Active return

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In finance, active return refers the returns produced by an investment portfolio due to active management decisions made by the portfolio manager that cannot be explained by the portfolio's exposure to returns or to risks in the portfolio's investment benchmark; active return is usually the objective of active management and subject of performance attribution. [1] In contrast, passive returns refers to returns produced by an investment portfolio due to its exposure to returns of its benchmark. Passive returns can be obtained deliberately through passive tracking of the portfolio benchmark or obtained inadvertently through an investment process unrelated to tracking the index. [2]

Contents

Benchmark portfolios are often represented in theoretical contexts to include all investment assets - sometimes called a market portfolio in these contexts, but is in practice a subset of practically available investable assets. [3] In those cases where the benchmark or the market portfolio include all investable assets, active management is a zero-sum game, as no group of active managers can achieve positive active returns over the benchmark portfolio without another group of managers taking the other side of those positions and producing negative active returns; active managers as a whole in this case cannot outperform the market portfolio. [4]

In a simple arithmetic return attribution, if denotes the return for the portfolio and denotes the return for the benchmark, then a simple active return is given by , and can be either positive or negative. [5]

Active return in the context of Brinson models

Brinson and Fachler (1985) and Brinson, Hood, and Beebower (1986) introduced the Brinson models as a foundation for investment portfolio performance attribution. [6] These models further sub-divide active returns due to active management into security selection - return achieved through selecting different securities than the benchmark, asset allocation - return achieved through weighting asset classes in a portfolio differently than the benchmark, and other types of return categories. These divisions are useful to account for and to measure portfolio manager skill. [7] The volatility of active return and volatility of sub-divisions of active return can be measured as active risk. [8]

Active return in the context of CAPM

Active return is often studied in the context of CAPM, the Capital Asset Pricing Model, as that model provides ways to measure and to justify active return. In the context of CAPM, a portfolio's investment benchmark represents a consensus market portfolio. [9] All portfolio and asset returns over a risk-free cash interest rate ("excess returns") can be decomposed into two uncorrelated components: (i) a fraction (beta) of the excess return of the market portfolio (M) and (ii) a residual return (theta). CAPM implies that, under certain assumptions, the expected residual return is zero, and that all expected portfolio and asset returns equal to their fraction (or beta) of the return of the market portfolio. [10]

These predictions imply that one may measure active returns relatively easily: a linear regression of the excess returns of a portfolio against a consensus market excess return. Such a linear regression produces an estimated alpha (or intercept), and an estimated beta on market excess returns. Assuming all CAPM assumptions hold in the particular context, the estimated beta of the market portfolio excess return is the CAPM beta, the residual (assumed to be zero in a linear regression) represents the residual return in CAPM, and alpha represents active returns achieved through active management of the portfolio. [11] CAPM implies that changing the beta of a portfolio to time for periods of high market portfolio returns, a type of market timing, cannot achieve active returns, since in the CAPM context active return is defined as return in excess of market portfolio returns. The assumptions of CAPM also point to ways for active management to achieving active return, which involves investing on information not yet incorporated into the consensus around the market portfolio. [12]

Uses of Active Return

Measurements of active return play a big role in investment manager evaluation, compensation, and selection. [13] Active return forecasts are an input into portfolio return forecasts, which are crucial inputs in investment planning and asset-liability management. Portfolio managers could examine active returns to evaluate which active decisions or types of active decisions have succeeded in their portfolios, to allocate resources (personnel, dollar budgets, risk budgets, etc.) to implement different active decisions, and to communicate with fund sponsors about portfolio performance.

Uses from the perspective of fund sponsors

Fund sponsors typically look for proficiency, consistency, and precision in the ability of active portfolio investment managers to produce active returns. A portfolio's scale of active returns implies a manager is proficient in producing active returns, its repeatability of active returns over time implies a manager is consistent at producing active returns, and its conformity of its sources of active returns with the manager's stated investment objectives implies a manager is precise in producing active returns. Fund sponsors typically choose a number of investment managers and allocate them assets to manage; they could compare these qualities of active returns among different investment managers to adjust allocations to their mandates. [14]

Uses form the perspective of investment managers

In cases where investment managers pursue multiple investment strategies in a single portfolio, such as fund of funds or multi-strategy portfolios, investment managers could use qualities of active returns of particular strategies to shift resources between investment strategies in the portfolio much like how fund sponsors would shift allocations between investment managers. [15] The active return and active risk of individual investment strategies can be used to calculate information ratio, which can be used to allocation investment strategies, and/or individual investments in assets, such as stocks, in a portfolio to maximize total portfolio active return. [16]

See also

Related Research Articles

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In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.

