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.The information coefficient (IC), which is the correlation between forecasted and realized return, is a popular measure of signal quality. The signal quality for active managers tends to vary over time because market inefficiencies are always evolving. I show that variation in signal quality affects performance and that it exerts its impact through risk. The original fundamental law of active management states that the information ratio (IR) is equal to the IC multiplied by the square root of breadth (which is defined as the number of active decisions taken per year). According to the fundamental law, signal quality determines the expected return of an active strategy, so when signal quality varies from one period to the next, the expected return also fluctuates. Active risk arises not only from portfolio holdings’ return variations but also from variation in signal quality. The analysis presented here leads to a generalized fundamental law of active management stating that the performance of active strategies is determined not only by breadth and signal quality but also by variation in signal quality and by constraints.The analysis in this article sheds light on how managers can select optimal portfolio structures that are suitable to their forecasting skills. Intuitively, the right skew in stock returns causes a difference in distribution between the overweighted and the underweighted segments of active portfolios. If these two segments have the same amount of active risk, the overweighted segment will have a higher IR than the underweighted segment. Therefore, to achieve an optimal allocation of risk, a manager should allocate more risk to the overweighted segment than to the underweighted segment—and even more so when signal quality is unstable. The analysis suggests that the long-only constraint, which causes a disproportionately large amount of risk to be allocated to the overweighted segment of a portfolio, may be desirable for managers whose signal quality is unstable.The analysis has an important implication for the application of short-extension strategies. The ideal amount of short extension depends on how stable the signal quality is. Simulation results show that managers who can maintain a stable IC over time will benefit from the efficiency gains of short extensions but managers with unstable ICs may see their performance deteriorate as they take more short positions.