Can someone explain to me in layman terms why this is wrong using the IR=IC*SQRT(Breadth) formula?
*bump*
If you’re using a long only strategy, the IR is constrained by the IC. No matter how much you double the active risk, which is the (Breadth) in the formula, the IC will shrink it by X%. Think of it as diminishing returns.
Example:
Case 1 - IC = 0.8, BR = 50.
IR= 0.8*SQRT 50…equals 5.65
Case 2 - IC =0.8, BR =100
IR= 0.8*SQRT 100…equals 8.
We have doubled BR (the measure for active risk) but the IR has not doubled because it is constrained by the IC.
Hope that helps. I did CFA EOC qs on equities earlier, and one of the qs has a good explanation of this.
I looked up the question in the CFA EOC. In their example IC drops, whereas Breadth remains constant. They argue that IC goes down because this is a long only strategy wherein less of the manager’s insight is captured (i.e. he cannot go lower than a 0% weighting).
Given this is a long only constraint, how will a long short strategy behave? Can double alpha be achieved for double risk in such portfolios?
Put it this way - lets say long/short enables you to have a completely unconstrained strategy. Therefore, IC would be 1 right?
The breadth is still constrained by the Square root function, so doubling it would not result in a doubled IR.
Even if you doubled your BR, you would be constrained by the Sq rt function.