Subject 3. The active manager's objective
Objective: maximize the value added from residual return, where value added is measured as:
where λR = aversion to residual risk. It transforms residual variance into a loss in alpha.
The loss in alpha increases as:
- The residual risk (i.e. ω2P) increases.
- The level of residual risk aversion (i.e. λR) increases.
The value added is also referred to as the certainty equivalent return.
Practice Question 1The loss in alpha increases if ______ increases.
I. information ratio.
II. residual risk.
III. level of residual risk aversion.
Practice Question 2The active manager's objective is to maximize the:
A. residual return.
B. information ratio.
C. value added.
Practice Question 3An λ of 0.15 usually means ______ level of residual risk aversion.
Practice Question 4The three parallel constant value added lines shown in the reading (figure 4) assume we have a constant:
A. value added.
B. aversion to residual risk.
C. loss in alpha.
Study notes from a previous year's CFA exam:
c. explain the objective of active management in terms of value added;