Exploring the Dimensions of Active Management

Abstract

The level of active return, the volatility of active return, and the covariance structure of active return are three important dimensions of active management for understanding optimal portfolio structure. An optimal portfolio structure is highly sensitive to various assumptions about the covariance structure of active return; it varies with both the degree of diversification in active returns and the number of unique sources of active return. If the sources of active return are not diversified, investors should make a substantial allocation to risk-controlled active strategies. As there are more separate sources of active return or greater diversification among those sources, the optimal allocation to index strategies and risk-controlled active strategies may be lower.