New spin on the Fundamental Law of Active Management finds US mutual funds were “a victim of their own success”
| Mar 31st, 2011 | Filed under: CAPM / Alpha Theory, Real Estate, Today's Post | By: Alpha Male |
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The Fundamental Law of Active Management posits that the success (i.e. Information Ratio) of an active manager depends on three things: their “information coefficient” (ability to forecast security prices), the number of opportunities in their universe of securities, and their “transfer coefficient” (their flexibility in pursuing those opportunities). In our January 2007 post on the topic, we observed that:
“The information coefficient is just the correlation between the manager’s forecasts and what actually transpires. It’s 1.0 if the manager has a crystal ball and is named “the Amazing Kreskin” and it’s 0.0 if the manager is a chimpanzee taking target practice.”
What we didn’t mention was our skepticism that you could ever really measure the manager’s forecasts for each stock – especially for a fundamental bottom-up manager who probably doesn’t even have a price target (or time frame) for their picks. If only there was a way to restate the Fundamental Law that didn’t require such detailed (and theoretical) information.
Now there just might be. In an article published in the Fall 2010 Journal of Portfolio Management, Edouard Senechal of asset manager Singer Partners lays out a framework that “requires no assumption regarding the manager’s asset returns expectations or investment process.” (Article is also available here on the Singer website.)
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