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Fundamental Law of Active Management shows way to higher information ratio

05-01-2015 | Insight formula-ir-250x100px.jpgThe Fundamental Law of Active Management by Grinold and Kahn is designed to assess the value of active management, as expressed by the information ratio, using only two variables. The first variable is the portfolio manager ‘skill’ in selecting securities. In other words, how well is the portfolio manager at forming correct predictions? The second variable is breadth; the number of independent investment opportunities.

If two portfolio managers have the same investment skills but one manager follows an investment strategy that relies on a higher level of breadth compared to the second manager, the first manager is more likely to outperform. The analogy can be made to the game of roulette in a casino. If the wheel spins 100 times and at each spin the player’s bet is EUR 1, the expected return is the same as when the wheel spins only once and the bet is EUR 100. But for ‘the house’, the first option is far more preferable, because the level of breadth is higher and it offers a better reward-risk ratio.

The quantitative equity strategies we offer at Robeco benefit from the implications that follow from this formula. First, the ‘skill’ lies in years of our in-house research on equity markets and investor behavior. This resulted in our Quantitative Stock Selection Models which are designed to systematically identify and exploit market inefficiencies arising as a result of predictable patterns in investor behavior. Second, the level of breadth is high since we can use our models to analyze thousands of stocks in only a short period of time.

Let’s take Robeco Quant Emerging Markets Core (QEM Core) as an example. The individual stock exposures are only 20 bps versus the benchmark, whereas a traditional portfolio manager can have an individual active weights of 300 bps or even more. However, since the individual active weights of QEM Core are small, the number of positions is in the hundreds and the level of breadth thus is high.

The combination of having a well-developed stock selection model with using a high level of breadth has led to a consistently strong track record for our QEM Core strategy (3 years = 1.27; and 5 years = 1.52, since inception= 1.35, as of end of November 2014).

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