Integrating the Building Blocks: Breadth of Expertise
A manager may be more or less successful at combining these three sources of return into a portfolio. Success is a function of a manager’s breadth of expertise. Broader expertise may increase the manager’s likelihood of generating consistent, positive active returns.
IC = Expected information coefficient of the manager—the extent to which a manager’s forecasted active returns correspond to the managers realized active returns
BR = Breadth– the number of truly independent decisions made each year
TC = Transfer Coeffficient– the ability to translate portfolio insights into investment decisions without constraint (a truly unconstrained portfolio would have a transfer coefficient of 1)
σRA = the manager’s active risk (the volatility of active returns)
This equation clearly shows that there is a direct link between breadth and expected outperformance—a larger number of independent decisions (higher breadth) should lead to higher active return.
A manager who considers a single factor defined by a single metric is unlikely to be making truly independent decisions, because all investment decisions are being driven by the same dimension, and therefore, are likely to have low breadth.
A manager who uses multiple factors and multiple metrics for each factor is likely to make more independent decisions when constructing their portfolio, and hence, have higher breadth.