Skip to content

FRM Part II · FRM Exam Part II · Portfolio Construction

A manager has IC of 0.06 and 64 independent bets, and the benchmark-relative target is an active risk of 5%. Using the basic fundamental law and the assumption that the manager scales active risk to target, what expected alpha results, and what happens if the manager's 64 bets turn out to be only 16 effectively independent bets due to correlated positions?

Expected alpha is 2.4%, falling to 1.2%. IR is 0.06 times the square root of 64, or 0.48, and multiplying by 5% active risk gives 2.4%. With only 16 effective independent bets, IR is 0.24 and alpha is 1.2%, since alpha moves with the square root of breadth.

  1. AAlpha 2.4%; falls to 1.2%Correct
  2. BAlpha 2.4%; falls to 0.6%
  3. CAlpha 1.2%; falls to 0.6%
  4. DAlpha 3.0%; falls to 1.5%

Explanation

IR = 0.06 x sqrt(64) = 0.48; alpha = IR x active risk = 0.48 x 5% = 2.4%. With effective breadth 16, IR = 0.06 x 4 = 0.24, so alpha = 0.24 x 5% = 1.2%. Breadth falls by 4x but alpha by only 2x because of the square root; the 0.6% option assumes linear scaling.

Did you get it right without looking?

One question tells you little. A timed set on Portfolio Construction shows your real accuracy, how long you take and where you lose marks.

Practise Portfolio ConstructionFree diagnostic mock

More Portfolio Construction questions