Can someone pls explain this to me in English? Scweser suddenly changes from english to gibberish while covering this topic.
i can try when we look at the managers return and compare it vs a broad benchmark we call this alpha(active return). however we need to break this down. we learned that we should use a custom benchmark to measure managers b/c this will better represent them. so lets call this custom benchamrk their normal benchmark. now we can compare the managers actual return to their normal benchmark this is their true active return. now their misfit return is what we get when we compare the normal benchmark to the broad based benchmark. thus active return = true active return + misfit active return. or look at it like a formula portfolio retrun - normal bench = true + normal bench - broad bench = misfit ---------------------------------------------- portfolio return - broad bench = alpha
Just to add - An active manager should be compared to the universe of securities that they will actually pick from. This is what nikko refers to as the “normal” portfolio. A traditional, broad based, benchmark may not represent this well. So a manager may beat the overall benchmark but not really add any value. For example, if you are a micro cap manager and you are being compared to the Russell 2000 index (small cap index). At the end of the first quarter we tally up performance and you, the manager, have beat the Russell 2000 by 200 basis points. Yah for you! But when you compare you portfolio to a benchmark of only microcaps (your normal portfolio) you have actually lost to it by 300 basis points. BOO, that no Majix! So as a microcap manager (what you really are because you only pick from microcaps) you lost to the index (normal portfolio). But when comared to the Russell you are a genius. Breaking active return down to the components allows one to analyze where the return came from - misfit risk (you are a micro cap manager being compared to small cap index) or true (you are a micro cap manager beating a representative micro cap index).
That is beautiful! You guys - nikko0355 & mwvt9 - thanks for explaining something that i thought was so confusing in such an easy an effective manner. Now if i can indulge you guys, can you tell me what the following statement implies? “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” My question is, how does some misfit risk (normal portfolio - benchmark) help in generating some true active return?
If you are the micro cap manger that I have described above and you are being compared to the small cap benchmark, IF you have some true active return (port - normal) you are adding value. Now unless the benchmark (russell) is changed in order to get that true active return you are going to have to accept some misfit risk (micro cap manager benchmarked against small cap index).
could i please ask you an additional question related to a similar subject: the completeness fund? Schweser: “To minimize the differences in risk exposures between the portfolio and the benchmark, the investor can use a completeness fund. The completeness fund complements the active portfolio, so that the combined portfolios have a risk exposure similar to the benchmark. The advantage of the completeness fund approach is that the active return from the managers can be maintained, while active risk is minimized.” how can the active risk still be maintained, if i decrease my exposures to the benchmark? why dont all all active mngrs do that? minimal active risk and still the same alpha? how does misfit risk becomes a disadvantage here? thanks guys.
could i please ask you an additional question related to a similar subject: the completeness fund? Schweser: “To minimize the differences in risk exposures between the portfolio and the benchmark, the investor can use a completeness fund. The completeness fund complements the active portfolio, so that the combined portfolios have a risk exposure similar to the benchmark. The advantage of the completeness fund approach is that the active return from the managers can be maintained, while active risk is minimized.” how can the active return still be maintained, if i decrease my exposures to the benchmark (thus reducing active risk)? why dont all all active mngrs do that? minimal active risk and still the same alpha? how does misfit risk becomes a disadvantage here? thanks guys.
IMO completeness fund is the investment a manager makes to get the overall risk of the portfolio closer to that of the benchmark. Remember that the objective is to balance alpha (active risk) with minimum risk (least deviation in returns from the benchmark). When the manager implements a strategy wherein he expects to generate alpha but where the risk is above an accepted level, he uses the completeness fund to bridge the current risk and desired risk level. Think of this as a plug.
thanks amgix. In addition to this, found on google: “A completeness fund is a customized basket of stocks or style indices designed to offset or neutralize the aggregate investment style bias of the other funds included in a portfolio. One of the challenges faced by users of completeness funds is determining how much of the overall portfolio should be allocated to the completeness fund. Too large an allocation dilutes the ability of other (active) funds to add value to the portfolio. Too small an allocation and the completeness fund will not be very effective in reducing the portfolio’s style risk.” i guess the disadvantage comes from diminishing active return as it approaches benchmark
thanks magix. In addition to this, found on google: “A completeness fund is a customized basket of stocks or style indices designed to offset or neutralize the aggregate investment style bias of the other funds included in a portfolio. One of the challenges faced by users of completeness funds is determining how much of the overall portfolio should be allocated to the completeness fund. Too large an allocation dilutes the ability of other (active) funds to add value to the portfolio. Too small an allocation and the completeness fund will not be very effective in reducing the portfolio’s style risk.” i guess the disadvantage comes from diminishing active return as it approaches benchmark
Why would the manager’s portfolio be even benchmarked to the Russell 2000 in this case? I would think this benchmark would violate the the definition of a valid benchmark because you are using for micro crap, which is not appropriate. Doesn’t this make the concept of misfit risk/return moot? Please enlighten.
L3BeatIt Wrote: ------------------------------------------------------- > Why would the manager’s portfolio be even > benchmarked to the Russell 2000 in this case? I > would think this benchmark would violate the the > definition of a valid benchmark because you are > using for micro crap, which is not appropriate. > Doesn’t this make the concept of misfit > risk/return moot? Please enlighten. I think sometimes a manager uses a more widely known and accepted benchmark as opposed to creating a new more appropriate benchmark by which to judge their performance.
L3BeatIt Wrote: ------------------------------------------------------- > Why would the manager’s portfolio be even > benchmarked to the Russell 2000 in this case? I > would think this benchmark would violate the the > definition of a valid benchmark because you are > using for micro crap, which is not appropriate. > Doesn’t this make the concept of misfit > risk/return moot? Please enlighten. The benchmark might also be for the entire pension plan (russell would be a bad example here) that has many managers.
good thread. Thanks MWVT and Olfy.
- i always remember “misfit” return = “style” return. Just think of an actuary in a star treck suit: misfit -v- style… If a micro cap manager goes and buys the micro cap index then plays golf all day he should get no credit for the “style return” (= micro cap BM less broad market index) coz he did nothing except play golf. The True return is when he beats the micro cap index with micro cap stock-picking - that’s skill and he should get paid for that only.
I have come up with another way of looking at this: Lets assume that the Total active return for an investment in mid-cap stocks is 20% (gone are those days, but still) Lets assume that the return on a broad benchmark (index) is 10% That gives an excess return (alpha) of 10% on the investment Lets also assume that the return on a more relevant benchmark (mid-cap index) is 15% Compared to the more relevant benchmark, the excess return (true active return) is 5% The misfit active return here is the Mid-cap index return - Broad benchmark return (15%-10% = 5%). Please give inputs if this thinking is flawed, or if you have questions.
I have a q regarding total risk. Is there any chance that this calculation can show up on the exam?? worth practicing ?
The question (or part of the question) could be where you have to calculate the true information ratio for which you will need the true active risk and true active return. These might not be given directly, but may have to be derived from total active return and risk (Which is fairly straightforward). For me understanding this in a calculation form was necessary to understand the underlying concepts.
Point well taken. I will practice then.