Explain how the information ratio can help in picking investment managers and in deciding how much active risk a portfolio should carry
The idea
Because the IR does not change with aggressiveness, the choice of manager can be separated from the choice of risk level. First pick the manager with the highest IR, because combined with the benchmark it gives the highest achievable Sharpe ratio: at optimal active risk, with active returns uncorrelated with the benchmark, combined SR² = benchmark SR² + IR². Then set active risk at its optimal level, the IR divided by the benchmark Sharpe ratio, times benchmark volatility. If the fund's tracking error is higher than that, put optimal active risk ÷ fund active risk of the money in the fund and the rest in the benchmark. The trap is choosing the fund with the highest expected active return or Sharpe ratio rather than the highest IR.
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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- Explain how the value that active management adds is gauged
- 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)
- 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