The Three Critical Ingredients to Adding Value

Abstract

The article starts with the observation that the relationship between a manager's level of skill and the actual value-added to a portfolio can be quite nebulous. Thus, while the ability to make good predictions should result in value-added returns, actual portfolio results are often only minimally correlated to the manager's skill level. In this article, we explain why this relationship can break down and provide a framework for quantifying the expected value-added of a constrained portfolio. The article focuses on the three distinct factors that contribute to investment performance-the manager's forecasting skill: his ability to predict excess returns; the manager's range of opportunities to apply his skill across securities and over time; and the flexibility provided to the manager to express his forecasting skill in a portfolio, which is constrained to some degree.