Achieving Higher Information Ratios: The Fundamental Law of Active Management
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How to achieve higher information ratios?
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We need to understand the *fundamental law of active management*
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The *fundamental law of active management*:
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a manager's IR can be estimated using two attributes of her strategy: *skill* and *breadth*
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Skill:
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is represented by the manager's *information coefficient*, which represents the correlation between her residual return forecasts and subsequent results (actual residual returns)
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Breadth:
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the number of independent forecasts of exceptional return that a manager makes *per year* !!NOT dependent forecasts
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The fundamental law is additive in the squared IRs:
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Overall IR^2 = IRA^2 + IRB^2 + IRC^2
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IC common:
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?: the correlation between the two information sources or managers ICcom: the skill level of the combined sources
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3 assumptions of the fundamental law:
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(1) the manager has an accurate measure of his or her own skills and exploits information (2) the sources of information are independent (3) the skill level (IC) involved in forecasting each active bet (BR) is the same
