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Subject 5. Value added: risk-adjusted residual return
The optimal portfolio P* lies at the point where the residual frontier is tangent to the preference line.
This implies that the ability of the manager to add value increases as:
- The square of the IR increases. In fact, the key to active management is the information ratio.
- The manager's risk aversion level decreases.
Given our risk aversion level, we all want the investment manager with the highest IR.
Practice Question 1In seeking maximum value added, different investors will differ in:
A. IR: how high the information ratio to take.
B. λ: how aggressive of the investment strategy.
C. ω: how much residual risk to take.
They all seek the manager with the highest IR. A and B will determine the optimal level of residual risk to take.
Practice Question 2The value added by a very good manager (IR = 0.75) with a conservative implementation (λ = 0.15) is:
0.752/(4 x 0.15) = 0.9375%.
Practice Question 3The key to active management is the:
A. IR: information ratio.
B. λ: risk aversion level.
C. ω: residual risk level.Correct Answer: A
The value added is determined by IR and λ. The IR has a bigger impact on the value added.
Practice Question 4The value added by a very good manager (IR = 0.75) with an aggressive implementation (λ = 0.05)is:
C. 3.75%.Correct Answer: A
0.752/(4 x 0.05) = 2.8125%.
Study notes from a previous year's CFA exam:
5. Value added: risk-adjusted residual return