The Fundamental Law of Active Management provides a critical framework for understanding how active managers generate excess returns. It quantitatively links a manager’s skill and opportunity to their ability to add value. At its core, this law helps us dissect the sources of active performance.
The law begins with the understanding that an active manager’s opportunities are effectively measured by their Information Ratio (IR). Assuming the manager leverages these opportunities with mean-variance efficiency, the value they add is proportional to the square of this Information Ratio. This means consistent, efficient active management can significantly compound value.
The law is expressed by the equation:
$IR = IC \cdot \sqrt{BR} \cdot TC$
Let’s break down the four essential elements that comprise this fundamental relationship:
- IR (Information Ratio): This is the active return of a strategy relative to its benchmark, scaled by the volatility of that active return (tracking error). It quantifies the efficiency of the manager’s active bets.
- IC (Information Coefficient): This measures a manager’s skill. Specifically, it’s the correlation between their forecasts or predictions and the actual subsequent outcomes. A higher IC indicates more accurate insights.
- BR (Breadth): Defined as the number of independent forecasts or active decisions a manager makes within a year. It represents the degree of diversification of active bets. More independent bets allow a manager’s skill to manifest more consistently.
- TC (Transfer Coefficient): This element gauges the quality of implementation. It’s the correlation between the actual portfolio constructed and an “ideal” theoretical portfolio that perfectly exploited all forecasted opportunities. Constraints, trading costs, and other real-world frictions can reduce the TC.
The implications of the Fundamental Law are profound for any active manager or those evaluating them. Successful strategies don’t just happen; they require a deliberate combination of these elements:
- Skill (IC) is often the hardest to cultivate and sustain, requiring deep research, unique insights, and consistent decision-making.
- Breadth (BR), or diversification, can be more readily obtained—for example, by expanding the universe of stocks followed or the number of independent signals used. However, it only enhances performance when combined with genuine skill; simply making more random bets doesn’t help.
- Efficiency (TC) can be improved by minimizing constraints, optimizing trading processes to reduce costs, and ensuring that investment ideas are translated into portfolio positions as faithfully as possible.
Ultimately, every active manager, regardless of their specific investment style or asset class focus, must articulate how their process achieves a winning combination of skill, breadth, and efficient implementation to deliver consistent, valuable active returns.