“The disadvantage of a completeness fund is that it may result in a reduction of active returns arising from misfit risk” [Schweser V3 p 158] --> don’t really get this…thought that return due to misfit risk was undesirable? So are active returns aristing from misfit risk good or bad?
good
Um, I would have said bad too?
Some misfit risk is OK. From Book 3 p. 161 at the top: “The decomposition of the total active performance into true and misfit components is also useful for optimization. The objective is to maximize the total active return for a given level of total active risk while allowing for an optimal amount of misfit risk. Note that misfit risk is not optimized at zero because a manager may be able to generate a level of true active return for some level of misfit risk. In other words, if you let the manager concentrate in the style he is familiar with, the manager is more likely to generate an excess return relative to his normal portfolio.” So a manager may be skilled in managing some areas NOT covered by the benchmark, and doing so would generate misfit risk. As long as the manager is not excessive in trading in areas outside the benchmark to the extent that the benchmark is no longer appropriate for *most* of the portfolio, some misfit risk is OK.
It doesn’t matter if a cat is black or white, so long as it catches mice. a positive active return is good, not matter is from misfit or pure active management.
Good explanation.
ok …makes a bit more sense now. Ideally you would like all your active return to be true active return. But that aside, lowering active return (regardless of its source) would be a bad thing. Thanks guys.
think of it in terms of risk-adjusted return: mgr’s skilled in certain areas, therefore they should be able to (1) earn active return (portfolio return - normal benchmark return), in an amount sufficient to compensate for (2) additional misfit risk (normal benchmark risk - investor’s benchmark) … i.e. you must grow (2) as a condition for growing (1) “Misfit” implies bad, that’s why it’s confusing I think