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Turnover-Adjusted Information Ratio

Author

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  • Feng Zhang
  • Xi Wang
  • Honggao Cao

Abstract

In this paper, we study the behavior of information ratio (IR) as determined by the fundamental law of active investment management. We extend the classic relationship between IR and its two determinants (i.e., information coefficient and investment "breadth") by explicitly and simultaneously taking into account the volatility of IC and the cost from portfolio turnover. Through mathematical derivations and simulations, we show that - for both mean-variance and quintile portfolios - a turnover-adjusted IR is always lower than an IR that ignores the cost from turnover; more importantly, we find that, contrary to the implication from the fundamental low but consistent with available empirical evidence, investment managers may improve their investment performance or IR by limiting/optimizing trade or portfolio turnover.

Suggested Citation

  • Feng Zhang & Xi Wang & Honggao Cao, 2021. "Turnover-Adjusted Information Ratio," Papers 2105.10306, arXiv.org.
    • Handle: RePEc:arx:papers:2105.10306
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    References listed on IDEAS

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    2. Herskovic, Bernard & Kelly, Bryan & Lustig, Hanno & Van Nieuwerburgh, Stijn, 2016. "The common factor in idiosyncratic volatility: Quantitative asset pricing implications," Journal of Financial Economics, Elsevier, vol. 119(2), pages 249-283.
    3. Ding, Zhuanxin & Martin, R. Douglas, 2017. "The fundamental law of active management: Redux," Journal of Empirical Finance, Elsevier, vol. 43(C), pages 91-114.
    4. Vermaat, M.B. & van der Meulen, F.H. & Does, R.J.M.M., 2008. "Asymptotic behavior of the variance of the EWMA statistic for autoregressive processes," Statistics & Probability Letters, Elsevier, vol. 78(12), pages 1673-1682, September.
    5. Zhuanxin Ding & R. Douglas Martin & Chaojun Yang, 2020. "Portfolio turnover when IC is time-varying," Journal of Asset Management, Palgrave Macmillan, vol. 21(7), pages 609-622, December.
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