Hedge Fund Portfolio Construction
Great hedge fund interviews rarely stop at 'Is this a good long or short?' They quickly move to: How would you size it, hedge it, and fit it into a portfolio without blowing up your drawdown?
Note
Module Reading: This article accompanies the Portfolio Construction module in our Hedge Fund interview prep track.
Great hedge fund interviews rarely stop at "Is this a good long or short?" They quickly move to:How would you size it, hedge it, and fit it into a portfolio without blowing up your drawdown? That jump from single-idea thinking to portfolio thinking is exactly what separates "smart analyst" from "ready-to-run-risk."
In this module, you'll learn the practical mechanics real pods and multi-manager platforms care about: position sizing in risk units, gross and net exposure, factor and beta control, correlation traps, and drawdown-aware risk limits.
Early Interview Edge
When asked "How big?" don't answer in dollars first. Start with risk: "I'd size it to ~X bps of NAV at my stop, then adjust for liquidity, correlation, and factor overlap."
1) From a Good Trade to a Good Portfolio
A single trade can be "right" and still be a bad portfolio decision. If you already have five positions that all behave like high-beta momentum, adding a sixth is not diversification. Portfolio construction is about what your book is truly exposed to, not how many tickers you own.
In interviews, portfolio construction is usually tested in three layers:
- Sizing: How much can you lose if you're wrong?
- Exposure: What are you implicitly betting on (market, sector, rates, factor)?
- Path risk: Can you survive the drawdown before you're proven right?
Interview Answer Style
"I'd start with a base risk budget per position, size off stop distance and volatility, cap it by liquidity and borrow, then sanity-check factor and beta overlap. After that I'd look at portfolio-level scenario P&L and drawdown limits."
2) Position Sizing: Think in Risk Units, Not Dollars
Most hedge funds size positions using some version of risk budgeting. The core idea is simple: you decide how much of the fund you are willing to lose if the thesis is wrong, then back into position size.
Two common "interview-friendly" sizing approaches:
A) Stop-based Risk Sizing (Very Common in Discretionary L/S)
- Choose a loss limit per position (for example, 30–75 bps of NAV at stop)
- Estimate your stop distance (for example, -6% from entry)
- Position size ≈ (Risk Budget in $) / (Stop Distance in %)
B) Volatility-based Sizing (Common in Systematic and as a Cross-check)
- Target a risk contribution based on volatility
- Position size scales down when vol rises and scales up when vol falls
- Intuition: you want each position to "speak" with similar loudness in the portfolio
Sizing Method Comparison
| Term | Definition | Note |
|---|---|---|
| Stop-based | Control max loss per thesis | Pitfall: stops can be gappy or subjective |
| Vol-based | Normalize vol contribution | Pitfall: correlations can dominate in stress |
| Kelly-style | Growth-optimal fraction connecting edge + payoff | Pitfall: inputs are unstable, overbet risk |
| Liquidity-capped | Ensure you can exit | Pitfall: candidates forget to apply it |
Important Nuance
A "2% position" means nothing without context. A 2% position in a low-vol defensive stock is not the same risk as 2% in a meme-y small cap with borrow risk.
You run a $200m long/short equity book and cap single-position loss at 50 bps of NAV at the stop. A long idea has a thesis-invalidating stop 8% below entry. Ignoring correlations and slippage, what is the largest position size (as % of NAV) that matches your risk cap?
3) Gross and Net Exposure: What You're Actually Running
Once you can size a position, the next interview move is portfolio-level: How exposed is your book to the market? In long/short equity, you'll constantly hear:
Gross Exposure = Long + Short (absolute)How much you have 'on' in total
Net Exposure = Long − ShortHow directional you are
Example: 140% long, 60% short → Gross = 200%, Net = 80%
Gross tells you how much you have "on." Net tells you how directional you are. But interviews often go one level deeper: beta-adjusted exposure. A book with "low net" can still be very market-sensitive if the longs have high beta and the shorts have low beta.
A strong interview answer mentions all three:
- Net exposure (direction)
- Gross exposure (activity + leverage)
- Beta and factor tilts (what really drives P&L)
Platform Preference
Many platforms like "controlled net, meaningful gross." The idea is to monetize alpha from longs vs shorts while keeping market direction risk in a tight band.
A long/short book is 110% long and 90% short (net +20%, gross 200%). The longs have beta 1.3 and the shorts have beta 0.8 (to the market). Roughly, what is the book's beta-adjusted net market exposure?
