How Variation in Signal Quality Affects Performance

The information coefficient (IC), the correlation between forecasted and realized return, is a popular measure of signal quality. As shown in this article, variation in IC is an important source of active risk, and IC variation has an effect on optimal portfolio structure. Contrary to popular belief, the ability to take short positions in equity portfolios does not necessarily lead to superior performance. Managers who can maintain a stable IC over time will benefit from short extensions, but managers who have an unstable IC may see their performance deteriorate from increased short positions.