Chartered Financial Analyst (CFA) Practice Exam Level 2

The Fundamental Law of Active Management can be expressed by which equation?

1. IR = IC + Breadth

2. IR = IC × Breadth

3. IR = IC - Breadth

4. IR = IC / Breadth

The correct answer is: IR = IC × Breadth

The Fundamental Law of Active Management describes how portfolio managers can generate excess returns over a benchmark. It is articulated through the equation that states the information ratio (IR) is equal to the product of the information coefficient (IC) and the breadth of the strategy. The information coefficient measures the skill of the manager in generating excess returns, indicating how well they can predict the outperforming or underperforming assets. Breadth, on the other hand, represents the number of independent investment decisions over a period. Therefore, when evaluating a portfolio manager's performance, a higher IC indicates better forecasting ability, while greater breadth suggests more opportunities to apply that forecasting ability effectively. By multiplying these two elements, we arrive at the information ratio, which provides a comprehensive view of the manager's potential to outperform the market. This establishes that both the quality of predictions and the number of independent decisions significantly contribute to the excess returns achieved by an active manager. In summary, the equation capturing this relationship demonstrates that the more skilled a manager is (higher IC) and the more opportunities they have to exploit that skill (higher breadth), the greater the potential for excess returns, which is precisely what the Fundamental Law of Active Management aims to convey.