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FRM Part II · FRM Exam Part II · VaR and Risk Budgeting in Investment Management

Which of the following changes would, all else equal, most clearly reduce the information ratio implied by the Fundamental Law of Active Management?

A long-only constraint that lowers the transfer coefficient reduces the implied information ratio, because the manager cannot fully express forecasts in the portfolio. More independent bets or a higher information coefficient would each raise the information ratio instead.

  1. AIncreasing the number of independent investment decisions per year
  2. BImproving the correlation between forecasted and realized residual returns
  3. CImposing a long-only constraint that lowers the transfer coefficientCorrect
  4. DAdding forecasts that are uncorrelated with existing ones

Explanation

Constraints such as long-only reduce the transfer coefficient, meaning forecasts are not fully translated into portfolio positions, which lowers realized IR. The other options raise IC or breadth and so raise IR.

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