The Case for Tactical Alpha, Part 2: The Fundamental Flaw of Grinold’s Fundamental Law

In Asset Allocation, Uncategorized on

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Reminder: Grinold’s Fundamental Law of Active Management is Fundamentally Flawed

In Part I of this series we explored Grinold’s Fundamental Law of Active Management and why we believe the theory leads to misguided conclusions in the presence of asset correlations. Recall that Grinold asserted that a manager’s information ratio (IR) is a function of both their skill in selecting attractive investments and the breadth of independent bets from which investments are drawn.

Unfortunately, Grinold makes the strong assumption that the individual securities in a stock picker’s universe represent independent bets.  But as most managers have constrained mandates, this is generally not the case.  Take, for example, a US Large Cap manager required to focus on stocks in the S&P 500.  Clearly, this cohort of securities does not represent 500 uncorrelated investment possibilities.  But there is a way to determine the amount of breadth in a given investment universe.

Here’s how we do it…read more