This paper discusses how we apply active management and the common misconceptions around active and passive investing. We apply a framework to estimate the “pure alpha” opportunity of an active strategy. Our evaluation reveals that a quantitative active strategy may deliver a significant amount of pure alpha away from static passive exposures.
In cases where an investor’s goal is to maximize returns within a risk budget, we often look at the realized Sharpe ratio in evaluating a strategy. Active management, however, has a different investment objective.
Broadly speaking, active management refers to a portfolio management strategy that aims to outperform a market benchmark index subject to the residual risks taken. One way to measure an active manager’s outperformance of a benchmark, and the consistency of the performance, is referred to as the information ratio.
Thanks to the development of rules-based strategies, investors can access part of the active management return at a much lower cost. So, in a narrow sense, modern active management refers to delivering a pure alpha opportunity that cannot be explained by a mix of factor, style, or sector exposures.
Originally published on Abacus FCF Advisors FCF Institute