Active Portfolio Management Series
The Fundamental Law of
Active Management: Let’s
Make it Simple
Since its appearance Grinold’s Fundamental
Law of Active Management has attracted a lot
of interest from academic and researchers.
Many efforts has been invested in developing
the full econometric presentation of the law.
But in its genesis the law was developed as an
intuition, as a simple direction for small
individual investors. In this paper we would
like to be as simple as it could be. We try to
apply the Fundamental law as an intuition for
individual investors. Usually individual
investors “feel” which stock is good for
investment. The Law is just a tool which is
used for convincing them in their decisions.
Here we present the Fundamental law in its
simplest form and its simplest application –
without difficult calculations, without strong
econometric instruments.
1. The role of E ( )
Active management is entirely based on
the concept of expected alpha. If a portfolio
manager or investor is able to determine the
expected E ( ) he will be able to construct an
active portfolio. Therefore, the preparation of
E ( ) is a core of active management.
Active management assumes that the sum
of all assets alphas is zero. This means that
one part of the assets would have expected
positive E ( ) and another part of the assets -
negative alpha. Investors will seek to find
those assets that are positive, to expand
investment in them. Also, investors will seek
to find those assets where the alpha is
negative to limit their investments in these
assets or to invest short in them.
If for all assets E ( i )  0 , then the
investors have no reason to increase or limit
investment. Therefore, in such case the
investors should invest fully in the
benchmark portfolio. Thus they will apply
only passive portfolio management. However,
if the calculated alphas for individual assets
are different from zero ( E ( i )  0 ), then the
active portfolio management could be applied
intensively. Investors should increase the
proportion of those assets in the portfolio,
which alphas are positive and have to reduce
the weight of assets, which alphas are
negative. As a result, the investors will
construct a portfolio that differs from the
reference.
2. Elements of E ( )
The fundamental law of active management
can be described with (1.)
(1.) E( i )  i .IC j .Zi
where
E ( i ) expected alpha
 i - active risk of stock i
IC j . - information coefficient of j-investor
(portfolio manager)
Z i - Scoring of stock i
2.1. Active risk  i
From a mathematical point of view,
the presence of  i is essential because this
indicator defines the unit of measurement.
Practically the other two elements in (1.) -
respectively IC, and Z, are coefficients. These
coefficients are correcting  i which is in
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 Active Portfolio Management Series
percentage terms. This means that as a result
the alpha is expressed in percentage (we have
situation: percent -  i corrected by a
coefficient IC, corrected by coefficient Z).
According to (1.), high alpha is possible to
get assets with high active risk  i . If  i is high,
then E ( ) is high also. It's a little strange
conclusion. Always in investment area the
high risk is associated with high uncertainty,
therefore bigger problems for the investors.
But here we have a manifestation of the
strangeness of active portfolio management,
expressed in (1.). According to the logic of
active management, assets whose active risk
is high should be regarded as a preferable
candidate for investment. This is
understandable: only assets that have a large
deviation from their equilibrium yield could
be used to provide an additional (active)
returns. Assets whose profitability is always
close to equilibrium are interested only for
passive investment. But active investors seek
to find those assets that only they "know" that
will achieve returns other than equilibrium.
2.2. Information coefficient IC
Information coefficient is based on
intuitive understanding of economic indicator.
It measures the ability of the investors to
predict the future state of the analyzed
variables. Mathematically we can present IC
as a correlation between expected alpha and
realized alpha, but this formula is more
theoretical than providing practical economic
meaning. It is hard to collect such data base
for the ability of the investor to forecast future
returns.
IC depends on personal characteristics of
the investors. These characteristics include
