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Equity Portfolio Management 569ficient (IC) is a measure of the depth of an active manager’s skill. On a
more formal basis, IC measures the “correlation” between actual
returns and those predicted by the portfolio manager. According to the
fundamental law of active management, the information ratio also
depends on breadth (BR), which reflects the number of creative insights
or active investment opportunities available to the investment manager.
There are several interesting implications of the fundamental law of
active management. First, we see that the information ratio goes up when
manager skill level rises for a given number of independent insights or
active opportunities. This fact should be obvious, as a more skillful man-
ager should produce higher risk-adjusted returns, compared with a less
skilled manager whose performance is evaluated over the same set of
investment opportunities (possibly securities). Second, a prolific manager
with a large number of independent insights for a given skill level can, in
principle, produce a higher information ratio than a manager with the
same skill but a limited number of investment opportunities.
Equally important, the fundamental law of active management sug-
gests that a manager with a high skill level, but a limited set of opportu-
nities, may end up producing the same information ratio as a manager
having a relatively lower level of skill but more active opportunities.
According to Ronald Kahn,^10 a market timer with an uncanny ability to
predict the market may end up earning the same information ratio on
the average as a somewhat less skillful stock picker. This might happen
because the stock picker has numerous potentially mispriced securities
to evaluate, while the otherwise successful market timer may be con-
strained by the number of realistic market forecasts per year (due, per-
haps, to quarterly forecasting or macroeconomic data limitations).
Thus, the ability to profitably evaluate an investment opportunity (skill)
and the number of independent insights (breadth) is key to successful
active management.
With an understanding of the fundamental law of active manage-
ment, we can now look at the risk of failing to produce a given level of
active portfolio return. In this context, Bruce Jacobs and Kenneth Levy
suggest that even traditional equity managers face a portfolio manage-
ment dilemma involving a trade-off between the depth, or “goodness,”
of their equity management insights and the breadth or scope of their
equity management ideas.^11 According to Jacobs and Levy, the breadth
of active research conducted by equity managers is constrained in prac-
tical terms by the number of investment ideas (or securities) that can be(^10) See Kahn, “The Fundamental Law of Active Management.”
(^11) Jacobs and Levy, “Investment Management: An Architecture for the Equity Mar -
ket.”