In finance, arbitrage pricing theory (APT) is a multi-factor model for asset pricing which relates various macro-economic (systematic) risk variables to the pricing of financial assets. Proposed by economist Stephen Ross in 1976, it is widely believed to be an improved alternative to its predecessor, the capital asset pricing model (CAPM). APT is founded upon the law of one price, which suggests that within an equilibrium market, rational investors will implement arbitrage such that the equilibrium price is eventually realised. As such, APT argues that when opportunities for arbitrage are exhausted in a given period, then the expected return of an asset is a linear function of various factors or theoretical market indices, where sensitivities of each factor is represented by a factor-specific beta coefficient or factor loading. Consequently, it provides traders with an indication of ‘true’ asset value and enables exploitation of market discrepancies via arbitrage. The linear factor model structure of the APT is used as the basis for evaluating asset allocation, the performance of managed funds as well as the calculation of cost of capital. Furthermore, the newer APT model is more dynamic being utilised in more theoretical application than the preceding CAPM model. A 1986 article written by Gregory Connor and Robert Korajczyk, utilised the APT framework and applied it to portfolio performance measurement suggesting that the Jensen coefficient is an acceptable measurement of portfolio performance.

In finance, the beta is a statistic that measures the expected increase or decrease of an individual stock price in proportion to movements of the stock market as a whole. Beta can be used to indicate the contribution of an individual asset to the market risk of a portfolio when it is added in small quantity. It refers to an asset's non-diversifiable risk, systematic risk, or market risk. Beta is not a measure of idiosyncratic risk.

In finance, the Sharpe ratio measures the performance of an investment such as a security or portfolio compared to a risk-free asset, after adjusting for its risk. It is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment returns. It represents the additional amount of return that an investor receives per unit of increase in risk.

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Alpha is a measure of the active return on an investment, the performance of that investment compared with a suitable market index. An alpha of 1% means the investment's return on investment over a selected period of time was 1% better than the market during that same period; a negative alpha means the investment underperformed the market. Alpha, along with beta, is one of two key coefficients in the capital asset pricing model used in modern portfolio theory and is closely related to other important quantities such as standard deviation, R-squared and the Sharpe ratio.

<span class="mw-page-title-main">Asset allocation</span> Investment strategy

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The information ratio measures and compares the active return of an investment compared to a benchmark index relative to the volatility of the active return. It is defined as the active return divided by the tracking error. It represents the additional amount of return that an investor receives per unit of increase in risk. The information ratio is simply the ratio of the active return of the portfolio divided by the tracking error of its return, with both components measured relative to the performance of the agreed-on benchmark.

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Gary P. Brinson is a former investor and money manager. He is the founder of Brinson Partners a Chicago-based asset management firm acquired in 1994 by Swiss Bank Corporation, the predecessor of UBS, and Adams Street Partners. Prior to retiring in 2000, Brinson would run the asset management division of Swiss Bank Corporation and later UBS Global Asset Management.

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References

  1. ↑ Bacon, Carl R. (2019). "Performance Attribution History and Progress". CFA Institute Research Foundation. p. 18. Retrieved 2020-05-15.
  2. ↑ Grinold, Richard C.; Kahn, Ronald N. (1999). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk (2 ed.). McGraw-Hill. p. 1,7,12.
  3. ↑ Grinold, Richard C.; Kahn, Ronald N. (1999). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk (2 ed.). McGraw-Hill. p. 13. S2CID   153107814.
  4. ↑ Clarke, Roger G.; de Silva, Harindra; Thorley, Steven (2015). "Analysis of Active Portfolio Management". CFA Institute. p. 3. Retrieved 2020-05-15.
  5. ↑ Bacon, Carl R.; Wright, Marc A. (2012). "Return Attribution". CFA Institute. Retrieved 2020-05-10.
  6. ↑ "Return Attribution". CFA Institute. 2012. Retrieved 2020-05-11.
  7. ↑ Bacon, Carl R.; Wright, Marc A. (2012). "Return Attribution". CFA Institute. Retrieved 2020-05-10.
  8. ↑ Steiner, Andreas (2012). "Active Risk Attribution" . Retrieved 2020-05-11.
  9. ↑ Grinold, Richard C.; Kahn, Ronald N. (1999). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk (2 ed.). McGraw-Hill. p. 18.
  10. ↑ Grinold, Richard C.; Kahn, Ronald N. (1999). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk (2 ed.). McGraw-Hill. pp. 12–17. S2CID   153107814.
  11. ↑ Fama, Eugene F.; French, Kenneth R. (2004). "The Capital Asset Pricing Model: Theory and Evidence" (PDF). p. 44. Retrieved 2020-05-13.
  12. ↑ Grinold, Richard C.; Kahn, Ronald N. (1999). Active Portfolio Management: A Quantitative Approach for Producing Superior Returns and Selecting Superior Returns and Controlling Risk (2 ed.). McGraw-Hill. p. 24. S2CID   153107814.
  13. ↑ Urwin, Roger (1998). "Avoiding disappointment in investment manager selection" (PDF). International Association of Consulting Actuaries, March 1998. Retrieved 2020-05-11.
  14. ↑ Bacon, Carl R.; Wright, Marc A. (2012). "Return Attribution". CFA Institute. p. 334. Retrieved 2020-05-10.
  15. ↑ Bacon, Carl R.; Wright, Marc A. (2012). "Return Attribution". CFA Institute. p. 334. Retrieved 2020-05-10.
  16. ↑ Ding, Zhuanxin (2010-06-16). "The Fundamental Law of Active Management: Time Series Dynamics and Cross-Sectional Properties". doi:10.2139/ssrn.1625834. S2CID   16440076 . Retrieved 2020-05-13.{{cite journal}}: Cite journal requires |journal= (help)
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