Misfit Risk and True Active Return

CFA Level III Equities
#1

In CFA text book, it states " a nonzero amount of misfit risk maybe optimal. In seeking to eliminate misfit risk through a completeness, a fund sponsor may be giving up some of the value added from the stock selection of the active manager"

From Kaplan notes, “Note that misfit risk 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.”

I understand, keeping misfit risk can have chance to increase active return.

My question is why misfit risk is related to stock selection or true active return? I think it’s just related to misfit return. Thanks.

#2

Stock selection is a deviation from the manager’s normal portfolio, therefore by definition it will involve some active return and active risk, you cannot have active return with absolute zero active risk… and a component of active risk is misfit active risk Total Active Risk = √ real active risk squared + misfit active risk squared

#3

Thanks, but still need a better explanation.