Value Added By Active Management
What you'll learn
- LOS 35.aDescribe how value added by active management is measured.
Active management seeks to add value by outperforming a passively managed benchmark portfolio.
Benchmark Qualities
An appropriate benchmark should:
- Be representative of the investment universe from which the active manager may choose. 2. Be replicable at low cost. 3.
Have weights that are available beforehand (ex ante), and benchmark returns that can be obtained promptly afterwards (ex post).
Active Return
Active return (RA) is the value added by active management. Active return can be measured ex ante (i.e., based on expectations) or ex post (“after the fact”). Ex ante active return is the difference between the expected return of an actively managed portfolio and the expected return of its benchmark:
E(RA) = E(RP) − E(RB)
Active weights in a portfolio determine the amount of value added. Active weight is the difference between a security’s weight in an actively managed portfolio and its weight in the benchmark portfolio. Overweighted (underweighted) securities have positive (negative) active weights.
Active weights must sum to zero.
For an active portfolio of N securities:
Ex post active return is the difference between the realized return of the actively managed portfolio and its benchmark portfolio.
- The following information is available for an actively managed portfolio and its benchmark.
- Calculate the ex ante active return.
- Answer:
- Alternatively:
Given an investment strategy involving multiple asset classes, expected returns on the active and benchmark portfolios can be computed as the weighted average of securities returns:
Ex ante active return is the expected return on the active portfolio minus the expected return on the benchmark:
Alternatively, active return can be decomposed into two parts:
- Asset allocation return (from deviations of asset class portfolio weights from benchmark weights).
- Security selection return (from active returns within asset classes).
Consider an active portfolio manager with a benchmark portfolio composed of 25% stocks and 75% bonds. The portfolio manager could overweight stocks (and underweight bonds), resulting in a difference in return relative to the benchmark; this is the asset allocation return. The manager can also choose to have higher weight to a specific stock within the allocation to stocks (and correspondingly underweight some other stocks).
This contributes to the security selection return.
- Optoma Fund invests in three asset classes: U.S. equities, U.S. bonds, and international equities. The asset allocation weights of Optoma and the expected performance of each asset class and the benchmark are shown in the following table.
- Calculate the expected active return.
- Answer:
- Alternatively,
- It can be seen that all of the expected active return is attributable to security selection. The active weights do not contribute to any asset allocation return.