Ex post reality versus ex ante theory of the fundamental law of active management
- PDF / 163,894 Bytes
- 12 Pages / 599.317 x 767.575 pts Page_size
- 74 Downloads / 183 Views
David J. Buckle is Senior Fund Manager with Merrill Lynch Investment Managers. He has 11 years’ experience as a practising asset manager with JP Morgan Investment Managers, Putnam Investors and Lee Overlay Partners, specialising in quantitative approaches to asset management. Prior to this, he earned a PhD in portfolio construction from Imperial College, London. Merrill Lynch Investment Managers, 33 King William Street, London EC4R 9AS, UK Tel: ⫹44 (0)207 743 4399, Fax: ⫹44 (0)207 743 1000; e-mail: [email protected]
Abstract The fundamental law of active management provides considerable ex ante aid both to those constructing active management processes and to those estimating the future performance of those processes. Ex post, performance can be quite different to that expected by the law, and the violations of assumptions underlying the law which cause the greatest performance impact are identified. It is shown that biased forecasting in a trending market is the greatest cause for concern. Portfolio construction is also a sensitive input in certain circumstances. The remaining assumptions underlying the law are surprisingly innocuous, and violations have very little impact on performance. Keywords: active portfolio management, fundamental law of active management, information ratio
Introduction The fundamental law of active management of Grinold and Kahn (1999, for example) says that the active manager should maximise performance by maximising both the quality of the forecasting and the number of ‘bets’. Specifically, the law is expressed as IR ⬇兹BR ⫻ IC
(1)
where IR denotes the information ratio, defined as active portfolio return divided by active portfolio risk, and is proven by the mainstream financial theory to be the measure that should be maximised by the active manager; IC denotes the information coefficient defined as the
䉷 Henry Stewart Publications 1479-179X (2005)
correlation between the forecast of asset abnormal return and the return itself, thereby measuring the skill of the active manager; and BR denotes the breadth, defined as the number of independent signals behind these forecasts. The law is attractively simple and intuitive but is set in an ex ante context. An area of interest is to measure how it might hold up ex post. It is not the intention to discuss a specific case study but, instead, to measure the impact on Equation (1) of the law’s underlying assumptions being violated. In doing this, an indication is provided of which assumptions are the critical ones, and to what extent any violation will affect performance.
Vol. 6, 1, 21–32
Journal of Asset Management
21
Buckle
It will be shown that by far the most critical assumption is that the forecasts are unbiased and the residual returns have no expected return (ie average forecast and average residual return are both zero). This issue will be discussed in some detail, including recommendations to those involved in creating or measuring active management processes on how to minimise the risk of being erroneously influenced by tre
Data Loading...
