Reading 31: Equity Portfolio Management－LOS s

The decomposition of the total active performance into true and misfit components is useful for optimization. The objective is maximize the total active return for a given level of total active risk, while still allowing for an optimal amount of misfit risk. Note that misfit risk is not optimized at zero because a manager may be able to generate a level of true active return for some level of misfit risk. In other words, if you let the manager specialize in the style they are familiar with, the manager is more likely to generate excess returns relative to their normal portfolio.

Whenever the managers portfolio diverges significantly from the investors portfolio, there will be misfit risk. An investors portfolio is one that the investor uses to evaluate the manager and may not be appropriate for their style. The investors portfolio is usually a broad market benchmark for that asset class. By design, the completeness fund results in a reduction of misfit risk. The indexed and enhanced indexed portfolios will have small misfit risk. The portfolio generated using a core-satellite approach will have the highest misfit risk because the satellite portfolios allow for specialized manager styles.