I may be wrong, but I don’t think that’s right. On the next page (221) it says that eliminating misfit risk is sub-optimal. This doesn’t make sense with the above as eliminating misfit risk (and return) would create a fairer information ratio.
No, I don’t think that’s right. You’re not comparing like with like in that case. Bob has taken a higher level of risk (investing in small caps) and therefore should be compared against a high risk index (small-cap index) instead of the general US market (which is lower risk).
As an investor (not as Bob/asset manager), no. You can’t just say “oh if I knew you’d be investing in smallcaps, I’d have set the benchmark as smallcaps”. That would violate a key principle of benchmark setting: it has to be set in advance. The manager’s skill is in identifying that this high-risk asset will outperform this year, and taking that risk.
Note there’s a very relevant distiction between Bob’s benchmark and yours as the investor. I’m talking about the investor benchmark here.
First of all, picking a style (and it’s benchmark) is not “skill” from the manager. And usually, the mandate is clearly specified in this matter. Now beating your benchmark is the skill level that you would be measured against. Even if you underperform the market.
In short, beating the market means nothing. Beating the benchmark, is the true active return (and risk), which is how you decide if this is a good manager or not.
