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Many practitioners focus on trying to maximise the information ratio of active assets for a given tracking error, as there is a perception that higher information ratios imply higher skill. This paper first demonstrates that higher information ratios may not transfer into higher confidence in skill and, more importantly, that a new class of risk-adjusted performance measures are providing invaluable advice on optimal portfolio construction. In short, for a given tracking error budget, the paper demonstrates that the correct approach is to maximise risk-adjusted return. Using performance measures such as the M-square or the M-cube to evaluate risk-adjusted performance also provides clients with invaluable advice on optimal portfolio construction; specifically, allocations to cash, the passive benchmark ('the beta') and the active strategy (which may include multi-manager portfolios). In short, a more effective way of creating optimal portfolios is to integrate the active-passive and leverage-deleverage decisions to achieve a desired risk budget (with certain constraints on volatility of the optimal portfolio) and not just maximise the information ratio on the active component.
Abstract
Many papers on active management argue for maximising information ratios using a risk-budgeting framework. Recent innovations in risk-adjusted performance measures show why maximising information ratios on active portfolios could be the wrong policy and also provide a different twist to the discussion on separating alphas from betas. The literature on maximising information ratios focuses only on the active management process and ignores two actions used by clients or managers to improve risk-adjusted performance: passive management and leverage/deleverage using cash. This paper demonstrates the impact of maximising the wrong objective function and shows the benefit of maximising risk-adjusted returns for the entire fund, rather than the information ratio on the active component.
INTRODUCTION
Since the prospective returns for passive benchmarks are moderate (having declined over the last three years), clients are searching for higher returns. Many are exploring different ways to generate excess returns over the benchmark (alpha) through a mix of strategies. The challenge for clients, is to construct robust portfolios using the many possible investment ideas that they have researched or have access to. All this, however, needs to be done within existing risk budgets.
Portfolio managers are trying to create portfolios of the best investment rules for...