You take the passive portfolio, find mispriced securities, make an active portfolio from the mispriced securities, combine the active and passive portfolios in a certain weight that creates the most optimal portfolio, and combine the optimal portfolio with the rfr in the proportions that best suit the client based on risk aversion… the question: the active portfolio you create…is that a portfolio of ONLY the mispriced securities, or is that the entire market portfolio just with different weights on the misrpriced securities?
only the mispriced securities… and you would have only a few - since the cost of finding the mispriced securities is quite expensive. all the benefit you get from finding the mispriced securities would be lost if you used too many…
yep that and the fact that we assume that markets are always nearly efficent (if not efficient) so the assumption is that theres only a handful of mispriced securities out there so its a rather small active portfolio with a few long and a few short weights i assume
Clarification: Your weightings in the active portfolio can be huge in times of turbulance when alpha is high while not being penalized for lack of diversification using the TB model/