4) Correlation, Concentration, and the 'Hidden Bets' Problem
Most blowups aren't from one position. They're from many positions doing the same thing at the same time. In interviews, "diversification" is not "more names." It's uncorrelated return drivers.
Common Hidden Bets in Equity L/S
| Term | Definition |
|---|---|
| Same Factor | Momentum, value, quality, low vol—all positions moving together |
| Same Macro Sensitivity | Rates up, oil up, USD up—underlying driver is the same |
| Same Crowded Positioning | Everyone owns the same longs, shorts the same basket |
| Same Catalyst Calendar | Earnings week concentration |
A practical way to talk about correlation in interviews:
- Start with pairwise correlation and sector buckets
- Then mention factor exposure (styles explain a lot of "mystery" correlation)
- Finally, stress that correlations spike in drawdowns, so you need stress testing, not just normal-times covariance
You have 8 longs across different sectors, but factor analysis shows they're all high momentum and high beta. Markets sell off hard and correlations jump toward 1. Which action best reduces portfolio drawdown risk while preserving your alpha thesis exposure?
5) Drawdown Control: Limits, Liquidity, and Stress Testing
Hedge funds are judged not just by returns, but by how they behave in bad tape. Drawdown control is where portfolio construction becomes real risk management.
High-Signal Interview Topics
| Term | Definition |
|---|---|
| Hard Limits | Position loss limits, sector limits, factor limits, gross and net bands |
| Liquidity Buckets | Can I exit 1 day, 5 days, 10 days without moving the market? |
| Scenario Stress | Rates shock, credit widening, vol spike, commodity shock, single-name gap risk |
| Path Risk | Even a correct thesis can fail if you cannot survive the interim drawdown |
A simple, PM-like drawdown framework you can say out loud:
- Define portfolio-level stop (e.g., daily and monthly drawdown triggers)
- Predefine de-risking actions (cut gross, cut correlated cluster, raise hedges)
- Stress test your biggest "one factor" exposures
- Make sure liquidity and financing constraints do not force selling
Don't Forget This
Liquidity and financing are portfolio construction, too. A position that is "small in NAV" can still be "huge in liquidity terms" if ADV is low or borrow tight.
6) How PMs Actually Run a Book Day-to-Day
A common interview mistake is sounding like you only think at trade entry. PMs run portfolios continuously. A strong candidate can explain a simple daily process:
Morning (Before Risk On)
Check exposures and what changed: net and gross, factor tilts, sector concentration, top correlated clusters, biggest downside scenarios, and anything near risk limits.
During the Day
Manage catalysts and path risk: earnings, macro prints, headline risk. If a position moves, you don't automatically "average down." You ask: did information change, did price change, or did both change?
After the Close
Do attribution: what drove P&L (market, sector, factor, idiosyncratic). If you can't explain the day's P&L drivers, you don't understand your book.
PM-Style Language
"I'm overweight risk in X factor," "this cluster is too correlated," "I'm cutting gross into the event," "I'm hedging beta because I want the idiosyncratic."
Want this to feel natural in interviews? Drill factor, beta, and drawdown scenarios until your answers sound PM-ready.
Key Takeaways
What Interviewers Want You to Internalize
- Size positions in risk units (bps of NAV at stop), then adjust for liquidity and correlation.
- Always discuss gross, net, and beta-adjusted exposure, not just one metric.
- Diversification means different return drivers, not more tickers.
- Correlations rise in stress, so rely on stress tests and cluster limits, not normal-times math.
- Drawdown control is a process: limits, triggers, and predefined de-risking actions.
- Portfolio construction includes liquidity, financing, and operational constraints, not just investment views.
- Strong candidates explain a daily PM workflow: exposures, attribution, catalysts, and risk actions.
Continue Your Hedge Fund Interview Prep
Master these related topics to complete your hedge fund interview preparation:
- Hedge Fund Fundamentals & Strategy Types — L/S equity, event-driven, macro, and quant strategies
- Hedge Fund Market Analysis & Investment Ideas — Generate and defend trade ideas
- Hedge Fund Valuation & Price Targets — Turn analysis into tradable price targets
- Hedge Fund Trading & Execution — Order types, benchmarks, and short mechanics
- Hedge Fund Stock Pitch Mini Cases — Practice long and short pitch frameworks
- Hedge Fund Macro Scenarios & Market Judgment — Economic scenarios and articulating conviction