intelligence, knowledge, experience, training
and more. These are characteristics which
cannot easily be changed. That is why often
in the literature the authors assume constant
IC.
IC depend on market conditions. If the
market is efficient enough, each information
is already included in the price of assets and
serves to determine the equilibrium price.
There is no other source of information that
lead to changes in prices and therefore cannot
become a predictor. In this situation, even
intelligent, knowledgeable, experienced and
trained investor, as claimed by Thomas (2000)
was not able to have the ability to forecast. As
the market is imperfect, the IC of an investor
might be higher.
According to (1.) high alpha can be created
by an investor with high IC. Investor without
the ability to predict the future (i.e. IC = 0) will
not be able to create additional income. On
the other hand, the higher IC is not sufficient
to create high alpha. If return, which assets
provide is always equal to the equilibrium, the
skill of the investor to forecast cannot create
additional income. Under these conditions,
that the investor has the ability to select those
assets that will perform well in the future
cannot be fruitful. If the investor will select
one or other asset is not essential because
both will ensure return, which everyone
expects - equilibrium. High IC makes sense
only if there are assets whose returns deviate
from equilibrium (i.e., assets with higher  i ).
Then the skill of the investor to predict is
essential for the selection only those assets
which will realize higher returns.
2.3. Scoring Z
The scoring is that peculiar element in
formula (1.), which makes it strange in the
eyes of investors accustomed to heavy
econometric models, but along with that
makes the active management highly
attractive for the investors.
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The scoring is standardized measure of
subjective preference of the investors to the
object of forecasting. This kind of techniques
are very popular in our everyday life. In our
life we often have to give a quantitative
estimate of one kind and another objects.
It should be emphasized that the scoring
is standardized measure. Standardizing is
expressed in the fact that its average is 0 and
the standard deviation is 1, as noted in (2.)
(2.) Z  0 и  Z 1
According to (2.) the scoring has average
value 0. Therefore, if we valuate the group of
assets it means our preference for all them as
a group is indifferent. But to some of them we
manifest bias and evaluate them positively,
compared to others – we are negative biased
and evaluate them with negative values.
Along with this, the scoring should be
distributed between the shares so as to have
a standard deviation 1.
According to (1.), high E ( ) can be
created from those assets that are ranked
with high scoring by the investor. High
scoring, however, is not sufficient to be able
to realize high alpha. The high scoring means
From the signal f i investor have to extract
the information and to convert it into a
forecast R i . This process can be done by
several very complicated econometric
methods but also very simple methods could
that the investors "like" the asset and
evaluate it at the forefront compared to other
assets. But if this asset cannot create an
active income, i.e. additional return above the
expected equilibrium value (which means low
 ), then it is not possible to set high E ( ) .
Conversely, assets with high  can create
E ( ) only if they are positively assessed by
the investor with high Z. And let’s not forget,
this can only be done by an investor which IC
is high.
In no case should the scoring be mixed
with E ( ) . In fact, E ( ) is results from the
scoring turned into rate of return. Also, not to
be mixed concept of scoring and IC. IC
presents the ability to predict, i.e. how the
individual forecast will be manifested itself in
reality. While the concept of scoring is the
investor’s evaluation of the asset and the
investor’s expectation of how this asset will
perform in the forecasted period.
3. Fundamental law and information
process
The main idea of the Fundamental law is to
extract forecast form available information.
The information process can be described by
the following process:
be applied. The simplest way to apply the
information process is by fitting normal
regression – (3.)
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(3.) Ri ( f )  bf   i 4. Application of information process

