The Fundamental Law of Active Management: Time Series Dynamics and Cross-Sectional Properties

29 Pages Posted: 19 Jun 2010 Last revised: 5 May 2011

Date Written: June 16, 2010

Abstract

I derive a generalized version of the fundamental law of active management under some weak conditions. I show that the original fundamental law of Grinold and various extensions are special cases of the result presented in this paper. I also show that cross-sectional ICs are usually different from time series ICs even if the time series ICs are all the same across securities. The fundamental law derived in this paper is robust to forecast model specification. My results show that average signal IC and IC standard deviation are the two most important variables in determining the potential IR a strategy can achieve. I extend the fundamental law to models with multiple factors and study the impact of missing one or more return or risk factors to portfolio IR.

Keywords: the fundamental law of active management, information coefficient, information ratio, transfer coefficient, time series, cross section

JEL Classification: G1, C2, C3, C5

Suggested Citation

Ding, Zhuanxin, The Fundamental Law of Active Management: Time Series Dynamics and Cross-Sectional Properties (June 16, 2010). Available at SSRN: https://ssrn.com/abstract=1625834 or http://dx.doi.org/10.2139/ssrn.1625834

Zhuanxin Ding (Contact Author)

Analytic Investors ( email )

555 West Fifth Street
50th Floor
Los Angeles, CA 90017
United States

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