The Fundamental Law of Active Portfolio Management

The Fundamental Law of Active Portfolio Management is a postulate that states that the return from any investment strategy can be improved by adding an active management component to it. The law was first proposed in 1989 by Richard Grinold and Ronald Kahn and has been proven by decades of data. It was basically designed for assessing the value of active management, as expressed by the information ratio (IR), using only two variables. One variable is the “Skill” of the portfolio manager and another variable is the “Breadth”, or the number of independent investment opportunities.

So now let’s dig more into The Fundamental Law of Active Portfolio Management.

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What is the Fundamental Law of Active Portfolio Management

Let’s start with the definition:

The Fundamental Law Of Active Portfolio Management states that an investment approach can produce higher returns through a combination of two things. One component is active management and another component is the “breadth” or the number of independent bets placed on different opportunities.

The law basically shows that by adding more investments to a portfolio containing only a single investment, we can increase returns.

In a nutshell, the Fundamental Law of Active Portfolio Management states that by adding more bets to your portfolio you can get better performance.

The law also implies that higher performance is achievable with active portfolio management as opposed to passive investing. The question then arises if it’s possible to find investments that exhibit higher investment returns and demonstrate positive performance. The answer to this question is most certainly yes, but it’s a question of time and effort.

Picking the best investment portfolio requires hard work and research, but as with everything in life the rewards are proportional to your efforts.

How does The Fundamental Law of Active Portfolio Management work

Once you have identified the source of these opportunities then you can successfully implement the Fundamental Law of Active Portfolio Management.

The first step in implementing active management is the identification of the investment opportunities within one’s reach. The law offers some guidance for single manager investing, but it also works with a portfolio of several managers or a group effort.

Once you have identified these investment opportunities then you need to actively manage your portfolio by narrowing down your options to the best investment opportunities available.

In order to apply The Fundamental Law of Active Portfolio Management effectively then you need an accurate and realistic assessment of each portfolio manager’s skill or alpha:

Different styles have been developed that measure various elements of a manager’s performance. These include tracking error, risk-adjusted performance, absolute performance, and excess return.

The Fundamental Law of Active Portfolio Management states that the potential for achieving good portfolio performance is in direct proportion to the size or breadth of investment opportunities available as such an approach allows you to diversify your portfolio of investments, which results in eliminating negative investment returns from individual securities.

Benefits of The Fundamental Law of Active Portfolio Management

The Fundamental Law of Active Portfolio Management states that an investment approach can produce higher returns through a combination of two things. One component is active management and another component is the breadth or number of independent bets placed on different opportunities.

Let’s take a look at the Fundamental Law of Active Portfolio Management benefits:

  1. The potential for achieving good portfolio performance is in direct proportion to the size or breadth of investment opportunities available
  2. By adding more bets to your portfolio you can get better performance
  3. The Fundamental Law of Active Portfolio Management implies that higher performance is achievable with active portfolio management as opposed to passive investing
  4. The Fundamental Law of Active Portfolio Management states that it’s possible to find investments that exhibit higher investment returns and demonstrate positive performance
  5. Identifying the investment opportunities within one’s reach is the first step in implementing active management

Conclusion

The Fundamental Law of Active Portfolio Management can aid in the development and implementation of an investment portfolio that delivers higher investment returns than passive or simply diversified portfolios. It offers a useful guideline for all investors looking to achieve better investment performance through active investing.

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