I. A process for active investment management

The process includes researching ideas, forecasting exceptional returns, constructing

and implementing portfolios, and observing and refining their performance.

II. Strategic overview

1. Separating the risk forecasting problem from the return forecasting problem.

2. Investors care about active risk and active return (relative to a benchmark).

3. The relative perspective will focus us on the residual component of return: the

return uncorrelated with the benchmark return.

4. The information ratio is the ratio of the expected annual residual return to

the annual volatility of the residual return. The information ratio defines the

opportunities available to the active manager. The larger the information ratio, the

larger the possibility for active management.

5. Choosing investment opportunities depends on preferences. The preference

point toward high residual return and low residual risk. We capture this in a

mean/variance style through residual return minus a (quadratic) penalty on

residual risk (a linear penalty on residual variance). We interpret this as ¡°riskadjusted

expected return¡± or ¡°value added.¡±

6. The highest value added achievable is proportional to the squared

information ratio. The information ratio measures the active management

opportunities, and the squared information ratio indicates our ability to add


7. According to the fundamental law of active management, there are two sources of

information ratio:

IR = IC * BR

- Information coefficient: a measure of our level of skill, our ability to forecast

each asset¡¯s residual return. It is the correlation between the forecasts and the

eventual returns.

- Breadth: the number of times per year that we can use our skill.

8. Return, risk, benchmarks, preferences, and information ratios constitute the

foundations of active portfolio management. But the practice of active

management requires something more: expected return forecasts different from

the consensus.