Investment Theory and Risk Management, + Website

Summary

I introduced active management somewhat obliquely in Chapter 7 with the concept of managing to a benchmark. Active management is important to understand because virtually all managers manage relative to a bogey, that is, some notion of an opportunity cost embodied by a passive portfolio. Since investors have the option of investing in the passive benchmark, then the decision to invest with a manager who departs from that benchmark (a necessary condition for investors not holding the benchmark) is implicit confidence that the manager can beat the benchmark on a risk-adjusted basis net of fees. This chapter outlines how active management changes the objective function in the solution to the optimal mean-variance efficient portfolio, how the notion of risk is transformed to tracking error, returns to the notion of risk-adjusted alpha, and the decomposition of risk in active space.