to generate E ( ) for Taiwanese
companies
And in order to minimize expected error (3.)
can be rewrite as (4.)
Our purpose is to use the information from
stocks rating provided by investment
consultant which are publicly available. We
covr , f
(4.) R ( f )  E (r )  f  E ( f ) assume that this is the only signal we can use
 2f for return forecast. This assumptions is not
unreal. If one investor is completely unaware
with strong econometric models one very
The equation (4.) is in fact the other form of reasonable strategy is to coordinate his/her
the Fundamental law. Just have to present it investment decisions with recommendations
in other way –(5). of top analyst.

In order to make the model simple we do not

apply original approach for alpha as active
covri , fi
Ri ( f i )  E (ri )   f i  E ( f i )  return – return deviation from the benchmark
 2f i
return. For such approach it is necessary to
choose the “right” benchmark – some other
r , f  r  f
(5.)  E (ri )  i i
 f i  E ( f i ) 
i i
portfolio which serves as a standard for
 2f i investor’s investment. As this gives additional
 E (ri )   ri , fi  ri
 f i  E ( f i ) complication and instability of the process.
f i
We keep the process as simple as it could be.

Based entirely on analysts’ recommendation

and without benchmark we can apply the
The last form of equation (5.) gives us direct Fundamental law for this very simple source
link to the Fundamental law. The element of information – investing rating of the
 ri , fi fully corresponds with IC. It presents the companies. Then (6.) can be presented again
in (7.)
investor’s ability to transfer signal f into stock
return. The second element of (5.) is the stock
volatility  ri . And the third element is the
covr , f
standardized score Z. So, by this (5.) can be (7.) Ri ( f i )  E (ri )   f i  E ( f i )
rewrite as (6.)
 2f

(7a.) if E (ri )  0

(6.) Ri ( f i )  E(ri )  ICi . ri .Zi

(7b.) E ( i )  IC i . ri .Z i   ri fi  ri
 f i  E ( f i )
 2f

This form presents the idea of Fundamental

law.

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 Active Portfolio Management Series
(7a) stands for additional simplification. If we
assume that the investors do not based their
decisions on other information that
We apply the simple variant of information
process to calculate expected alpha for the
stocks of the 10 biggest Taiwanese companies.
Our approach is based on several principles:
1. We try to make the process as simple
as possible. We believe that academic
models should be developed in such
way to assist the ordinary individual
investors. Usually these investors are
nor armed with high-level statistical
tools for taking decisions
2. We try to keep the process close to
investment intuition. Usually the
academic models apply such deep
quantitative models that sometimes
the result cannot be understood by the
manager itself. This leads to gap
between the results and investor’s
intuition. The models gives some
results, investor does not believe in
these results or cannot understand
how they have been achieved.
3. We try to use as input only highly
accessible public information.
4. We try not to apply complicated
calculation tools.
Yahoo Finance web site is used as the only
source of information. There is nothing
special in this site neither we think it is the
best source of information. It is just one
available source of information among others.
We use very few items from this site: historical
stock prices for last year, recommendation
rating and earnings history. We downloaded
the basic information on the 1st of Feb 2017.
Calculation the volatility. The weekly data for
each stock close prices are used to calculate
the weekly return. Then from weekly return
we calculate standard deviation of each stock
and annualize it. I this way we obtain  ri . The
results are presented in column 2 of Tabl1.
Calculation the score. Actually in our case the
factor we use is the recommendation rating.
The rating system is established by Yahoo
Finance and it presents recommendations for
buy/sell from financial analysts. Strong buy
is marked as 1 and strong sell – as 5. We
assume that each stock has the same chance
to be marked from 1 to 5. This assumption
allows us to fulfill the requirement (2.). Of
course, the average score is 3, so, to convert
it to Z  0 it is just necessary to extract each
sore from the average score=3. The resultative
scores are presented in column 2 in Tabl.1.
Calculation the IC. In every attempt the
Fundamental law to be applied this has been
the most difficult part. Usually the authors
assume some level of IC around 0.1. Our
approach is much simpler, but fully reflects
the investor intuition. We use the information
provided by Yahoo Finance as Earning
estimated. They publish the following
indicator for the 4 previous quarters: EPS
estimated, EPS actual, difference between
them and surprise. We regard this
information as a representative of the ability
of analysts to predict the value of the
company. Whatever model of valuation they
use, the main indicator for their forecasts is
estimated EPS. If they miscalculated the
estimated EPS the estimated value of the
company will be miscalculated and their
recommendation for buy/sell will be not
correct. That is exactly what we think it must
be IC. For each quarter we calculate the
estimated value of the stock by applying the
simplest valuation:
EPS est
Vest 
P/E
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Then we calculate the actual value: Vest  Vactual

(8.) average
Vactual

EPS actual
Vactual 
P/E
The positive or negative side of the diversion
is not important but the absolute value of (8.).
We calculate the average percent of diversion
The difference between estimated value and
for the last 4 quarters (or as many as there is
actual value gives us the information how
available information). This percent we
much the analyst’s evaluation diverse from
subtract from 100 and this gives us ability of
the actual value. This difference as a percent
the analysts to forecast correctly and to
of the Vactual we assume as an indication of IC: produce correct recommendation. We take
this variable as IC i and it is presented in
column 6 in exhibit 1.

