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Subject 5. Practical Limitations PDF Download
The fundamental law of active management has its limitations.

Ex Ante Measurement of Skill

The fundamental law does not account for the uncertainty in the information coefficient, a core element in the equation. It is hard to accurately assess level of skill. Neither does the fundamental law consider the likelihood that the information coefficient changes over time and could be different for different asset segments.

Independence of Investment Decisions

Breadth is conceptually defined as the number of independent decisions by a manager. It is equal to the number of individual assets if:

  • the active returns between individual assets are uncorrelated AND
  • forecasts are independent from period to period.

If these constraints are violated, the breadth will be different from the number of individual assets. Analysts need to understand how to correctly measure breadth when there is cross-sectional dependence and/or time-series dependence.

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