Active Risk and Information Ratio

Journal of Investment Management, Vol. 2, No. 3, Third Quarter 2004

Posted: 16 Sep 2004

See all articles by Edward Qian

Edward Qian

Putnam Investments

Ronald Hua

Putnam Investments

Abstract

One of the underlying assumptions of the Fundamental Law of Active Management is that the active risk of an active investment strategy equates estimated tracking error by a risk model. We show there is an additional source of active risk that is unique to each strategy. This strategy risk is caused by variability of the strategy's information coefficient over time. This implies that true active risk is often different from, and in many cases, significantly higher than the estimated tracking error given by a risk model. We show that a more consistent estimation of information ratio is the ratio of average information coefficient to the standard deviation of information coefficient. We further demonstrate how the interaction between information coefficient and investment opportunity, in terms of cross sectional dispersion of actual returns, influences the IR. We then provide supporting empirical evidence and offer possible explanations to illustrate the practicality of our findings when applied to active portfolio management.

Keywords: Portfolio management, portfolio optimization, active risk

JEL Classification: G00

Suggested Citation

Qian, Edward and Hua, Ronald, Active Risk and Information Ratio. Journal of Investment Management, Vol. 2, No. 3, Third Quarter 2004, Available at SSRN: https://ssrn.com/abstract=569281

Edward Qian (Contact Author)

Putnam Investments ( email )

One Post Office Square
Boston, MA 02109
United States

Ronald Hua

Putnam Investments ( email )

One Post Office Square
Boston, MA 02109
United States

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