CFA Level II 2014 curriculum updates: Portfolio Management – Residual Risk and Return: the Information Ratio

For the 2014 CFA Level II curriculum, there are ten new readings that candidates need to cover. These will be of particular interest to repeating Level II candidates, as they contain new material that will need to be mastered over the coming months.

The changes are:

• Financial Reporting & Analysis: Intercorporate Investments, Multinational Operations and The Lessons We Learned have been rewritten
• Equity: two new readings have been added, Your Strategy Needs A Strategy and Industry and Company Analysis
• Alternative Investments: one new reading has been added, A Primer on Commodity Investing
• Fixed Income: the first chapter on credit analysis has been rewritten, now called Credit Analysis Models
• Derivatives: the last chapter on credit derivatives has been rewritten, now called Credit Default Swaps
• Portfolio Management: one chapter (Active Portfolio Management) has been replaced with two new chapters, Residual Risk and Return: The Information Ratio, and The Fundamental Law of Active Management.

We will review some of these readings to give you an introduction of what to expect.

Residual Risk and Return: The Information Ratio (Grinold & Kahn)

This reading begins fairly light-heartedly, though rapidly delves into the concepts of active management. Firstly, ignore market efficiency – if markets were truly efficient then (1) the chapter would be irrelevant, and (2) you wouldn’t be reading this or studying for your Level II CFA exam.

Managers have an ability relative to the market: some will be able to beat the benchmark index, some won’t. Alpha is defined as the mean residual return, and the information ratio (which you may already have seen) is stated as annualized residual return divided by annualized residual risk. This can be in two timeframes, ex post (how was it historically?) and ex ante (what do we expect?).

Fundamental to the chapter is the notion that a manager can achieve a certain IR, whether positive or negative, and this is considered pretty constant. The manager can invest in many portfolios with this IR: greater active weights will result in both higher alpha and higher residual risk, in the same proportions. Algebraically we can say that alpha = IR x residual risk. The residual frontier is a straight line showing the available portfolios, all with the same IR.

The concept of value added is defined: this is alpha minus residual risk squared times risk aversion. Hence VA increases if (1) alpha increases, (2) residual risk decreases, or (3) risk aversion decreases. An increase in residual risk offsets alpha, and this can be shown graphically as a parabolic curve. Other curves show “constant value added” lines. Although this may sound highly technical, a small amount of algebra and some succinct Quartic explanations will help to clarify.

We can now identify an investor’s optimal portfolio: take the manager’s residual frontier (using their IR) and the constant VA lines, and see where VA is maximised. The VA lines look very similar to the indifference curves you saw at Level I: in fact they are effectively the same thing.

Using the graphs, plus a bit of mostly harmless algebra, we have now identified an investor’s optimal portfolio. The grand conclusion of this reading (well, the examinable part of the reading) is that an investor will choose the manager with the highest information ratio – regardless of the investor’s level of risk aversion.

The reading is pretty short, just 17 pages in the curriculum, but there is scope for a full item set within it. Be prepared!