Active portfolio mgmt

The apparent discrepancy arises from a misunderstanding of the role of TC (Transfer Coefficient) in the Information Ratio (IR) formula.

Information Ratio (IR): Measures the excess return generated by a portfolio manager relative to its risk. It is a key performance metric for active managers.

Transfer Coefficient (TC): Represents the proportion of active risk that can be converted into active return. It essentially captures the manager’s ability to translate their investment ideas into portfolio returns.

Crucially, TC is not directly related to constraints. It’s a measure of the manager’s skill, independent of any portfolio restrictions. Even if a manager has no explicit constraints (like a benchmark, style box, or risk budget), their ability to convert information into returns (TC) still exists and influences their performance.

IR = TC * IC / BR

IC (Information Coefficient): Measures the manager’s ability to predict returns.

BR (Breadth): Represents the number of independent investment ideas.

While TC, IC, and BR together determine the potential IR, the actual realized IR can be influenced by various factors, including market conditions, luck, and implementation skills.

The absence of constraints doesn’t negate the importance of TC in evaluating a portfolio manager’s performance. It’s a fundamental component of the IR formula that measures the manager’s skill in transforming information into returns.