has been discussed. you can search. Completion funds are used to reduce the active risk of highly concentrated portfolios by investing in a broadbased index or other stocks. It does not have any misfit risk.

Active portfolios tend to have concentrations, and biases because of stock selection processes employed rather than deliberate macro economic bets. Completion portfolios try to bring active portfolio exposures in line with desired macro economic bets, mostly by bringing cumulative exposure in line with the investor’s benchmark. They might eliminate misfit risk. This is not always a positive. As the active return (which might justify certain level of misfit risk) might be eliminated while eliminating misfit risk.

Can someone explain why it might not be optimal to have misfit risk = zero? Is it just because it adds another portfolio constraint that could prevent the manager from pursuing more alpha?

zero misfit risk would imply perfect replication of the benchmark… you take on some risk in exchange for return

wouldn’t the risk in exchange for return be “active risk” not “misfit risk”? why can’t the manager just take on active risk without misfit risk?

right… i got confused. but then just to have active risk and no misfit risk one would have to use custom benchmarks and ‘normal’ portfolios… which might be both tough and expensive to construct… anyone else with a better answer ?

“True” active return = Mgrs Return - Mgrs Normal Benchmark Return “Misfit” active return = Mgrs Normal Benchmark Return - Investors Benchmark So Say I’m a LCV manager and I return 10%, my benchmark is the R1000V and it returned 9%, but my client holds me to the S&P500 which returned 8%. So… “True” active return = 10-9 = +1% “Misfit” active return = 9-8 = +1% Total Active Return = 1+1 = +2% Sorry just had to do that little exercise. Also, “True” Active Risk is the std deviation of your "True Active Returns and your “Misfit” Active Risk is the std deviation of your “Misfit” Active Returns. As long as you have a Benchmark that is different than your Investor’s/Client’s Benchmark you WILL have Misfit Return/Risk regardless of a completion portfolio or not… The completion portfolio though will help reduce NonSystematic Risk and thus lower your Overall Total Risk, but won’t eliminate Misfit Risk, unless Mgrs Benchmark = Investor’s Bench.