Exhibit 1. Input information for the 10 biggest Taiwanese companies

Company Recommendation rating Volatility  r P/E ratio

i

Hon Hai Precision 2.1 0.22 10.94

Taiwan Semiconductor 2.7 0.19 17.84
Fubon Financial 2.2 0.21 14.14
Quanta Computer 2.6 0.24 15.22
Cathay Financial 2.9 0.22 19.32
Chunghwa Telecom 2.8 0.11 18.96
Formosa Petrochemical 3.5 0.25 15.20
Mega Financial Holding 2.1 0.16 12.37
AsusTek Computer 2.2 0.18 11.87
China Steel 3.0 0.24 31.53

Exhitbit 2. Generated alphas for the 10 biggest Taiwanese companies

Company ICi Volatility Standardized rating Zi Generated alpha i

r i

Hon Hai Precision 0.75 0.22 0.9 0.15

Taiwan Semiconductor 0.97 0.19 0.3 0.06
Fubon Financial 0.50 0.21 0.8 0.09
Quanta Computer 0.55 0.24 0.4 0.05
Cathay Financial 0.22 0.22 0.1 0.005
Chunghwa Telecom 0.84 0.11 0.2 0.02
Formosa Petrochemical 0.16 0.25 -0.5 -0.02
Mega Financial Holding 0.82 0.16 0.9 0.12
AsusTek Computer 0.52 0.18 0.8 0.07
China Steel 0.76 0.24 0.0 0.00

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The final result for generated alpha is here is the aquarium expected return which
calculated by the model (7b.). The results are in our case is assumed to be 0.
presented in column 5 of exhibit 2.

Comments on alpha.
References
First, we have to emphasize that our model,
1. Clarke, R., H.de Silva and B. Wander. Risk
according (7b.) involves E (ri )  0 . That means
Allocation versus Asset Allocation, Journal
that we do not model the stochastic process of Portfolio Management, fall 2002, pp.9-
of return. In other words, these expected 30
alphas are generated based only on one factor 2. Clarke, R., H.de Silva and St. Thorley.
– the recommendation ratings. Because of Portfolio Constrains and Fundamental
that the value of alphas are too high Law of Active Management, Financial
comparing to other studies. Analysts Journal, September/October
Second, the highest alpha we derive for Hon 2002, pp.25-32
Hai Precision. This is company which has 3. Flood, E. Jr. and N. Ramachandran.
been rated by financial analysts higher Integrating Active and Passive
comparing to other companies. It volatility is Management, Journal of Portfolio
not the highest, neither it’s IC. For that Management, fall 2000, pp.10-19
company we can say that the tree elements 4. Grinold, R. Alpha is Volatility Times IC
consisting the Fundamental law are optimal. Times Score, Journal of Portfolio
Management, summer 1994, pp.9-16
Third, the consistence of the alpha –
percentage is given by the stock’s volatility.
The other two elements are only correctors to
that indicator. We may observe that
increasing in volatility decreases the IC. That
is consistent with the normal investment logic
– the less volatile stocks are more precise
evaluated (and as a result – higher IC could
be achieved by analysts).

Fourth, the alpha’s sign is given by the

scoring. In our sample only Formosa
Petrochemical has negative scoring,
indicating that analysts are oriented towards
sell recommendation. As a result – the alpha
is negative here.

Fifth, for the situation where the score is zero,

the alpha is also zero. When the analysts are
not neutral on the scale buy/sell then no
return can be expected. The only expectation

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