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FRM Part II · FRM Exam Part II · Portfolio Construction

A manager claims breadth of 50 stock picks per year, but the picks are driven largely by one common macro view, so the forecasts are highly correlated. What is the correct implication for the Fundamental Law?

Effective breadth is lower than 50, so the information ratio will fall short of what IC times the square root of 50 implies. The law counts only independent bets, and correlated forecasts based on one macro view duplicate information.

  1. ABreadth is understated, so IR will be higher than IC x sqrt(50)
  2. BThe correlation raises the information coefficient, leaving IR unchanged
  3. CCorrelation is irrelevant because breadth counts the number of positions held
  4. DEffective breadth is below 50, so the IR will be lower than IC x sqrt(50) impliesCorrect

Explanation

The Fundamental Law requires breadth to be the number of independent bets. Highly correlated forecasts duplicate information, so effective breadth is less than 50 and the expected IR is overstated by the naive formula. Counting positions rather than independent decisions is the error in the other options.

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