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Decline

09-04-2018 · Insight

Fundamental Law of Active Management shows way to higher information ratio

The 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 Emerging Markets Enhanced Index Equities 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 Emerging Markets Enhanced Index Equities 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 Emerging Markets Enhanced Index Equities strategy (3 years = 1.24; and 5 years = 0.78, since inception= 1.27, as of end of March 2018).

Updated on 9 April 2018. This article was first published in January 2015.

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In all cases where historical performance is presented, please note that past performance is not a reliable indicator of future results and should not be relied upon as the basis for making an investment decision. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. Robeco Institutional Asset Management B.V. (“Robeco”) expressly prohibits any redistribution of the Information without the prior written consent of Robeco. The Information is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to law, rule or regulation. Certain information contained in the Information includes calculations or figures that have been prepared internally and have not been audited or verified by a third party. Use of different methods for preparing, calculating or presenting information may lead to different results. Robeco Institutional Asset Management UK Limited (“RIAM UK”) is authorised and regulated by the Financial Conduct Authority. RIAM UK, 30 Fenchurch Street, Part Level 8, London EC3M 3BD (FCA Reference No:1007814). The company is registered in England and Wales under Ref No. 15362605.

In all cases where historical performance is presented, please note that past performance is not a reliable indicator of future results and should not be relied upon as the basis for making an investment decision. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. Robeco Institutional Asset Management B.V. (“Robeco”) expressly prohibits any redistribution of the Information without the prior written consent of Robeco. The Information is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to law, rule or regulation. Certain information contained in the Information includes calculations or figures that have been prepared internally and have not been audited or verified by a third party. Use of different methods for preparing, calculating or presenting information may lead to different results. Robeco Institutional Asset Management B.V. is authorised as a manager of UCITS and AIFs by the Netherlands Authority for the Financial Markets and subject to limited regulation in the UK by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.