Strengths and Limitations of Fundamental Law
Strengths of Fundamental Law As discussed in the previous section, the fundamental law of active management can be employed in sectors such as security selection, sector rotation, and market timing. Limitations of Fundamental Law I. Ex-ante Skill Measurement The information…
Active Management Strategies
The active approach of selecting and managing stocks in a portfolio is composed of: Security selection. Sector analysis. Market timing. I. Security Selection Security selection involves choosing stocks that are expected to offer superior risk-return characteristics. An investor with a…
Application of the Information Ratio
An optimal portfolio can be obtained by combining a risk-free asset with an optimally risky asset portfolio. The optimally risky asset portfolio is the point where the capital allocation line is tangent to the efficient frontier. The optimal portfolio is…
The Fundamental Law of Active Portfolio Management
The Basic Law (Unconstrained Portfolio) The basic fundamental law of active portfolio management states that the optimal expected active return is the product of the assumed information coefficient (IC), the square root of breadth (BR), and the active portfolio risk….
Information and Sharpe Ratios
Information Ratio The information ratio (IR) is the proportion of the active return to the volatility of the active returns, also known as the active risk. It measures a portfolio’s risk-adjusted rate of return. The information ratio (IR) of an…
Value Added
Value-added, also called active return, is the difference between the managed portfolio return and the benchmark portfolio return. It is calculated using the following equation: $$ R_A=R_P-R_B $$ Where: \(R_A\) is the value-added. \(R_P\) is the investor’s return. \(R_B\) is…
Commercial Real Estate
Rental Income Rental income includes the cash flows that investors in commercial real estate hope to receive. The credit quality of the underlying tenants influences the credit quality of a commercial property portfolio. The higher the credit quality of the…
Economic Analysis in Sector Rotation Strategies
Cyclical equities are very volatile since they follow such economic cycles as recession, expansion, and peak. Growth in the economy implies a subsequent growth in cyclical stocks and vice versa. On the other hand, non-cyclical equities are issued by companies…
Valuation Multiples
Valuation multiples include the price-to-earnings ratio (P/E) and the price-to-book ratio (P/B). A high P/E ratio implies an expected high growth of a company’s earnings in the future. Therefore, investors will be more willing to pay a higher price for…
Equity and Equity Risk Premium
Equity refers to a security with an indefinite size and timing of dividends. Moreover, these dividends may stop in the event of bankruptcy. This makes equities riskier than debt. Equities, therefore, require an additional risk premium. More precisely, investors who…
