations.
• Regulatory: Restricts exposure to certain asset classes or securities, or sets diversification minimums, due to jurisdictional requirements.
• Tax: Preference for tax-efficient investments or constraints on trading activity to manage realized gains or losses.
• Legal: Trust, endowment, or pension mandates may stipulate eligible investments or prohibit certain transactions.
• Client or mandate: Limits on allocation to asset classes, borrowing, use of derivatives, or maximum relative or absolute risk levels.
• Position limits: Restrict the size of any single security or sector to control concentration risk.

Worked Example 1.1

A pension fund has a 2% maximum allowable investment in non-investment-grade bonds and must maintain daily liquidity for 90% of the portfolio. Identify the types of constraints and their likely impact on portfolio strategy.

Answer:
The 2% limit on non-investment-grade bonds is a regulatory or legal constraint; the liquidity rule is a mandate or liquidity constraint. These will restrict asset selection, reduce expected returns, and require maintaining highly liquid investments.

Exam Warning

Do not assume all constraints are quantitative; qualitative restrictions (e.g., ethical investment policies) may also impact allowable investment strategies.

Setting Risk Targets

A risk target provides a benchmark for acceptable portfolio risk. This prevents unintended concentration or excessive volatility.

Types of Risk Targets

• Absolute: Specifies maximum annualized volatility or maximum value-at-risk (VaR)
• Relative: Limits tracking error, active risk, or portfolio beta versus a benchmark
• Qualitative: Prohibits investments that could materially increase risk under adverse scenarios

Linking risk targets to investor objectives ensures risk-taking aligns with the investor's goals and constraints.

Worked Example 1.2

A balanced fund specifies an annualized volatility target of 10% and a 4% tracking error limit versus the composite benchmark. What does this mean for risk budgeting and manager behavior?

Answer:
The manager must construct the portfolio so that total volatility does not exceed 10%, and active risk versus the benchmark remains under 4%. Portfolio weights and exposures will be actively managed to keep total and relative risk within these boundaries.

Position Sizing and Implementation

Position sizing converts risk budgets and constraints into actionable exposures for each portfolio investment.

Position Sizing Approaches

• Fixed weights: Assign equal (or fixed) capital to each asset within limits
• Risk parity: Size positions so each contributes equally to total portfolio risk
• Volatility targeting: Allocate larger weights to lower volatility assets, keeping total risk within target
• Maximum single position or sector: Enforces concentration limits as a percent of NAV
• Convex or marginal risk: Sets positions so each uses the same fraction of total risk budget

Correct position sizing helps avoid unintentional bets that may breach risk or regulatory limits.

Worked Example 1.3

A manager applies a 3% maximum position size and a risk parity approach within a portfolio targeting 7% annualized volatility. How are holdings determined?

Answer:
Each asset’s position size must not exceed 3% of portfolio NAV. Among eligible assets, weights are chosen so that all contribute equally to portfolio risk, and overall volatility targets 7%.

Combining Risk Budgeting Elements

The practical combination of constraints, risk targets, and position sizing supports sound portfolio construction:

• Constraints narrow the opportunity set
• Risk targets summarize desired portfolio volatility
• Position sizing ensures individual investments fit within the combined limits
• Risk budgeting allocates total acceptable risk to strategies or holdings

Monitoring and rebalancing ensure ongoing compliance and responsiveness to changes in risk or constraints.

Revision Tip

On the CFA exam, always relate portfolio construction arguments back to specific investor constraints and risk targets shown in the case. Justify position sizing methods with reference to risk budgeting.

Summary

Combining clear constraints, explicit risk targets, and robust position sizing is fundamental to constructing and maintaining portfolios within a risk budgeting framework. CFA candidates must demonstrate an ability to articulate how these pieces interact, ensure regulatory and mandate compliance, and support investment objectives with controlled risk.

Key Point Checklist

This article has covered the following key knowledge points:

• Constraints define the boundaries for permissible portfolio decisions
• Risk targets set absolute and relative limits for portfolio volatility or tracking error
• Position sizing turns risk budgets and constraints into actual portfolio weights
• Risk budgeting allocates risk across assets, managers, or strategies
• Ongoing monitoring is essential to ensure compliance with all limits
• Exam answers must reference specific investor constraints and risk targets

Key Terms and Concepts

• Constraint
• Risk Target
• Position Sizing
• Risk Budgeting