The Role of Cross-Sectional Dispersion in Active Portfolio Management
Forthcoming in Investment Management and Financial Innovations
25 Pages Posted: 12 Sep 2008 Last revised: 12 Jul 2010
Date Written: July 1, 2010
We derive and interpret the main results of Modern Portfolio Theory and the Theory of Active Portfolio Management from the perspective that, for active investors, the cross-sectional dispersion of returns is more relevant as a measure of risk than time series volatility. We show that all key measures of portfolio risk - total, systematic and idiosyncratic - are positively related to return dispersion, with dispersion primarily affecting idiosyncratic risk. Moreover, active portfolio returns are a function of managers’ skill and cross-sectional dispersion, with realized dispersion acting as a leverage factor for realized skill. Regardless of their level of skill, however, active managers will tend to reduce their active weights as the cross-sectional dispersion of returns increases. While higher levels of dispersion represent opportunities to earn higher active returns, managers’ information ratios are expected to remain unchanged, as realized tracking error is expected to vary proportionately with dispersion and managers’ active returns. Absolute return investors are therefore more likely to benefit from tactically adjusting the activeness of their strategies with the level of return dispersion.
Keywords: Dispersion, Active Management, Volatility, IC
JEL Classification: G11, G14
Suggested Citation: Suggested Citation