Aurora Borealis
1 March 2008 Financial Analysts Journal Volume 64, Issue 2

Forecasting Fund Manager Alphas: The Impossible Just Takes Longer

  1. M. Barton Waring
  2. Sunder R. Ramkumar

Expected alpha from active fund managers can be forecasted — as long as one is mindful of the rules of the zero-sum game of investing. Explicit forecasts are preferred over implicit forecasts because sponsors can use explicit forecasts to build optimized portfolios of managers with improved manager weighting. To make explicit alpha forecasts, the investor combines two equations derived from the fundamental law of active management. The elemental variables for the equations are the sponsor’s estimate of the manager’s “goodness” at beating the manager’s benchmark, the sponsor’s assessment of the sponsor’s skill in estimating manager ability, the cross-sectional standard deviation of manager skill, portfolio breadth, implementation efficiency, expected active risk of the portfolio, and fees.

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