Estimation Error and the 'Fundamental Law of Active Management' Is Quant Fundamentally Flawed?
The Journal of Investing, June 2020; DOI: https://doi.org/10.3905/joi.2020.1.133
Posted: 16 Oct 2019 Last revised: 3 Apr 2020
Date Written: March 28, 2020
Abstract
According to widely referenced applications of the Grinold (1989) “Fundamental Law” theory, simply adding more securities to an optimization universe, adding more factors to a forecast return model, trading more frequently, or reducing more constraints can add investment value to an optimized investment strategy. We show with intuitive discussion followed by a novel simulation study that applications of the Grinold theory for optimized portfolio design are often unreliable and self-defeating. Critical limitations are due to ignoring estimation error (Michaud 1989) and constraints required in practical applications. A substantial fraction of professional actively managed funds may be negatively impacted.
Keywords: active management, portfolio construction, asset allocation, quantitative finance, Fundamental Law of Active Management, optimization
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