The Dimensions of Active Management

Abstract

When one eliminates all the market factors that active managers deliver (and that are available almost for free through index funds), what remains is the pure alpha. The cost of seeking this alpha is that one is forced to take on active risk. The authors draw on these observations to argue that building portfolios of active managers is an optimization problem that may be solved separately from the asset mix optimization problem (because pure active risk is uncorrelated with policy risk). They suggest that portfolios constructed using this approach emphasize index and risk-controlled active funds, while giving lighter allocations to traditional active funds and almost none to highly concentrated funds. For investors who are allowed to sell short, market-neutral long-short funds also have a place in the optimal solution.

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