Analysis of Active Portfolio Management

Correct Answer: The manager's ability to generate alpha relative to the benchmark

The most important consideration when evaluating the performance of an active portfolio manager is their ability to generate alpha relative to the benchmark. Alpha represents the excess return a manager generates above the benchmark return, adjusting for the level of risk taken. A skilled active manager should be able to consistently outperform the benchmark on a risk-adjusted basis. The overall return of the portfolio, while important, does not provide insight into the manager's skill if it is not compared to an appropriate benchmark. A high absolute return during a strong bull market, for example, does not necessarily indicate a skilled manager. Closely tracking the benchmark with minimal deviation suggests a more passive approach and does not justify the higher fees typically charged by active managers. Investors expect active managers to deviate from the benchmark in an attempt to generate superior returns.

Correct Answer: Information Ratio

The most appropriate measure to assess the risk-adjusted performance of the fund relative to its benchmark is the Information Ratio. The Information Ratio measures the excess return of a fund relative to its benchmark, adjusted for the tracking error. It is calculated as the difference between the fund's return and the benchmark's return, divided by the tracking error. In this case, the fund has an annualized return of 10% and the benchmark has an annualized return of 8%. The tracking error, which measures the volatility of the fund's excess returns relative to the benchmark, is given as 3%. The Sharpe Ratio is not the most appropriate measure because it considers the total risk (both systematic and unsystematic) of the fund, rather than its performance relative to the benchmark. The Treynor Ratio is also not the most appropriate measure because it considers only the systematic risk (beta) of the fund, ignoring the specific risk component captured by the tracking error.

Correct Answer: Increasing the number of independent investment decisions with positive expected returns

Increasing the number of independent investment decisions with positive expected returns is most likely to have a positive impact on the information ratio of an active portfolio manager. The information ratio measures the risk-adjusted return of a portfolio relative to a benchmark. It is calculated as the excess return of the portfolio over the benchmark divided by the tracking error. A higher information ratio indicates better risk-adjusted performance. By making more independent investment decisions with positive expected returns, the manager can potentially increase the portfolio's excess return while diversifying the sources of risk. This should improve the information ratio. Reducing the correlation between the manager's decisions and market movements can also be beneficial, but it is not as direct as increasing the number of positive expected return decisions. Decreasing the tracking error while maintaining the same excess return would improve the information ratio. However, the question asks for the most likely positive impact, which points to increasing the number of independent positive expected return decisions.