The Impact of Constraints on Value-Added

Abstract

While cynics view investment constraints as a lawyers' way of managing risk or simply as a manifestation of the risk management of the 1950s when no computers and risk models were available, other observers regard constraints as a worst case safeguard against a breakdown in risk management practices and a practical reality of peer risk in institutional investing. A closer look at the costs of constraints suggests a new methodology to measure the impact of individual constraints on an investor's value added. This approach differs from current methods that either focus on a headline measure of information ratio shrinkage (also called transfer coefficient) or express the impact of constraints as distortions in implied alphas.