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

See all articles by Larry R. Gorman

Larry R. Gorman

California Polytechnic State University

Steven G. Sapra

Analytic Investors, Inc.; Claremont Graduate University

Robert A. Weigand

Washburn University School of Business

Date Written: July 1, 2010

Abstract

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

Gorman, Larry and Sapra, Steven and Weigand, Robert A., The Role of Cross-Sectional Dispersion in Active Portfolio Management (July 1, 2010). Forthcoming in Investment Management and Financial Innovations. Available at SSRN: https://ssrn.com/abstract=1266225

Larry Gorman

California Polytechnic State University ( email )

College of Business
Department of Finance
San Luis Obispo, CA 93407
United States
805-756-1312 (Phone)
805-756-1473 (Fax)

Steven Sapra

Analytic Investors, Inc. ( email )

555 W. 5th St.
50th Floor
Los Angeles, CA 90013
United States
213-688-3015 (Phone)
213-688-8856 (Fax)

HOME PAGE: http://www.analyticinvestors.com

Claremont Graduate University ( email )

150 E. Tenth Street
Claremont, CA 91711
United States

Robert A. Weigand (Contact Author)

Washburn University School of Business ( email )

Topeka, KS
United States

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