Explain how the value that active management adds is gauged
The idea
Value added is the return on the actively managed portfolio minus the return on its benchmark, where the benchmark should carry the same systematic risk as the portfolio. Because portfolio and benchmark weights each sum to one, active weights sum to zero, and value added equals the sum over assets of each active weight times that asset's return. For a multi-asset fund it splits into asset allocation, each asset class's active weight times the benchmark return for that class, and security selection, each class's portfolio weight times the active return earned within the class. The trap is measuring value added against cash or against a benchmark of different risk, which mistakes market exposure for skill.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Work out the information ratio on both an ex post and an ex ante basis, explain what it means, and contrast it with the Sharpe ratio
- Set out and explain the fundamental law of active management for portfolios and each of its terms: breadth, the information coefficient, the transfer coefficient, and active risk (aggressiveness)
- Explain how the information ratio can help in picking investment managers and in deciding how much active risk a portfolio should carry
- Contrast active strategies such as security selection and market timing, and use active management's fundamental law to assess shifts in strategy
- Set out where active management's fundamental law is useful in practice and where it falls short