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. Theinformation 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
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
-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