Reading 59 - The Fundamental Law of Active Management Flashcards
What are the 2 sources of investment opportunity?
- Strategy’s breadth
- Managers skill
What does the Information coefficient (IC) measure?
**Critical Concept**
A manager’s forecasting accuracy.
Is measured as the correlation of a manager’s forecasts with actual outcomes.
What is Breadth (BR)?
**Critical Concept**
The number of independent forecasts of exceptional return per yr that the manager makes.
The fundamental law of active management says the formula to calculate the information ratio is what?
**Critical Concept**
Joe Smith, equity analyst with Smith Asset Management, currently follows 100 stocks and makes quarterly forecasts. Joe’s information coefficient is 0.05.
- Compute Joe’s information ratio
- If Joe chooses to follow an additional 100 stocks(w/qtrly forecasts) but with an information coefficient of 0.04, what will be Joe’s new information ratio?
- Breadth is 400 (ie 4 * 100 ),current IR = 1,-> = 0.05 * (400)1/2
- Information ratio = [1.002 +(0.04)2(400)]1/2►1.28
How do you calculate the level of aggressiveness given the information coefficient (IC),risk aversion and breadth?
**Critical Concept**
How do you calculate the Manager’s ability to add value given the information coefficient (IC) and breadth?
**Critical Concept**
Given the number of bets made by a manager, how can the information coefficient (IC) be calculated?
**Critical Concept**
What are the 3 assumptions of the Fundamental Law of Active Management?
- The manager has accurate knowledge of his skills and exploits this optimally
- Sources of information are independent
- The information coefficient is the same for each bet
Two managers have the same IC and risk aversion. Manager A makes 200 forecasts a yr and Manager B makes 100 forecasts a yr.
Who how the higher Valued Added and why?
Roger Tankart is reviewing a piece of analysis performed by a junior member of staff within his investment firm. The analysis covers the performance of active managers, and the appendix contains the following two statements:
Statement One: The information coefficient is multiplied by the breadth of a strategy to get the information ratio.
Statement Two: The information coefficient is the correlation of each forecast with the actual outcome.
How many of the statements are CORRECT?
A) Zero.
B) One.
C) Two.
Statement 1 is incorrect as the IC is multiplied by the square root of breadth to get the information ratio. Statement 2 is correct.
Which of the following statements regarding the optimal level of residual risk is most accurate? Optimal level of residual risk:
A) will decrease as the breadth increases
B) will increase proportionately with the skill of the manager
C) is independent of the accuracy of the manager’s forecasts
Harmesh Zuma is an active manager who last year achieved an information coefficient of 0.06 and made 52 forecasts over the year. A comparable manager had an information coefficient of 0.03 and made 160 forecasts for the year. Assuming a constant level of risk averseness for both managers, Zuma’s value added at the optimal level of risk is most likely:
A) equal to the comparable manager
B) lower than the comparable manager
C) higher than the comparable manager
A client is currently considering three active managers to manage his portfolio. The three active managers have the following information ratios:
Manager Information Ratio
A 0.45
B 0.50
C 0.70
Assuming the managers have independent active risks, which of the following is closest to the highest information ratio the client could achieve across all three managers?
A) 0.55
B) 0.97
C) 0.70
If I have the below three portfolio managers, what is their combined Information Ratio?
Manager 1 : 0.70
Manager 2 : 0.80
Manager 3 : 0.40
How do you calculate the IC for 2 sources of uncorrelated information?
IC = the original information coefficient
r = correlation between the two sources of information
