The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

KEY POINTS

• The decision as to whether to pursue an active or passive strategy depends on the view of the price efficiency of the market. A price efficient market is one where security prices at all times fully reflect all available information that is relevant to their valuation. The distinction between the three forms of pricing efficiency—weak form, semistrong form, and strong form—rests in the relevant information that is believed to be embodied in the price of the security at all times.

• Active strategies are those that seek to outperform the market based on the belief that there are abnormal returns due to the existence of some pricing inefficiencies. Investors who believe that the market prices stocks efficiently and that active management will not generate abnormal returns will pursue a passive strategy, the most popular passive strategy being indexing.

• Tracking error measures the dispersion of a portfolio’s returns relative to the benchmark’s returns. That is, tracking error is the standard deviation of the portfolio’s active return where active return is the difference between the portfolio return and the benchmark return. Backward-tracking error is calculated from historical active returns; forward-tracking error is computed using the portfolio’s current holdings based on a statistical model developed using historical tracking error.

• The information ratio is a reward-to-risk ratio where the numerator is the average active return (alpha) and denominator is the ...